The following is a guest post from Rob of A Rich Life. Rob is a long time reader of this blog and a prolific and passionate writer. The “RobCasts” section of his web site contains over 180 podcasts in which Rob describes the Valuation-Informed Indexing investing strategy, an approach to indexing which according to Rob greatly reduces the risks of stock investing by having investors lower their stock allocations at times of insanely dangerous valuations.
This post is one of several guest posts I am publishing while my family and I are living the good life on our family vacation in Costa Rica. I will resume publishing my original articles after the first of the year. Here is the post:
Most people have mixed feelings about stocks. They love the high return. They are not so crazy about the high risk. Stocks without risk -- that would be the middle-class investor’s dream!
The dream is available to us today. That’s my take.
There is nothing inherently risky about stocks. Many of us make stocks risky by believing crazy things about them. But it’s not fair to blame the investment class for that. That’s us. It’s our investing beliefs that make stock risky, not anything to do with the asset class itself.
When people say that stocks are risky, what they mean is that prices jump around a lot. One year you might see a 30 percent price increase. Another year you might see a 20 percent price drop. Volatility scares us. It’s because stock prices are volatile that we have come to view stocks as a risky asset class.
But you know what? The price volatility of stocks is an illusion. It’s not real. Change how you react to it and it goes away. Stop taking volatility seriously and it goes “Poof!”.
You’ve probably heard that the average return on U.S. stocks is 6.5 percent real. That’s because that’s the return justified by the productivity of the U.S. economy. When you buy a share of an index fund, what you are really buying is a share of U.S. productivity. So long as the U.S. economy remains roughly as productive as it has been for a long, long time, your reward for owning a share of an index fund is going to be a return something in the neighborhood of 6.5 percent real.
There’s no volatility in that reality, is there? You buy stocks, you get a 6.5 percent real return. Simple. Safe. Nice.
What causes us to perceive volatility where it doesn’t really exist is the newspaper and television reports that tell us that stocks are up 30 percent or down 20 percent. What if we tuned out the noise? Would that bring an end to volatility and risk? It would.
We have historical data on U.S. stock returns dating back to 1870. There’s a neat thing that happens if you work through the historical returns year by year, subtracting from the reported return to bring it back down to 6.5 percent real whenever the nominal number is higher than that and adding to the reported return whenever it is lower than that. If you take that step, you will see that stocks don’t just provide a return of 6.5 percent on average but each and every year. Yes, stocks provide the same return every year -- so long as the effect of volatility is ignored.
Volatility is not real. Volatility is an illusion. We should be making that adjustment in our returns each year. U.S. stocks have always paid a return in the neighborhood of 6.5 percent real, never more and never less.
Some will say this is crazy talk. They will point out that, if you sell stocks after they go up 30 percent, you really will obtain the higher price for them. That’s so. In this short-term sense, returns higher or lower than 6.5 percent are “real.”
However, the price that applies for a few months or a few years is immaterial to the long-term investor. So long as you have no immediate plans to sell, what practical difference does it make to you if stocks are temporarily selling for a price 30 percent higher than their true value or 20 percent lower than their true value? What matters to you is what your investment is really worth. Your investment is worth 6.5 percent more than it was worth 12 months earlier. That’s always so. Regardless of the current-day selling price.
How do I know?
I know from looking at the historical data that the stock price always returns to what it would be if stocks increased in value each year by 6.5 percent real like clockwork. Price changes that do not last are not real. Price increases greater than 6.5 percent real never last. And price changes less than 6.5 percent real never last. No matter how much crazy volatility we experience in one direction or the other, we always end up with that 6.5 percent number coming through for us in the long run.
That cannot be an accident. The reason why the 6.5 percent number always holds is that that number is the return that the productivity of the U.S. economy supports. You can count on earning 6.5 percent real from your stock investment each year. Any gains greater than that or less than that are a mirage that should be ignored for financial planning purposes.
When you see a gain of 30 percent, you should count 6.5 percent as the real gain and 23.5 percent as a mirage gain. When you see a loss of 20 percent, you should count 6.5 percent as the real gain and 26.5 percent as a mirage loss.
If you did this, volatility would disappear from your stock investing experience. You would enjoy all the benefits of owning stocks but not need to endure any of the downside. You would get gains without volatility, returns without risk. It’s the best of all worlds for the middle-class investor.
