Tuesday, July 28, 2009

Guest Post: We’re All Better Off As a Result of the Stock Crash

This is a guest post by Rob Bennett of A Rich Life:

You’re a 55-year-old investor. You hope to be able to retire when you turn 65. You were on track to just barely meet your goal until last September. But you recently lost one-third of your life savings in the huge price crash. This is a true disaster. You are feeling depressed.

You shouldn’t be. The truth is -- this isn’t a disaster at all. We’re all better off as a result of the stock crash. We just don’t know it because of the way we have grown used to thinking about stock investing during the Passive Investing Era.

I have a calculator at my web site called “The Investment Strategy Tester.” It permits investors to create any of thousands of possible investment scenarios and compare the long-term results that are likely to follow from them, presuming that stocks perform in the future somewhat as they always have in the past. I recently compared two scenarios to see what the effect of the price crash has been on someone in the circumstances of the investor described at the opening of this blog entry.

The first scenario I created was of an investor with a $100,000 portfolio and a 70 percent stock allocation at a time when the P/E10 value is at 14 (a fair value P/E10 level, where we are today). The second scenario was of an investor with a $150,000 portfolio and a 70 percent stock allocation at a time when the P/E10 value is at 32 (an exceedingly high P/E10 level, the sort of valuation level that applied for much of the time from the mid-1990s through the first part of 2008).

Guess which investor is likely to have a higher portfolio at the end of 10 years? It’s the investor with $100,000 in his account at a time when prices are reasonable. If you have one-third less in your portfolio today than you had pre-crash, you have a better chance of meeting your retirement goal in 10 years than you possessed pre-crash.

Considered in isolation, it is of course a bad thing for you to lose one-third of your life savings. But the loss of your retirement money isn't something that happened in isolation. It happened as a consequence of a huge price drop. The price drop is a great development for everyone alive in the United States today. It makes it possible for stocks to provide appealing long-term returns once again, something that hadn’t been possible for more than 10 years prior to the crash. We’ve got stocks back! The stock crash is the reason!

I think it is important that we get the word out to people about how stocks really work. There have been three earlier times in history when we went to the sorts of price levels that applied pre-crash. On each of those three occasions, we ultimately saw price drops of far greater size than those we have yet experienced this time, price drops that took us to valuation levels one-half of those that apply today. It’s not economic realities that caused those price drops, it’s the emotional letdown that follows when large numbers of investors come to believe that prices don’t matter all that much and then learn the hard way that that is never so in the real world.

Job #1 today is to restore confidence in the market. We do that by shooting straight with people. We do that by letting people know that the price crash was a good thing for all of us.

But why would everyone not be spreading this happy news? Doesn’t everyone want to restore confidence in the markets?

In theory, yes. But the unfortunate reality is that the vast majority of big-name experts has been advising us for years to invest passively, not to change our stock allocations in response to big price changes. That never works. That always brings on disaster sooner or later. Letting people know that they are in better circumstances today than they were in before the crash causes people to ask dangerous questions about the true effect of valuations on long-term returns. The reality is that the effect is huge. The reality is that we should have been paying attention to valuations all along and that we never would have seen prices go to the levels they went to if we had been doing so.

The widespread advocacy of Passive Investing has put us in a pickle. We need to assure people to persuade them to stay invested in stocks. But we cannot assure them without letting them know how important valuations are to determining long-term returns. And doing that means undermining the argument for Passive Investing, the model for understanding how stock investing works that most experts have been promoting big time for three decades now.

The full reality is that you are not better off today in one important sense. You would be better off if you appreciated the realities and if most other investors did so too and if you could engage in conversations with them about how stock investing works and be reassured by those conversations. However, the odds are that you are not going to be able to participate in such conversations; there’s a lot of institutional opposition to getting the word out on the effect of valuations. If the word does not get out, we will likely see yet another big price crash in the years ahead. And then we will all be cooked. Even those not invested in stocks at all will lose if the economy goes into a major depression.

Investors are emotional to begin with. Advocacy of Passive Investing makes them ten times more emotional than they would otherwise be. People are filled with doom and gloom today even though these are the best days to invest in stocks that we have seen in a long, long time. I believe that we need to move to a new model, one that helps us all understand that stocks are like anything else that can be bought and sold -- they offer a great value proposition when sold at good prices and a poor one when sold at bad prices.

The price crash made stock prices good again. I think we all should be celebrating. I think it’s a darn shame that most of us are not. I think it’s the fault of the Passive Investing model that we are not. I hope that the long term effect of the price crash is going to be to prompt us to become excited about the development of a more realistic and effective model.

Rob Bennett writes the “A Rich Life” blog. His “The Investment Strategy Tester” shows investors how they can recover all of their recent stock losses by converting from the Passive Investing strategy to a valuation-informed strategy.

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Anonymous said...

Some odd things about this post.

First, for a 55-year-old investor to lose one-third of his life savings in the last year, the person would have had to have done something fairly dumb. For example, broad-scale index funds tracking the S&P 500 are down 25% since last September. So, a person would have lost 25% (not "one-third") only if they had their ENTIRE life savings in such a stock fund. No diversification whatsoever.

