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The Good Side of Stocks’ Lost Decade

This article was written by in Investing. 29 comments.


This is a guest article by Rob Bennett, a personal finance journalist and author of the blog A Rich Life. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s.

Most view the years from 2000 through 2009 as bad years for stocks. Returns were so low that many have come to refer to that 10-year stretch of time as the “Lost Decade” for stock investors.

This is a mistake. Those years were actually good years for most stock investors; it is the prior decade, the years from 1990 through 1999, that was more problematic.

To explain why I say this, I will need to report to you numbers generated by the Returns-Sequence Reality Checker, a calculator that I have co-developed with Sam Parler. Please don’t feel a need to learn how the calculator works to read this article. I will report the numbers it generated for me when I explored scenarios I will describe to you. If you like, you can return to the calculator at some later time and examine additional scenarios of your own.

The reason why I call the calculator “The Reality Checker” is that it throws doubt on one of our most fundamental beliefs about stock investing — that positive returns are good and that negative returns are bad. It’s not hard to understand why most of us think that. If your stock portfolio is valued at $100,000 at the beginning of the year and you see a 10 percent gain for the year, the portfolio is valued at $110,000 at the end of the year. If the gain is 20 percent, the ending value is $120,000. It’s obviously better to have $120,000 in your retirement account than it is to have $110,000 in your retirement account.

Except it’s not. Not really. Not when you look at what big, positive returns do to your portfolio balance in the long run.

The thing that fools us is that we think of ourselves as owners of stocks. In markets, the interests of the owners of the thing being offered for sale are opposed to the interests of the people considering buying the thing being offered for sale. Owners want high prices and buyers want low prices. To the extent that we really are owners of stocks, we are right to think of price gains as a good thing.

But we forget that we are not only owners of stocks. We are also buyers of stocks. Most of us are more buyers than we are owners. To the extent that we are buyers, we are rooting against our self interests to root for price gains.

Say that you have $10,000 invested in stocks today and that over the next 30 years stocks will be generating the same long-term return that they have generated since the U.S. market opened for business — 6.5 percent, after taking inflation into account. Are you better off seeing 10 years of 20 percent gains or seeing 10 years of 5 percent losses?

Both scenarios produce the same portfolio value at the end of 30 years: $66,144. Positive returns in the early years cause negative returns in the later years and negative returns in the early years cause positive returns in the later years. It all evens out over time.

But few of us invest a single lump sum in the market and then sit back and watch it grow over three decades. Most of us are buying stocks each year. That means that positive returns hurt us. Positive returns increase the amount that we need to pay to acquire stocks. The higher the price we pay for the shares we acquire, the lower our lifetime return and the smaller our end-point portfolio values.

You will be shocked to learn how big a difference this makes.

Say that you start with a portfolio of $10,000 and add $10,000 to it in each year of a 30-year time period in which stocks produce an annualized return of 6.5 percent real. In Scenario One, you see gains of 20 percent in each of the first 10 years. In Scenario Two, you see losses of 5 percent in each of the first 10 years. Do you care to take a guess as to how much difference that will make in the size of the two end-point portfolio values?

The Scenario One portfolio will be worth $549,859 at the end of 30 years. The Scenario Two portfolio will be worth $1,739,987. The portfolio with early losses grows to more than three times the size of the portfolio with early gains!

We’ve got it backwards! Losses (lower prices) are good. Gains (higher prices) are bad.

If you happened to start making annual contributions of $10,000 to the market in 1990 and the 30-year return ends up being the 6.5 percent average return that has applied for as far back as we have records, at the end of 30 years your portfolio value will be $746.162. However, if you happened to start making annual contributions of $10,000 to the market in 2000, at the end of 30 years your portfolio value will be $1,628,503.

We need more Lost Decades!

Published or updated April 7, 2011. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Rob Bennett's "A Rich Life" blog focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s. Rob Bennett created the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. View all articles by .

{ 29 comments… read them below or add one }

avatar Hunter

This is a insightful piece. I have to agree that, while most people are hesitant, it is a better strategy to invest a lump sum at one time, rather than many minor installments in an attempt to dollar cost average. You simply can’t time the market, it’s time in the market that is more important.

What about stock returns over the last decade while factoting in the value of the US dollar? That would be a very interesting study and I think that real returns would be negative.

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avatar Rob Bennett

Thanks for your kind words, Hunter.

We are not entirely in agreement re market timing. I agree that short-term market timing (trying to guess which way prices are headed) does not work. But I do not at all agree that long-term market timing (going with a higher stock allocation when prices are good than you do when they are bad) does not work. My view is that long-term market timing is the key to long-term investing success. This particular calculator does not look at valuations-related questions in a direct way. But most of my work does and my view is that even this calculator has something to say about valuations in an indirect way.