You would also come to think about stocks very, very differently than you think about stocks today. Do you remember January 2000, when stocks were selling at a price three times their fair value? Most investors continued buying stocks even at those insane prices, prices at which the chance that stocks could provide a solid long-term return were virtually nil. Those of us who see through the nonsense volatility did not make that mistake. We lowered our stock allocations dramatically when prices went to the moon and thereby avoided most of the pain of the recent price crash.
We saw something that Buy-and-Hold investors did not. We saw that stocks always provide a return of 6.5 percent real. And that, when you pay three times fair value, you are obtaining stocks with only one-third of the money you are putting out; the rest goes to buying cotton-candy nothingness. What you want to buy is stocks, not the hot air created by deceptive volatility. Learn how to see through volatility and you can obtain far higher returns at far less risk. For the first time, you will be seeing stocks as they really are, not as The Stock-Selling Industry (which spends millions promoting Buy-and-Hold Investing) wants you to see them.
The investor who gives up the belief that crazy price increases are real (any price increase beyond that justified by economic productivity is crazy) gains the ability to avoid falling into the traps that cause him to suffer crazy price drops on the other side. The way to avoid the pain of bear markets is to understand the phoniness of bull markets.
If you think 6.5 percent real is a good enough return on your investing dollar (and I sure do), you are set. Just ignore all the volatility junk and it can no longer bother you. For you stocks will carry only a fraction of the risk experienced by investors who follow the Buy-and-Hold model.
[Shadox - I agree with Rob on many things including the fact that indexing is the way to go where stocks are concerned. I also strongly disagree with him on others such as his assertion that stock investing is essentially risk free. I recently wrote a post about stock market volatility. While that particular post discussed daily price volatility, in a coming post I will try to extend the concept to the longer time horizons to which Rob is referring]
12 comments:
Interesting article, I think you provide a unique approach to the topic. It sounds to me very similar to the idea of actually researching and understanding the companies you invest in but taken to a different level.
Rather than researching individual companies you seem to promote the research of an economy's productivity as a whole. Do you think that's a fair comparison?
Thanks for running the Guest Blog Entry, Shadox. I am particularly grateful for your use of the adjective "passionate" to describe me. That's me! That's what I believe that I bring to the table that perhaps a good number of investing "experts" who came before me did not. I think we need more passion in this field. Stock investing is in part a numbers game but it is also in part an emotions game. I think that one of the problems we face is that many who are today thought of as experts are strong in the numbers department but not in the emotions department. We need to strive for a better balance of the two strengths.
I believe that the headline for the blog entry was left out somehow. The headline that I had intended to suggest (perhaps I somehow failed to do this) was: "Stocks Are A Lot Less Risky Than You Think."
Rob
I think you provide a unique approach to the topic.
Thank you for those kind words, Edwin. I think I bring something new to the table. It's not entirely new because all of my insights are rooted in insights that lots of smart people who came before me have shared with us all over the years. But I do think that I've created a new mix of lots of exciting stuff and I have become extremely proud of the work that I have done in this area as I have developed it ever more deeply over the past eight years.
It cheered my New Year's Eve morning to hear you say that. My hope is that we will be bringing this message to thousands (millions?) of new people in 2010.
Rob
Rather than researching individual companies you seem to promote the research of an economy's productivity as a whole.
Yes! Yes! Yes! Yes! Yes!
You get it exactly, Edwin. What you are pointing out here is so profound that I don't think that most people are able to appreciate it until they have heard it a few hundred times. This is big stuff. This changes the history of investing.
There are three eras in the history of investing. There was the pre-Bogle era. That was a time in which everyone was trying to be a little Warren Buffett. Everyone was seeking to study individual stocks and identify which companies are going to do well. The problem with this approach is that 90 percent of us lack the time or skill needed to do a good job of picking individual stocks. So this is never going to be the answer for the majority of middle-class investors.
The second era is the Bogle Era, or the Buy-and-Hold Era. Bogle solved the problem outlined above by launching the Indexing Revolution. With indexes, we can all share in the wonderful returns provided by the stock market without needing to identify good stocks. Bogle made stock investing a practical and realistic and prudent option for the typical middle-class investor.
Almost.
Bogle made a huge mistake. He failed to stress how important it is that indexers change their stock allocations in response to changes in valuation levels. That one mistake changed the Buy-and-Hold Model from what it was intended to be (the best investing strategy ever known to humankind) into what it has become (the most dangerous investing strategy ever known to humankind).