A more typical 55-year old investor might have 50% in such an index fund and 50% in a bond market fund. The latter are essentially unchanged since last September. Result: a 12-13% loss. Not nearly as dramatic.

Second, the most recent data for P/E10 is not 14 but rather 16.1 (from Shiller's data for the end of June). That also makes Bennett's example less dramatic.

This type of exaggeration for dramatic effect doesn't give me much confidence in Bennett, and the rest of the post strikes me as rather silly (got to denigrate those "big name" experts!)

Shadox said...

I have to take the blame for some of the issues you raise in your comment. Rob sent me his guest post a few weeks ago and I only scheduled it for posting this week - this caused some discrepencies in the numbers, as you point out.

Rob Bennett said...

This type of exaggeration for dramatic effect doesn't give me much confidence in Bennett, and the rest of the post strikes me as rather silly (got to denigrate those "big name" experts!)

I don't think it's possible to exaggerate the damage done by the promotion of the Passive Investing model in recent years, Anonymous. We have already seen the greatest loss of middle-class wealth in the history of the United States. There are millions who have lost jobs, millions who are going to suffer busted retirements, millions who have seen their retirements delayed by many years. All of this was 100 percent unnecessary. The first academic research showing that valuations affect long-term returns (and that, thus, Passive Investing cannot possibly work in the real world) was published in 1982.

We would not call doctors whose patients all died "experts." We would not call mechanics who caused our cars to break down "experts." We would not call baseball players who always struck out "experts." Passive Investing (the "strategy" of failing to adjust your stock allocation in response to price changes) has been tried four times in U.S. history. It has brought on bone-crushing losses (an average loss of 68 percent) each and every time. Those who advocated Passive Investing are not "experts"in any meaningful sense of the term.

In real terms, the value of stocks (not counting dividends) declined over 60 percent from January 2000 to the levels reached recently. Those who have been investing in super-safe asset classes like Certificates of Deposit since the early 1990s are now ahead of stock investors. Yet 90 percent of the "experts" were telling middle-class investors to put most of their retirement money in stocks even at the prices that applied from 1996 to 2008 (when the historical data showed that the long-term return on stocks was likely to be poor).

Worst of all, the flaws in the Passive Investing model do not do harm only to those who choose to invest according to it. The massive losses suffered as a consequence of the hundreds of millions spent by The Stock-Selling Industry to promote the Passive model have brought the strongest economy on earth to its knees. We all have a stake in the success of the U.S. economy. Each and every one of us should be concerned about the damage done by the promotion of this reckless investing strategy.

I have spoken to thousands of middle-class investors who have expressed a desire to learn the realities of stock investing. The most basic reality is that stocks are like any other asset that can be bought or sold -- they are a wonderful deal at some prices, a good deal at some prices, and a horrible, horrible, horrible deal at some prices. This story needs to be told and I think that it is fair to say that the "experts" in The Stock-Selling Industry have done precious little in the past 28 years to get the word out.

The "experts" from The Stock-Selling Industry have failed us. It is time that we start going about the business of developing some expertise of our own so that we can distinguish the advice that makes sense from the stuff that pushes back our retirement dreams by many years. This stuff matters.


Anonymous said...

You have been spammed.


Shadox said...

OK, guys. Take it outside please.

You may not agree with the posts, but please be courteous to my guest posters.

Rob Bennett said...

please be courteous to my guest posters.

This has been going on for seven years.

I invite those reading these words to reflect on why that is. What is it about the idea that valuations affect long-term returns that causes a good number of stock investors to get so upset?

It's not an idea that hurts anyone. Incorporating valuations into stock analyses is an idea that helps every single person alive. It's a win/win/win/win/win. There's only one problem. It's a change. If we accept that valuations affect long-term returns (the academic research has been showing that this is so dating back to 1981), we have to rewrite most of the investing books and studies and redo the calculators and so on. We have to say the three magic words "I" and "Was" and "Wrong."

That's it. That's the only price of admission to a world in which stock investing really makes sense for the first time ever.

We should be 100 percent united on this. There should be no dissent to the idea of at least exploring whether all the things that the research has been telling us for 28 years really is so.



Anonymous said...
This comment has been removed by a blog administrator.
critter said...

I urge you to go to Rob's site and listen to the 130 podcasts that explain his financial plan.

Anonymous said...

While the previous poster's advice to listen to each and every one of Mr. Bennett's catalog of one hundred and thirty-six personal podcasts is laudable, making that choice represents a personal time investment of around 170 total hours. So if you listened to two hours of Rob per day, five days a week, you'd need over four months to dedicate to this single task.

For those with more modest available time, I would offer that this (link) is a good representative single podcast. And if one is even more pressed for time, one could just flip the slider on your player to exactly the 48 minute mark.

In a mere two minutes, from 48 to 51 minute mark, Rob will instruct you as to what he is all about, and what his purpose is.


Rob Bennett said...

So if you listened to two hours of Rob per day, five days a week, you'd need over four months to dedicate to this single task.

I pass.