A Rich Life

The Old Ideas on Saving & Investing Don't Work -- Here's What Does

“The ‘Experts’ Won’t Tell You This. Most of the ‘Experts’ in This Field Make Money Only When People Buy Stocks. So They Are Compromised. You Need to Become Personally Familiar With What the Academic Research Really Says, Not Just What the People Quoted as Experts in This Field SAY That It Says.”

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Set forth below is the text of an answer that I recently posted to a question (“When Will the Stock Market Crash Again?”) at the Quora site:

There are two popular schools of thought re market timing. One is that it is impossible to time the market effectively and a waste of effort to try. The other is that knowing when crashes are coming is so valuable that you just have to give the objective of predicting them your best possible shot.

I hold a third view, a view which I believe is strongly supported by the research of Yale University Economics Professor Robert Shiller and research (including one paper that I did most of the work on myself!) done over the past 32 years (and largely ignored so far!). That view holds that short-term timing (predicting when crashes will come with precision) really is impossible but that predicting in a general way when they will come (long-term timing) is highly doable and absolutely required for those seeking to hold any realistic hope of long-term investing success.

Shiller’s model uses valuations to make long-term predictions. Once prices go insanely high, we ALWAYS experience a wipe-out. There has never in 140 years of stock market history ever been an exception. But we CANNOT say with precision when the wipeout will come, only that it is on its way.

There is a wipe-out on its way today, according to the Shiller model. Thus, I think it makes sense to go with a low stock allocation today.

Now —

We may see stock prices double over the next year. If we see that, there are people who will complain that I was “wrong” in my advice.

I don’t see it that way. The way I look at it is that the RISK of a crash is high this year. Thus, we all should be going with low stock allocations. It doesn’t matter whether stocks actually crash this year or not. The risk is there. That’s what matters.

Those who stay in stocks and enjoy another run-up in prices will NOT get to keep the money. They will lose all those gains plus a lot more in the crash that will follow next year or the year after that. So what good do those gains do them? I invest for the long-term. I want gains I can keep. Investors have never earned permanent gains from stock purchases made when stock were selling at the sort of prices at which they are selling today.

The losses you will see if stocks continue to perform in the future anything at all as they have always performed in the past will be devastating. It is hard for people to get their heads around how much one wipeout in a lifetime can hold you back. You lose not only the dollar value taken from your portfolio, you also lose decades of compounding returns on those dollars. Stay heavily in stocks at a time like today and you could easily set your retirement back 10 years, according to the last 30 years of academic research.

The “experts” won’t tell you this. Most of the “experts” in this field make money only when people buy stocks. So they are compromised. You need to become personally familiar with what the academic research really says, not just what the people quoted as experts in this field SAY that it says. These are very, very, very different things, in my experience. The conventional wisdom in this field is dangerous stuff.

Rob

Director of Center for Health Law, Policy and Practice Scott Burris: “The Fact that Aggressive and Short-Term Market Timing Was Unproductive Did Not Mean That There Were Never Times That It Would Be Wealth-Maximizing to Get Out of the Market”

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I have been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Scott Burris, Director of the Center for Health Law, Policy and Practice at Temple University Law School,  sent me a response saying: “I found the piece interesting — what one would expect from a Temple grad. I read the Pfau paper. Good luck with your endeavors.”

I wrote back: “Thanks for your kind wishes!”

Scott replied:

“This is what I wrote to my investment advisor. Did I correctly understand the argument?

“The Pfau paper addresses a point that, in my casual observation of the market and investment strategy, had also occurred to me: that the fact that aggressive and short-term market timing was unproductive did not mean there were never times that it would be wealth-maximizing to get out of the market. The challenge, of course, was to figure out the moment. This piece tests the use of a ten year average of PE ratio, and finds results comparable to buy-and-hold when adjusted for risk. This approach seems particularly applicable to people hitting their sixties, for whom shorter-term risks matter more. It’s notable, for example, that someone who’d followed this approach for a few decades would have gone to t-bills in 2009 and so, if they were about to retire, would have been richer and happier in 2010-11 and would still likely have been back in stocks in time to get some of the recent appreciation. Finally, in an era of economic financialization and weak regulation, one might expect a return to our pre-1929 pattern of frequent boom and bust cycles, suggesting, again for the retiring person, more of the unfortunate short-term effects of volatility.”