I understand your point about the drop in value of the U.S. dollar. My guess is that you are right. But non-stock investments held in U.S. dollars were hurt just as bad. So I don’t see the fall in the dollar as an argument either for or against owning stocks in the early 2000s.

The Reality Checker focuses on the effect of price gains and losses. The dollar was not falling through most of the 1990s. But investors were still being hurt by the price gains we experienced in those years. The moral is that price gains are generally bad for stock investors and price drops are generally good (an exception applies for retirees who are taking money out of stocks each year rather than putting more money in). That’s so regardless of what happens to the dollar.

Price gains are just bad news. It’s a highly counter-intutive reality. But it’s a mathematical reality all the same.

Rob

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avatar 4hendricks ♦248 (Cent)

I never have thought of it in these terms. Good article to get you thinking. Thank you

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avatar Rob Bennett

Thanks, 4hendricks.

It was Bill Bernstein who put the thought in my head. He makes the basic point being made here in Chapter Two of his book “The Four Pillars of Investing.”

I’ve read Chapter Two four or five times now and each time I came across that passage, I thought — that is just crazy, it cannot be so! But it’s math. If the numbers say it, it is so!

I got to a point where I wanted a calculator making the point so I could play with possibilities and thereby think it through some more.

It’s very strange. I don’t at all disagree with people who say that. I think so too. But I don’t see how you can argue with the numbers. The numbers say what the numbers say. So it’s both crazy and true at the same time.

Rob

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avatar shellye ♦107 (Cent)

Great post – I look forward to all the discussion!

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avatar Ceecee ♦53 (Newbie)

Some logic here. It feels great when the market is up, but it seems to inhibit one from buying at that time, even though it could be a good time. If any of us could answer this with total authority, we wouldn’t be here, we’d be jetsetting on our riches!

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avatar Rob Bennett

Shellye — Thanks for the kind words. I too very much look forward to hearing what lots of people coming from lots of different perspectives have to say about this.

Ceecee — I don’t believe that anyone can say with “total authority” where stocks are headed. However, I don’t at all go along with the idea that the future is entirely unknown. I have studied this question in great depth. Everything that I have seen sends the same message. We cannot know the future precisely, but we can make good assessments of the long-term direction of stock prices. That is, the odds are much, more with you when stock prices are low or moderate than they are when stock prices are insanely high.

This particular view of mine is controversial (I don’t think it should be, but it is a fact that it is). The Reality Checker does not look at the question of valuations. So there is a sense in which it should not be as controversial as my four earlier calculators. However, there is an indirect way in which the findings generated by the Reality Checker bear on the controversial valuations question.

The Checker offers a possible explanation of WHY valuations-oriented discussions can get so confusing and even friction-filled. What it is telling us is why the stock market behaves like no other market. The stock market is the only market in which there are not two opposing interests playing a role in setting prices. In the stock market, EVERYONE is rooting for higher prices. I believe that this is why things get so out of control and emotional. This is why the stock market often sets prices so wildly off the mark from fair value while markets like the used-car market do a good job of getting prices at least roughly right.

I think we need to take this difference into account in all stock analyses. The Buy-and-Hold Model for understanding how stock investing works is rooted in the Efficient Market Theory, an academic construct that posits that the market is a well-functioning market. I believe that Yale Economics Professor Robert Shiller’s research throws very serious doubt on this (my personal view is that Shiller’s work discredits the Efficient Market Theory).

I believe we need a new model that takes the unique way in which the stock market operates into account. I call the new model “Valuation-Informed Indexing.” If you google that term, you’ll find lots of articles I’ve written about it.

Rob

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avatar Jason

While being thought provoking, this is really quite ridiculous. It can only be looked at as good if it is early on in your investing. If those “good” years of losses happened at the end of your 30 year period, you are just out of luck.

Also the 6.5% average as you stated goes back to the beginnings of the stock market. This means that in any 30 year period, you are likely to have a different experience than the 6.5%. This is important because you are comparing 20% gains in the first 10 years to 5% losses. To average out those 20% gains, you need fairly poor 20 years to get down to 6.5%. In reality, this may or may not happen.

In short, you have shown that you can play with numbers to get them to “prove” whatever you want.

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avatar Rob Bennett

It can only be looked at as good if it is early on in your investing. If those “good” years of losses happened at the end of your 30 year period, you are just out of luck.

I encourage you to play with the calculator a bit to learn how the realities play out in different circumstances, Jason. If your point is that the penalty for high returns is not precisely the same for all investors, you are right. If you are trying to say that the pattern in which returns fall doesn’t matter, all I feel that I can say is that the numbers do not support that claim.

