Enjoyed this post? Please consider subscribing to Money and Such by free RSS Feed or by email. You can also follow me on Twitter.
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.