I replied:

Scott:

Yes, you understand the point. All of the things you say in that paragraph are accurate.

My personal view is that there is an even broader implication. The root question here is: How are stock prices determined? The conventional view is that it is a day’s economic and political developments that determine whether prices go up or down and by how much. The Shiller/Pfau research shows that this conventional view cannot be accurate. If the conventional view were accurate, prices would follow a random walk in the long term, just as they do in the short term. The research shows that long-term prices are highly predictable. The really important question is — How can that be? How can we know years in advance what stock prices will be?

The answer is that investors hold two opposite ideas in their heads at the same time. We all have a Get Rich Quick urge. So we very much want to believe that temporary and crazy bull market prices are real. We also all have a Common Sense urge. The Common Sense urge tells us to reject the temporary and crazy bull market prices. We SUPPRESS the Common Sense urge for the length of the bull market. Eventually, though, the Common Sense urge strengthens enough to gain the upper hand. That’s when prices crash. Crashes make no logical sense. All price changes should be gradual if the market is responding to economic or political developments, which play out gradually over time. But emotional changes can be violent. Crashes make sense in a world in which the dominant influence on price changes is investor emotion.

This means that 80 percent of the research being produced today looks at the wrong things. Most investing research is numbers-oriented. If it is an understanding of investor emotion that determines success or failure, we need to be looking at all sorts of thing that today we ignore. For example, we shouldn’t be blaming the stock crash on our economic problems. It is our lack of understanding of how investing works that caused our economic problems. Trillions of dollars are tied up in the stock market. The stock market is part of the economy. To successfully manage the economy, we first need to permit ourselves to learn more about how stock investing works. The first step is acknowledging that we did not know it all before Shiller and Pfau did their research.

This turns everything we think we know about stock investing on its head. It’s because the implications are so far-reaching that people are reluctant to discuss this. But the news is good, not bad! It’s true that we got a lot wrong. But that just means that we have lots of room for improvement. We have ignored Shiller’s research for 30 years. Imagine where we would be in the computer technology field if we determined in 1981 that every advance possible had already been achieved and that no further advances would be permitted. That’s what we have done in the investing field. If we open up discussion on all the advances that we achieved intellectually over the past 30 years, we would see 30 years of knowledge advancement in a very short amount of time (and these are the best 30 years of knowledge advancement we have ever seen in this field).

It’s impossible to overstate the importance of this (presuming the insights are valid). Look at the risk chart Wade provides on Page 8 of his paper. The Portfolio Drawdown Percentage goes from 60 percent to 20 percent with the move from Buy-and-Hold to Valuation-Informed Indexing. That’s a risk reduction for stock investing of nearly 70 percent! For investors who index and who pay attention to valuations when setting their stock allocation, stocks are today not much more risky than Certificates of Deposit. That changes everything.

One last practical point. The best way to think about this is not to say “there are times when it is a good idea to get out of the market.” It’s not possible to know precisely the right exit and entry points. P/E10 told you that stocks were insanely dangerous in 1996 and returns were amazing in 1997 and 1998 and 1999. The way to think about his is to say “risk is greater when the P/E10 level is greater and so I need to gradually lower my stock allocation in response to increases in the P/E10 level to keep my risk profile roughly constant.” The full truth is that, while stocks did well in 1997 and 1998 and 1999, the investor who lowered his stock allocation in 1996 is ahead of the game today. And he will be farther ahead after the next crash (every secular bear market in U.S. history eventually took us to a P/E10 level of 7 or 8, 65 percent down from where we are today. We cannot pick tops or bottoms. But we don’t have to. It’s risk that matters. We MUST manage risk. Those who follow Buy-and-Hold strategies are vowing NOT to manage risk as their first investing decision. That always ends up being a terrible choice in the long term.

Rob

Beyond Buy-and-Hold #97 — Is It Possible to Get “Stuck” at a Low Stock Allocation as the Market Takes Off?

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I’ve posted Entry #97 to my weekly Beyond Buy-and-Hold column at the Out of Your Rut site. It’s titled Is It Possible to Get “Stock” at a Low Stock Allocation as the Market Takes Off?