The thing that makes losses good is that they lower the price for the stocks you will be buying in coming years. If you start investing at age 25 and don’t see losses until the years from age 45 to 55, it’s not right to say that you are “out of luck” and those losses don’t help you. They help you by pulling the price down for the stocks you will be buying from age 55 to age 65. It IS true, though, that you do not get as big a benefit from losses experienced from age 45 to age 55 as you would for losses experienced from age 25 to age 35. You don’t have as many years of purchases ahead of you. So the benefit of being able to buy at a lower price is not as great.

The case where the rules would be reversed is where you are selling stocks to finance a retirement. If you are in the process of selling stocks, you really do want high prices. In that circumstance, low prices supply no benefit to you and high prices DO supply a benefit. So we see a reversal of the usual rule.

The incredible (but mathematically proven!) reality is that the pattern of the gains and losses sometimes matters more than the return obtained. Compare the result obtained with the return pattern we saw from 2000 through 2009 and a 30-year return of 3.25 percent with the result obtained with the return pattern we saw from 1990 through 1999 and a 30-year return of 6.5 percent. The 2000-forward pattern still beats the 1990-forward pattern even though the 30-year return generated by the 1990-forward scenario is twice as big. I find that amazing. But I do not see how I can deny what the numbers say.

Why do you say that I am trying to “prove” something with the numbers? I’m just reporting them! This is a math exercise.

The thing that throws us is that we have come to believe that high stock prices are a good thing. I encourage you to think through whether high prices are a good thing when you are buying anything other than stocks. Do you get excited when a car dealer puts a car up for sale at three times fair value? Most of us would run from such a dealer. But most of us were thrilled when stock prices rose to three times fair value in the late 1990s. Could it be that we were wrong to get so excited over the opportunity to purchase wildly overpriced stocks?

I have come to believe that stocks are not risky, as most people believe. What they are is tricky. Many of the rules of successful stock investing are counter-intutive. If we can come to a good understanding of these rules, I believe that we all can from that point forward earn far higher returns from stocks at only a fraction of the risk we have felt we had to take on in the past.

I am grateful that you were able to say that you found the article “thought provoking” even though you clearly do not personally see much value in the argument made. That was a kind and fair thing to say. I am also grateful for you taking the time to present the other point of view and thereby to offer a point of view to which people might otherwise not have been exposed. I of course wish you the best of luck in all your investing efforts.

Rob

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avatar OrchidGirl ♦16 (Newbie)

This reminds me of something Warren Buffet said about when stocks are down, they are just on sale and that is a good thing for investors.

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avatar skylog ♦368 (Nickel)

this came to my mind as well while i read this post. that said, i see where rob is coming from, but i am worried by the idea of these lost decades. sure, they can help you out as long as everything plays out for you down the road…but what if it doesn’t?

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avatar Rob Bennett

I see where rob is coming from, but i am worried by the idea of these lost decades. sure, they can help you out as long as everything plays out for you down the road…but what if it doesn’t?

I believe that a lot of people feel as you do, Skylog.

The math shows that gains hurt us and losses help us. But our emotions tell us a very different story. Gains bring us emotional relief. Losses make us anxious. Understanding this tension between what works and what feels good is the secret to becoming a successful long-term investor, in my view.

I did say “we need more lost decades.” But I don’t really believe that we should all root for bigger and bigger losses. What I really believe is that we should all root for the gains justified by the amount of economic productivity achieved in a year (6.5 percent real), nothing more and nothing less.

That means that the Lost Decade we saw in the 2000s was a good thing because it brought us closer to fair value (prices were at three times fair value in 2000 and they are now down to about two times fair value) and that it would be a good thing if prices continued to fall until we were once again able to buy stocks at reasonable prices (it’s been a long time!). But I don’t believe that losses greater than that would be a good thing. The calculator would show that even losses greater than that would be a long-run plus. But I worry that losses even greater than what it would take to get us to fair value would put us in the Second Great Depression and that might be Game Over. So I very much hope that we do not end up going there.

My view is that extremes in once direction beget extremes in the other direction. If we let people know how poor a value proposition stocks represent when they are selling at insanely high prices (as they have been for most of the time from 1996 forward), we would never again see another runaway bull market. That would be a very good thing. If we never again saw a runaway bull market, we would also never again see the stock crashes and economic crises that always follow from them. I could live with that!

Rob

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avatar Rob Bennett

What I try to do in my work is to combine the insights of Buffett and Bogle, OrchidGirl. You’re right that Buffett makes a big deal out of investing only in strong value propositions. The only problem that I see with Buffett’s approach (Value Investing) is that it is hard; you have to spend all your nights and weekends researching stocks to become skilled enough for it to work and even then you might not pull it off. Bogle gave us indexing, which makes it all as simple as can be. You don’t worry about picking winners or losers because when you buy an index fund you are essentially buying a share of U.S. productivity.

