the Returns Sequence Reality Checker

Yesterday’s blog entry reported on an e-mail sent to me by Academic Researcher Wade Pfau on March 2, 2011. Wade sent a follow-up e-mail later the same day.

He reported on a sentence he read in the Journal of Finance which he said “perfectly encapsulates (in an academic way) the exact point I had been trying to make about the rolling period results”. The sentence is: “To be fundamentally riskier, value stocks must underperform glamour stocks with some frequency, and particularly in the states of the world when the marginal utility of wealth is high.”

Wade said: “This is exactly what I showed with the rolling period results. Buy-and-Hold only occasionally did better, and that is when both strategies were doing pretty darn good anyway, and so the difference between them is not as important. As your wealth increases, the marginal utility of your wealth decreases.”

I responded the next day. The text of my response follows:

Wade:

The news about Dan Moisand is super. I also saw the article at Bankrate.com. My sense is that they generally do good work there. So that article too will advance the ball with the right people.

Here is an article I wrote that made use of the prototype calculator (to give you can idea of its purpose:

http://www.onlineinvestingai.com/blog/2010/11/12/all-stock-price-drops-help-you-all-stock-price-gains-hurt-you/

Here is the prototype:

[A link appeared here.]

The user provides two kinds of inputs:

1) He specifies the annualized 30-year return (in what I am sending, the choice is for a 6.5 percent return (2.0 dividends plus 4.0 percent non-dividends); and

2) He enters any results for any of the 30 years that he chooses (in what I am sending, a 30 percent loss is entered as the manual return for Year One).

As the article illustrates, the 30-year result that follows from seeing a 30 percent loss in Year One — $1,189,555) can be compared with the 30-year return that results from seeing a a 30 percent gain in Year One ($818,350). The finished version will include a feature that permits the user to enter any return sequence of less than 30 years that we have seen in the historical record to determine whether it was a good or bad sequence for purposes of achieving a particular investing goal.

I need help with three questions:

1) Does the concept make sense to you?

2) Does our way of setting things up make sense?

3) Do the formulas that were used appear to be the proper ones?

I am grateful for any help you are able to offer. If this tool generally makes sense to you, I am going to get back to Sam and see if we can return to our efforts to develop it. The project got dropped for a time because we ran into some problems with getting it put into calculator form. But those problems can be overcome if we become determined to get it out (and that’s how I am feeling today, depending somewhat on your reaction).

Rob

I’ve added a new section of the site to house our unique new calculator, The Returns-Sequence Reality Checker.

Juicy Excerpt: The purpose of The Returns Sequence Reality Checker is to bring an end to the irrational stock cycles that for over 100 years have been causing us such economic turmoil. The calculator aims to do this by educating investors as to the types of return sequences that are truly in their best interests.

The Reality Checker permits the investor to assume any annualized return he chooses for a 30-year time-period. The average return we have seen throughout U.S. stock market history is 6.5 percent real. So you might want to use that as your assumption. But if you believe that the U.S. economy will be more productive in the future than it has been in the past, you may choose 7 percent or 8 percent as the annualized 30-year return, and if you believe that the U.S. economy will be less productive in the future than it has been in the past, you may choose 6 percent or 5 percent as the annualized 30-year return.

After choosing a 30-year return, the investor assigns hypothetical returns to as many of the 30 years as he pleases. The calculator then fills in the returns that would need to apply in the remaining years for the annualized return specified for the entire time-period to apply.

An option is provided for the investor to choose historical return sequences. For example, the default results (the results that appear before you enter any numbers of your own) compare the 30-year returns sequence we saw beginning in 1971 and the returns sequence we saw beginning in 1981.

The lesson taught by the Reality Checker is that stock cycles always apply and that the nature of the stock cycles that turn up during a particular time-period have a big effect on the return enjoyed by those investing in stocks during that time period. Few of today’s investors pay much attention to stock cycles. The calculator teaches us that we all need to be paying a great deal of attention to them.