Juicy Excerpt: Follow a Valuation-Informed Indexing strategy with the mindset of a Buy-and-Holder and you might indeed suffer the lock-in effect warned of by a good number of our Buy-and-Hold critics. Come to understand why Valuation-Informed Indexing always produces better risk-adjusted results in the long term and you won’t even be tempted to make the extreme moves that the Buy-and-Holders worry you will make if you abandon their rigid insistence that you always stay at the same stock allocation regardless of how insanely high prices go.

Academic Researcher Wade Pfau: “Two Papers by FIsher and Statman Are Still All I Can Find That Provide Evidence Against Long-Term Market Timing”

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Yesterday’s blog entry reported on an e-mail that I sent to academic researcher Wade Pfau on January 17, 2011. Wade responded on January 20, 2011.

He described a thread that he started at the Bogleheads Forum:

http://www.bogleheads.org/forum/viewtopic.php?t=67093

He said that it was not his intent to start a debate on the merits of Valuation-Informed Indexing since he hadn’t yet finished his research paper. However, he wanted to know if anyone was aware of studies concluding that Valuation-Informed Indexing does not work. He explained that: “Once I finish my study, I would like to refer to the concept as Valuation-Informed Indexing, but I called it long-term market timing in this post since I really was trying to avoid controversy and just uncover more background reading materials.” He reported that: “Two papers by Fisher and Statman are still all I can find that provide evidence against long-term market timing.”

VII #85 — The Wall Street Journal Story That Didn’t Bark

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I’ve posted Entry #85 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Wall Street Journal Story That Didn’t Bark.

Juicy Excerpt: I’ve been telling people about the other half of the story for 10 years now. People often tell me that everything I say about investing makes perfect sense but that they just cannot bring themselves to go along with the ideas I put forward because the “experts” tell a very different story. So I was excited to see this article. The Wall Street Journal is of course a highly respected publication.

I was thinking that following this article we would see lots of publications publishing follow-up pieces. The New York Times would write a ten-part series on how we all were taken in by Buy-and-Hold and run it on the front page. Hundreds of blogs would start helping their readers learn about what the academic research of the past 30 years says about how to invest effectively. We would all agree to work together to bring the economic crisis to an end as soon as possible. That sort of thing.

We didn’t see any of that. Perhaps you’ve noticed.

How to Invest Wisely — RobCasts on Market Timing, True Diversification and Dollar Cost Averaging

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I’ve added an article to the Safe Investing section of the site titled How to Invest Wisely — RobCasts on Market Timing, True Diversification and Dollar Cost Averaging.

Juicy Excerpt: Have you ever considered that the “experts” employed by The Stock-Selling Industry might not really want you to learn how to invest wisely? The academic research of the past 30 years (rarely discussed by most “experts”) shows that the key is taking the price being charged for stocks into consideration when setting your stock allocation.

That is, you don’t want to follow a Buy-and-Hold strategy of staying at the same stock allocation at all times. You want to go with a higher stock allocation when prices are good and a lower stock allocation when prices are bad. That’s the secret of how to invest wisely!

This article sets forth brief descriptions of RobCasts exploring three key topics: (1) Market Timing — What Works and What Doesn’t; (2) True Diversification; and (3) Dollar Cost Averaging.

VII #71 — Is It a Good Idea to Call Long-Term Market Timing Something Else?

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I’ve posted Entry #71 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Is It a Good Idea to Call Long-Term Market Timing Something Else?

Juicy Excerpt: I believe that calling long-term market timing what it is constitutes the most direct way to get The Question That Absolutely Must Be Discussed But That Today Is Almost Never Discussed on the table. Stocks only offer a good value proposition when you pay  fair price for them. That’s a compelling message. We should say it that way rather than fuss it up by going out of our way to avoid the word “timing” and by adding references to “risk management.”

“The Statement ‘Timing Always Works’ Is Every Bit as True as the Statement ‘Timing Never Works'”

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Set forth below is the text of a comment that I recently posted to the discussion thread for an article on Valuation-Informed Indexing appearing at the Invest It Wisely site:

Look at the orange line at the bottom of Fig. 6: it follows the stock line (in black) most of the time, this is just plain buy-and-hold as long as valuations are sane. This strategy is closer to buy-and-hold than to, say, day-trading or stock picking.