My contribution has been to ask: What if we combined what Buffett says with that Bogle says? Then we could have a very simple approach (indexing) but one that also provided much higher returns at greatly reduced risk (Value Investing). This is the first time in history when the middle-class investor has had available to him a simple way to invest that provides returns plenty high enough to finance a solid middle-class retirement without requiring him to take on anything close to the level of risk that had to be taken on by stock investors in days past.

The only thing standing in our way today is the tricks that are played on our minds by the counter-intutive nature of the stock investing experience. All through the 1990s, most of us were cheering on the bull market, not realizing that the bull market was dramatically undermining our hopes of achieving solid middle-class retirements. There’s never been a time in history when as much middle-class wealth was destroyed as was destroyed in the bull market of the 1990s.

And this is not a case where we were just rooting for the wrong thing. With stocks, our rooting makes a difference. We are the market. So, when we develop a desire for higher prices, we have the power to achieve our desire by bidding prices up. If we came to understood that low prices let us retire many years sooner, we could be sure to never permit bull markets to take place and we could all retire many years sooner than is now possible. But for so long as most of us continue to think that price increases are okay or even a good thing, we all will be living lives far less fulfilled than the lives we would be living if we permitted our knowledge of how stock investing works to grow in accord with the insights mined in the academic research of the past 30 years (which shows that valuations affect long-term returns).

Rob

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avatar Josh

Rob,

Thanks for this article. It was a great read. As a young investor, I loved making new investments during the downturn, especially in 2009. Having just shown that price declines are good for investors, would you agree that psychology is one of the largest, if not the largest obstacle to higher retirement account balances? Everything I’ve read on the topic shows that investors tend to buy high and sell low.

Three cheers for the bear!

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avatar Rob Bennett

would you agree that psychology is one of the largest, if not the largest obstacle to higher retirement account balances?

Thanks for the kind words, Josh.

Yes. I would say that psychology is by far the biggest obstacle. The average long-term return on U.S. stocks is 6.5 percent real. My guess is that the typical middle-class investor obtains a lifetime stock return of something in the neighborhood of 3 percent real, half of what he should be getting. Our emotions are killing us.

This was not as true in the days before indexing. Before indexing, stock investing was an intellectually difficult task. You had to have the time and skill and inclination to research all sorts of things. None of that is necessary today. So we really are living in a great time. But we have to learn how to cope with the emotional aspects of this project, which can be tricky. I think that this is the future of investing analysis. I believe that in coming days there will be less focus on numbers and charts and tables and more on investor emotions and on what we all need to do so as not to self-destruct.

Three cheers for the bear!

I understand that you are joking around, Josh. But this is the right spirit. Bulls really do hurt us all in very serious ways. And bears serve an important purpose. They bring prices back to reasonable levels. If it were not for bear markets, the market would collapse altogether. Crashes are forced events. When large numbers of investors become unwilling to permit prices to return to reasonable levels, the market crashes as a way of avoiding collapse. I believe that we all should be far less tolerant of bull markets and far more cognizant of the merits of bear markets.

That said, I am very worried that the current bear market (I am talking about the secular bear that started in 2000 — the up move we have seen over the past two years is a counter-trend within a long-term downward move) is going to get out of hand. We have see three long-term bull markets in U.S. history. Each brought on a long-term bear market and an economic crisis. The first three long-term bears did not end until stock prices went to one-half fair value. If we see those price levels this time, it would mean a 65 percent price drop from where we are today. I think there’s a good chance that another 65 price drop on top of what we have already seen would put us in the Second Great Depression.

There is no law of the universe that says that we must see another 65 percent price drop. It is important that people understand that bear markets are every bit as much the product of emotion as bull markets. If we could teach people how stock markets really work, we could stabilize prices at fair-price levels rather than dropping to one-half fair value. I think that could spare us the economic and political catastrophe of entering a Second Great Depression. That should be our primary political and economic goal today, in my view.

Yes, low prices are good. But you don’t want them to go too low. When prices go too low, people lose hope and become frightened and the whole shebang can go down. The First Great Depression (which was brought on by the wild bull of the 1920s) almost brought us to Game Over. So we don’t really want a long-lasting bear. We want an end to both bulls and bears — we want fair, reasonable, moderate prices (a P/E10 level of 14 or 15).