Telling investors that they don't need to lower their stock allocations when prices get to insanely dangerous levels is like taking the brakes off of a car. It guarantees a crash! After the crash, it can take the middle-class investors who bought into the Buy-and-Hold concept decades to recover the savings lost due to this Greatest Mistake Ever Made in the History of Personal Finance.
I am trying to usher in the third era, the Rational Era of stock investing. I take all of Bogle's great ideas and just leave out the one that has caused such financial ruin for so many millions of investors -- the idea that there is no need to change one's stock allocation when prices reach insanely dangerous levels. Make that one change and it all actually works in the real world. Make that one change and we can all retire at least five years sooner than we previously thought possible. Make that one change, and we can help people regain their confidence in our economic and political leaders and get out of this economic crisis and avoid falling into The Second Great Depression.
Buffett always looks at the value proposition of the stocks that he buys. All smart investors do. Indexers need to do that too. Buy-and-Holders think that the market takes care of that. They are under the impression that the market always sets prices properly. Not so! The market is us! The market sets prices properly only if we act rationally. And it is not rational to ignore price when buying stocks, any more than it would be rational to ignore price when buying anything else.
We need to take Buffett's focus on value propositions and combine it with Bogle's focus on simplicity. Add the two together and you've got Valuation-Informed Indexing, the strategy that I recommend. The way that I like to say it is that Buffett and Bogle go together like chocolate and peanut butter!
All that Rob Bennett has ever done is to combine Buffett's insights with Bogle's insights. But that's no small thing. This is an amazing combination. It permits middle-class investors to obtain far higher returns at far less risk. This is the Reeses Cup of investing strategies, in my assessment.
Rob
"But you know what? The price volatility of stocks is an illusion. It’s not real. Change how you react to it and it goes away. Stop taking volatility seriously and it goes “Poof!”."
That's when I started taking your post seriously and it ...went Poof!. I'm sure that burying one's head in the sand works really well for the ostriches too :))
That's when I started taking your post seriously and it ...went Poof!. I'm sure that burying one's head in the sand works really well for the ostriches too :))
Fair enough, Anonymous. The idea that volatility is not real is an "out there" idea today, that's for sure. So skepticism is appropriate and I think even helpful.
That said, I ask you to consider this. There were years in the late 1990s when stocks went up by 20 percent or 30 percent in the space of 12 months. Productivity obviously wasn't enough to justify those sorts of price increases. So where did the money come from?
I say that we borrowed it from future returns and that we are today in the process of paying it back.
Are you sure that that's not the case? Are you absolutely certain?
If you're not sure, it's my view that you might want to at least open yourself to consideration of some new explanations of how stock investing works. I came to the ideas described above because I was not satisfied with the answers I got from Buy-and-Hold advocates when I asked some very simple questions.
It's not only Valuation-Informed Indexers who need to be wary of becoming ostriches. It's clear that at least some of us are putting our heads in the sand (as the explanations of how the market works are so different). I acknowledge that it could be me. Can you say the same?
Do you view it as even possible that the Buy-and-Holders have gotten it all terribly wrong for many years now? If you are not capable of even imagining the possibility that that could be so, that makes me anxious about what believing in Buy-and-Hold does to one's thinking processes. And I can tell you from long experience that there are a lot of Buy-and-Holders today who cannot bear even to talk about these matters in a civil and reasoned way.
None of us know it all, Anonynous. Not me. Not you. Not Robert Shiller. Not John Bogle. We all have the opportunity to learn from others. And we all hurt ourselves if we elect instead to go with an impersonation of our friend the ostrich. If it's me, I'd rather learn from having the weaknesses of my logic exposed on a discussion board than by opening my portfolio statement some day and seeing some numbers that in an earlier day I had viewed as unimaginable.
I wish you luck with your investing strategies in any event, Anonymous.
Rob
"I do think that I've created a new mix of lots of exciting stuff and I have become extremely proud of the work that I have done in this area as I have developed it ever more deeply over the past eight years."
I have read your site, as well as this article.
You haven't.
What you *have* done is illustrate first hand the ill-effects of succumbing to several behavioral traps, such as anchoring, mental accounting, overconfidence based on ignorance, hindsight bias, etc.
I'm not sure that posting links will work here, or I'd post several excellent ones. I do recommend strongly that you Google the terms "behavioral" and "rational" and "investing" all together. TIAA-CREF, JP Morgan, AABRI, JSTOR, and other respected sources will show up in your search with articles, and these are very enlightening.
