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:
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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]