I certainly agree that the strategy you suggest (I call it “Valuation-Informed Indexing”) is closer to Buy-and-Hold than it is to day trading or stock picking. I would describe it as a revision to Buy-and-Hold, based on Shiller’s research, which was published several years after the publication of A Random Walk Down Wall Street, the book that Buy-and-Holders cite as their Bible.

There’s only one difference between VII and Buy-and-Hold — Valuation-Informed Indexers make infrequent adjustments to their stock allocation percentages. But that one difference makes a huge difference to the long-term results obtained. VII produces far higher returns at greatly diminished risk. More importantly, it makes the investing project far less stressful. Buy-and-Holders never know what is coming. VIIers always know what’s coming (not precisely, but close enough). That’s huge.

Another huge difference is that Buy-and-Hold causes economic crises that we could avoid if we publicized VII. Since 1900, there have been four times when we have gone to P/E10 values above 25. There have also been four economic crises in that time. Each and every one of them followed the time we hit 25 by a few years. Why? The return to fair value P/E10 levels take a huge amount of spending power out of the economy, causing an economic crisis. The market was overpriced by $12 trillion in 2000. Today’s crisis became inevitable when we let prices rise to the insane levels to which we permitted them to rise in the late 1990s.

Buy-and-hold existed before Fama was even born

There’s a sense in which I agree with you and there is a sense in which I don’t, Mathieu.

The idea of not taking price into consideration when setting one’s stock allocation has been with us since the first market opened for business. I agree with that. I call that approach “Get Rich Quick” and I think it can be fairly said that Buy-and-Hold is just the old Get Rich Quick concept dressed up in modern, pseudo-scientific clothing.

The sense in which I would describe Buy-and-Hold as something new is that Buy-and-Hold purports to be rooted in research. Those promoting Buy-and-Hold strategies often claim that “timing never works.” There is of course precisely zero research showing this to be so. There is research showing that short-term timing never works. But every study of long-term timing shows that it always works. So the statement “timing always works” is every bit as true as the statement “timing never works.”

I think it would be fair to describe Buy-and-Hold as a marketing gimmick. Millions of middle-class investors have been led to believe that long-term timing is not required. They believe that there is some study somewhere showing this. So, when their common sense tells them that they had better lower their stock allocations because prices have risen so high, they ignore that voice on grounds that all the experts say that timing isn’t required. But of course there is no research supporting such a claim. It’s just a means by which stock salesmen persuade people to buy stocks even in circumstances in which stocks offer a poor long-term value proposition.

Rob

 

ITNR #54 — John Bogle Talks Out of Both Sides of His Mouth

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I’ve posted Entry #54 to my weekly Investing: The New Rules column at the Death by 1,000 Papercuts site. It’s called John Bogle Talks Out of Both Sides of His Mouth.

Juicy Excerpt: Bogle has a cute way of expressing his opposition to market timing. He says: “Not only have I never heard of anyone who engaged in successful market timing. I have never even known anyone who knew anyone who engaged in successful market timing.”

But –

Bogle himself has engaged in successful market timing! He lowered his stock allocation dramatically at the top of the bull market and spared himself some big-time losses by doing so.

Yet he still says that he does not know anyone who knows anyone who has engaged in successful market timing. Does he not know himself? Does he not think it might be a good idea to write a letter introducing himself to himself with the aim of getting to know himself better?

Once Bogle got on speaking terms with himself, sparks would begin to fly. He would no longer feel a need to tell people that he does not know anyone who knows anyone who successfully practiced market timing. He would be freed to tell what he knows but doesn’t today know that he knows. My sense is that the man knows some interesting stuff. If only he knew that he knew it!

Beyond Buy-and-Hold #35 — Why Stock Market Timing Scares Us

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I’ve posted Column Entry #35 to my weekly Beyond Buy-and-Hold column at the Out of Your Rut site. It’s called Why Stock Market Timing Scares Us.

Juicy Excerpt: Market timing is the answer. For those of us willing to engage in market timing, stock returns are highly predictable and thus stocks are a high-return/low-risk asset class.

But most of us are not today willing to do this. Most of us disdain market timing.

Huh? We have available to us a means of investing in stocks that offers much higher returns at greatly diminished risk and we are not interested? How could this be so?

Market timing scares us.

There are 10 reasons.