When Mr. Bennett uses the word "Rational," I can only reflect on a line from the Princess Bride: "You keep using that word. I do not think it means what you think it means."
When Mr. Bennett uses the word "Rational," I can only reflect on a line from the Princess Bride: "You keep using that word. I do not think it means what you think it means."
Thanks for sharing your thoughts, Anonymous.
I have some misgivings about the word "rational" myself. I worry that some may hear an insult in it, that I am saying that the Buy-and-Hold Model is irrational. I am saying that. But I don't mean any personal insult. I certainly acknowledge that there are millions of smart and good people who follow Buy-and-Hold and that the people who developed the Buy-and-Hold Model brought us many wonderful insights.
Why, then, do I view Buy-and-Hold Investing as irrational investing?
Because I view all overvaluation and undervaluation as irrational. I would like to see markets priced properly. So long as investors understand that they need to change their stock allocations in response to big valuation changes, markets would indeed always be priced properly. The long-term value proposition for stocks goes down with overvaluation and that should cause people to sell stocks and that should bring prices back to fair value.
The only reason that the market doesn't self-regulate in that way is because The Stock-Selling Industry has spent hundreds of millions of dollars on marketing campaigns aimed at convincing people that it is okay to ignore price (!) when buying stocks, thereby making the market disfunctional.
What is overvaluation really? It is emotion, no? By definition, an overvalued stock market is an emotional stock market. If investors were rational, they would price stocks properly. So overvaluation is equivalent to emotion.
Since it is Buy-and-Hold that causes overvaluation (market prices would self-regulate if Buy-and-Hold were not so heavily promoted by those who make millions by telling us that stocks are a good deal at any price) and since overvaluation is emotion, I think it is fair to say that Buy-and-Hold is pure emotion. The model that I favor is the opposite of the Buy-and-Hold Model. So I think it is appropriate to refer to that model as "Rational Investing." Rational Investing is valuation-informed investing or price-conscious investing.
I mean no slight to the people who follow Buy-and-Hold strategies. I of course understand that these people are entirely rational in many areas of life endeavor other than stock investing. I believe that the primary reason why investing has become so emotional in recent decades is that The Stock-Selling Industry has such a large marketing budget. Advertising works. It hits emotional hot buttons.
Rob
"Since it is Buy-and-Hold that causes overvaluation (market prices would self-regulate if Buy-and-Hold were not so heavily promoted by those who make millions by telling us that stocks are a good deal at any price)"
This is completely illogical, and certainly unsupported by any data you have provided, or that one can find in the main stream press!
Please give any basis (other than your own words) that would lend support for this outlandishness.
Please give any basis (other than your own words) that would lend support for this outlandishness.
Common sense tells us that the price we pay for stocks affects the long-term value proposition we obtain from them, Anonymous. The only reason why there is even one person alive who believes otherwise is because Buy-and-Hold has become so popular.
But Buy-and-Hold has been discredited in the academic literature for 30 years now.
Here is the URL for an article that quotes 20 articles that have recently appeared in the mainstream press and which make the point that the idea that the market is efficient has been entirely discredited over the past three decades:
http://www.passionsaving.com/buy-and-hold-investing.html
Here is the URL for an article that links to 20 studies showing that valuations affect long-term returns:
http://www.passionsaving.com/buy-and-hold-is-dead-part-one.html
Buy-and-Hold died in an intellectual sense a long, long time ago. We just need to bury the marketing pitch. The death of Buy-and-Hold is not the end for middle-class investors. It is the beginning. Life will go on better than ever before when we stop dressing in black over this.
Rob
"Since it is Buy-and-Hold that causes overvaluation (market prices would self-regulate if Buy-and-Hold were not so heavily promoted by those who make millions by telling us that stocks are a good deal at any price)"
So, putting aside your wall of words, the short answer is that you have NO independent basis for your ridiculous claim. You have only your own words at your own site, that eventually circle back to your claim that "it's common sense."
Well, respectfully, it is NOT common sense to believe either that the 'stock selling industry' has spent millions promoting buy and hold investing (they haven't) or that buy and hold is somehow causing any measurable effect on the economy, since most investors don't practice it, anyway -- including those who say they do!
In short, I now do not have any credence in you, or the material at your site.
I now do not have any credence in you, or the material at your site.
I understand, Anonymous.
Thanks for the helpful (at least for me!) back and forth, in any event.
And I do wish you well with whatever investing strategies you elect to follow.
Rob
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