My view is that we all should want stock prices to fall from where they are today (a P/E10 level of 24) down to fair value, but then to stabilize. The long-term numbers look better when prices drop even lower. But those long-term numbers don’t apply if our economic and political systems fail. I am not sure that we can take more financial pain than the pain that would follow from a drop to fair prices. So I believe that should be the goal. I oppose bear markets because of the great pain they bring. And I oppose bull markets because they lead to bear markets, which bring great pain.

Fair-value prices don’t bring pain. Fair-value prices just create wealth (for so long as valuation levels stay at reasonable levels, the market is generating that average 6.5 percent real return each year). Fair-value prices are where it’s at! Nothing headline-generating, nothing emotional. Just nice, steady 6.5 percent real returns without the crazy risk that comes from crazy levels of volatility (all bull markets cause huge price volatility, first on the up side and then later on on the down side).

Moderation is beautiful. Oh, let’s just say it — Fair-value stock prices are downright sexy!

Rob

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avatar razmaspaz

Rob,
First of all I agree with others that this is thought provoking. Your final statement says a lot. “We need more Lost Decades!”

I think you make a dangerous conclusion here. Yes absolutely, I would prefer to delay my gains and continue to buy cheaply as long as I can, but I need to eventually have the big year that brings the average return back to 6.5%.

I think you recognize this when you say “If you are trying to say that the pattern in which returns fall doesn’t matter, all I feel that I can say is that the numbers do not support that claim.” Yeah it matters. I would love to pay 10k a year for 30 years get no gains for 30 years, and have it all hit the year before I retire. That would be the best possible scenario. What you are advocating “long term market timing” is no easier than short term timing though. What do I do, invest after 4 years of sideways movement, 5?

When you say “Why do you say that I am trying to “prove” something with the numbers? I’m just reporting them! This is a math exercise.” you are being a bit deceptive (though I don’t think intentionally). You’re saying that because we have to average out to 6.5%, every year you do worse, means you are gonna benefit in the future. You’re talking averages, or statistics, not math. There is a big difference, and how does the saying go? Lies, damn lies, and statistics… Weather you realize it or not you are using a set of statistics, bending them to your argument and making a point. You are not presenting a mathematical proof that is indisputable.

I’m not arguing with your point, I just don’t see much value in it. What can I do to act on the information that you just gave me? I’m still trapped by the fact that I can’t move my horizon for retirement to take advantage of a period of lean years. Maybe I’m over indulging in your point, and the value of the advice is that I shouldn’t take my money out of the market out of fear, or buy out of “irrational exuberance”. In which case I’m in total agreement.

To me the only real rule is that stocks are cheaper today than they will be in 30 years, so I should buy as many of them today as I can. It all goes back to dollar cost averaged index funds as a “surefire” way to build wealth. As you point out “But those long-term numbers don’t apply if our economic and political systems fail.” If they fail, I’ll be worried about where to get my next bowl of soup, not where to go on vacation, so its an irrelevant point really. Catastrophic loss shouldn’t enter into the equation, so its reasonable to assume a continuation of the last X hundred years of returns.

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avatar Rob Bennett

You’ve offered both some kind words and some intelligent criticisms, razmaspaz. I’m grateful for both. We all like a pat on the back every now and again. And we all need to have our thinking challenged too if we are to hope to sharpen it over time. Thanks much for taking some time out of your day to help us all out.

I believe that the basic point being made by the calculator (losses are better for most investors than gains) really is pure math. I am not only talking “averages or statistics.” It’s true that we do not know for sure that the market will produce a return of 6.5 percent for the next 30 years. That part is an assumption. But the calculator lets you choose any assumption you like. Choose 9 percent if you don’t like 6.5 percent. Or choose 3 percent. The same moral will apply: Losses are better for most investors than gains. That aspect of this really is a pure mathematical reality.

In some of my comments above, I used that mathematical reality to argue for long-term market timing. That’s something different. I think the case for long-term market timing is exceedingly strong. I wouldn’t quite say that it is a pure mathematical reality. But, again, that doesn’t change the fact that it is a mathematical reality that losses are better than gains for most investors.

The key strategic issue is raised by your question “What can I do to act on the information that you just gave to me?” We all agree that these findings are startling. The question is — How should our behavior change given what we have learned?

The change that I would like to see is for people to become less tolerant of bull markets and of the idea (Buy-and-Hold) that there is no need for long-term investors to change their stock allocations in response to big price swings. Bull markets are times in which stocks are wildly mispriced. That’s by definition. They don’t call it a bull market if prices just go up by the amount justified by the productivity of the economy, 6.5 percent real. When we allow prices to go up by more than that, we are all kidding ourselves about what our portfolios are worth. We are making financial planning much, much harder than it needs to be. We are lowering our long-term return. We are causing bear markets and economic crises. We are setting in motion all sorts of bad stuff.

I propose that we stop doing that. That’s the thing that I say you should do in response to the findings of the Reality Checker. Stop permitting stock prices to get so out of hand.

How precisely can we achieve that goal? I can’t give a complete answer as a response to a blog comment. But I can mention some possibilities. A very simple thing is to publicize to people how much the long-term stock return drops when prices get too high. Do you know what the most likely 10-year return for stocks is when we get to the price levels that applied in January 2000? A negative 1 percent real. That’s the number you get by performing a regression analysis of the historical return data. We could all have moved our money to IBonds (they were paying 4 percent real at the time) and did far, far better than we were likely to do in stocks if only we had felt free to discuss the realities of stock investing openly.

All that we did in the late 1990s was borrow $12 trillion of stock returns from future years. We made returns “great” in the late 1990s by making them awful in the early 2000s. We were living on credit-card debt. It’s the same basic deal. You make yourself feel richer than you really are by pretending that you are wealthier than you really are for a time. But sooner or later you have to pay off the loan. And then it’s not so much fun.

When stock investors borrow trillions from their futures, there’s interest imposed on the debt. Those years of poor returns frighten people. Millions get worried that they won’t be able to retire. That causes them to spend less. That causes businesses to fail. That causes massive unemployment. That causes all kinds of political frictions. Who needs any of this junk? Why not just be straight about the realities of stock investing at all times?

Being straight means telling people that they need to lower their stock allocations when prices reach insanely dangerous levels. I am absolutely saying that investors should at times take money out of stocks. Not out of fear. Because it is the rational thing to do. And because our free market system will not be able to survive unless more of us start doing this and start encouraging others to do it too. There are always going to be people who will bid up stock prices as a way of voting themselves raises. The rest of us have a responsibility to lower our allocations when they do so that market prices adjust and we don’t get into a situation where we are all living through a long-lasting economic crisis or even another Depression.

All that we need to do is to tell people to pursue their self-interests. The risk associated with stock investing goes off the charts at times of high prices. In fact, it would be fair to say that the idea that stocks are risky in any general sense is a myth. Stocks have not once in history provided poor long-term returns starting from times of moderate or low prices. It is only when prices are sky high that stocks can fairly be said to be risky and at those times the risk is truly frightening. Just as there has never been a case in the historical record when stocks did poorly starting from a time when they were priced reasonably, there has also never been a time when stocks did well starting from a time when they were priced poorly.

Why not tell people that? Why not do all we can to get the word out? Why not develop studies and calculators and books that make the point? Have you ever thought through how much stock investing would change if we did that?

If we encouraged people to sell stocks when prices got too high, prices would never again get too high. It’s only because many investors practice Buy-and-Hold strategies that prices ever get out of control. If most of us sold when the value proposition became poor, that would bring prices back down to reasonable levels — and then the value proposition would be strong again!

Stock prices are self-regulating. IF investors know the realities. It’s when large numbers come to believe that there is no need to sell when prices get too high that we get bull markets and bear markets and economic crises. All the bad stuff follows from the one mistake that millions of investors are making today — failing to lower their allocations when the long-term value proposition of stocks gets so poor that far better returns are available from far safer asset classes.

I believe that I am indeed presenting a mathematical proof that is indisputable, rasmaspaz. The trouble (I believe) is that some cannot bear to accept it because they are emotionally invested in Buy-and-Hold strategies. It is the emotions that always get stock investors in the end. I don’t say that there is one mathematically proven valuation-informed strategy that all should follow. I believe that we all should be considering all sorts of possibilities.

But we shouldn’t even be talking about whether valuations matter or not. That’s so obvious that there should not be any controversy over it. I hope (and believe) that we are moving over time away from discussions of whether challenges to Buy-and-Hold can be permitted or not to discussions of how best to go about taking valuations into consideration when setting our stock allocations. In any event, I sure hope that’s so for my sake — all of the work I have done for nine years now is aimed at helping investors with that question!

Rob

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avatar razmaspaz

First off, you make some very valid and well reasoned points, and I’ve added your blog to my blog reader. So I hope you don’t feel like I’m just poo pooing you here. I’m just having a hard time coming around to the idea of market timing in any fashion.

Consider the statement: “Losses are better for most investors than gains. That aspect of this really is a pure mathematical reality.”, but your math doesn’t say that. Your math says that delayed gratification is better for investors, not losses. You still need a really big year right before you transition from buyer to seller, or we all just get poor. I think what I’m also hearing is that ideally we would have a 6.5% gain every year, where everyone wins no matter when we entered the market. That there would be no bumps in the road and it would be smooth sailing for everyone. But you can’t really believe that it’s possible can you? How do you make up growth in a year where there is a major natural disaster? What do you do if the CEO of GE does something stupid and runs it into the ground taking 3% of the S&P 500 with it (I made that number up) ? How do you deal with war? Bubbles have and will continue to occur, if for no other reason than that people are greedy. Based on that I assume you are advocating some sort of rational attempt by an individual to recognize a bubble and decrease our allocation in the market, coupled with increased allocation during lean times. But how do you do that? How do you recognize an asset class is overvalued?

“I don’t say that there is one mathematically proven valuation-informed strategy that all should follow. I believe that we all should be considering all sorts of possibilities.” I guarantee you that every bubble we have ever experienced someone somewhere had a valuation model that said that the valuation of an asset class was still undervalued the day before the bubble burst.

So if you can’t accurately value a stock, isn’t the next best thing to ride out the bumps in the most diverse investment vehicle you can dream up? Maybe you sell off a little as things rise, and buy back in as they go down, but that’s a lot of active management. Dollar cost averaging does basically the same thing, but its set it and forget it at the cost of a percentage point or two. And if you get the timing wrong it could cost you.

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avatar Rob Bennett

You’re in good company on the market timing matter, razmaspaz. I believe strongly in long-term market timing. But my view is very much a minority opinion. Some of the most respected (by me as well as by many people much smarter than me) experts in the field oppose all forms of market timing or at least speak out in opposition to market timing in general and fail to distinguish between short-term and long-term market timing when doing so.

But we don’t need to address the market timing question to explore the question raised in this particular blog entry. That comes into it in an indirect way. But valuations are not the focus here.

Say that you had the power to have stock prices drop by 50 percent today and then from that time forward perform just as they would have had they not fallen by 50 percent. Would that make you happy or sad? That’s the sort of question we are looking at here.

Our first reaction is to say “Of course I would not want stock prices to drop by 50 percent! My portfolio would not be worth as much!”

That’s so.

But you are missing something when you say that. You are missing that you would be able to buy stocks at far lower prices if that happened. Depending on how old you are today, you might be a lot better off in the long run if stock prices dropped 50 percent.

Every price gain has a good side to it and a bad side to it. The good side is that it increases your portfolio value. The bad side is that it means that you will be paying more for stocks from this point forward. Every price drop has a good side to it and a bad side to it. The good side is that it means that you will be paying less for stocks from this point forward. The bad side is that it diminishes your portfolio value.

You cannot say whether a 50 percent price drop is a net plus or a net negative for you without doing an analysis to see whether that change helps someone in your particular circumstances more than it hurts someone in your particular circumstances. The determining factor is your age. If you have many years of buying stocks ahead of you, it is a net plus for prices to drop. If you are close to retirement and you plan to sell stocks to finance your retirement, it is a net negative if prices drop.

My aim with this calculator is to change investor psychology. If we all come to appreciate the benefits of price drops, I believe that we will never again see a bull market. I think that would be a huge plus for our economy. I do NOT believe that bubbles will continue to occur because people are greedy. I do NOT believe that the primary cause of bubbles is greed. I believe that the primary cause of bubbles is that in the past we have not possessed a good understanding of how stock investing works. The great irony of my work is that many Buy-and-Holders take strong exception to things I say but I believe that the important insights brought to us by the Buy-and-Holders are responsible for getting us to a point where we can make some huge breakthrough advances. I am the biggest Boglehead in the world although a good number of Bogleheads want nothing to do with me.

You say: “If you can’t accurately value a stock, isn’t the next best thing to ride out the bumps?”

In pre-indexing days, you might have been right. Indexing is a huge advance. Indexing changes everything.

It’s true that it is very hard to accurately value a particular stock. However, it is not at all hard to accurately value a broad index. Please look at Shiller’s research. It is EASY to accurately value an index. All you need to look at is the P/E10 level (the price of the index over the average of the past 10 years of earnings). There is research showing that P/E10 has been accurately predicting long-term stock returns for 140 years now. There is not one case in the historical record in which the predictions did not pan out.

Why? Why is assessing valuations so much more effective with indexes?

It’s because there are so many things you need to get right to identify the proper value for a particular stock. You need to look at the quality of the management, the research pipeline, the level of competition, and on and on. You have to be Warren Buffett to get it right. None of that matters with indexes. With indexes, every factor but one is incorporated into the overall price. The only factor not incorporated is the extent to which the price assigned at a particular time is improper because it is too high or too low (it is obviously a logical impossibility for the extent of mispricing to be priced in).

So we CAN know the proper price for an index fund. It is the nominal price adjusted by the extent of overvaluation or undervaluation. If the index is priced at two times fair value (a P/E10 value of 28), the proper price is one-half of whatever the nominal price is. It’s that simple.

Now, again, you don’t need to agree on the valuations point to accept the mathematical reality that stock price gains are not necessarily a good thing. I am NOT saying here that price gains are bad because they lead to losses down the road (that’s a valuation-related point that I make with other calculators). What I am saying here is that price gains are often a bad thing REGARDLESS of whether valuations have any effect or not.

I am asking you to consider whether a 50 percent price drop might be a good thing for you. Forget about any idea that that the 50 percent drop will cause a gain at some later time (that’s a valuation-related argument). Assume that there will be a 50 percent drop tomorrow and that it will never be made up. That price drop could be a very good thing for you, depending on your age. That 50 percent price drop will permit you to buy stocks at lower prices for many years to come. That’s a huge benefit.

I am questioning a fundamental premise in our understanding of how stock investing works. This surprised me too when I learned about it. The point here is that we are not just owners of stocks, we are also buyers of stocks. When we wear our owner hat, price gains really are good. When we wear our buyer hat. price drops are good. It’s not that gratification is delayed when we see losses. It’s that losses are good! The losses are the gratification! The losses lower prices!

If you were buying a car and you talked the dealer into cutting the price by 50 percent, you wouldn’t see that as being good only because it raised the possibility of deferred gratification. You would be thrilled by the price drop itself. All stock investors should see the good in price drops. The good is very real and it is present in every price drop (so long as you intend to buy more stocks at some future day). I am seeking to change investor psychology in a fundamental way. I am trying to demonstrate to people with numbers that they should applaud price drops.

My hope is that that change in psychology will help people to better appreciate my valuation-related arguments. But this particular argument is not a valuation-oriented one. This one is rooted in the question of whether we are buyers or owners of stocks. Most of us are both. To the extent we are buyers, price drops are good stuff.

Rob

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avatar Rob Bennett

I think what I’m also hearing is that ideally we would have a 6.5% gain every year, where everyone wins no matter when we entered the market. That there would be no bumps in the road and it would be smooth sailing for everyone. But you can’t really believe that it’s possible can you?

Yes, I believe that. With 90 percent confidence.

We would see the greatest economic growth in history if this happened. Stocks would no longer be perceived as a risky asset class. That’s the opportunity before us today.

What skeptics are missing is that the systematic, academic study of stock investing did not begin until the 1960s. We are today only beginning to understand what works. Wr are like people who have recently discovered how to harness electricity. In the future we are going to find all sorts of uses for it that we can barely imagine today. People say “well, these things have never been done before.” No, they haven’t. So? The entire point of research is to ADVANCE in our understanding. Well, we are advancing. All we need to do now is let it in how far we have come in the first 50 years of our investigations.

There have been two major advances in those 50 years: (1) the discovery by Eugene Fama that short-term timing never works; and (2) the discovery by Robert Shiller that long-term timing always works. Combine those two insights and you change the history of stock investing. Stocks no longer need to be a risky asset class. As of today, 80 percent of all stock risk is voluntarily taken on by those investors who refuse to engage in long-term timing. Stock risk is today optional.

The biggest tragedy in the history of personal finance is that the two major advances did not occur at the same time. Fama made his discovery in the 1960s, Shiller made his in 1981. If both discoveries had been made at the same time, we all would have been Valuation-Informed Indexers going back to the first day. Unfortunately, Fama did not know what Shiller was going to discover many years later so he jumped to a hasty conclusion that his showing that short-term timing never works suggested that long-term timing might not work either. Nothing could be further from the truth. Long-term timing is the key to successful long-term stock investing.

Long-term timing is taking price into consideration when setting your stock allocation. It is not just that this has worked going back to 1870, as far back as we have records. It is that it is a logical impossibility that there could ever come a time when long-term timing could stop working. Are you able to imagine any way that it could ever become a bad thing to consider price when buying cars? Taking price into consideration is always a plus. It works that way with stocks too. Or at least that’s what the first 140 years of historical data tell us.

We need to overcome the mindset that says that because stocks have always been risky, stocks will always be risky. Risk is uncertainty. Shiller has shown us that long-term returns are highly predictable for those willing to look at valuation levels when setting their allocations. By removing much of the uncertainty from stock investing, Shiller has removed much of the risk (about 80 percent) of stock investing. We all will be living far richer lives once word gets out about this. The only thing holding things back today is that a lot of big names have endorsed Buy-and-Hold and they don’t like the idea of acknowledging that they made a perfectly understandable mistake back in the days when we did not know all of the things we have learned over the past 30 years but have thus far been reluctant to talk about for fear of hurting the feelings of the Buy-and-Hold advocates.

Rob

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avatar Rob Bennett

How do you make up growth in a year where there is a major natural disaster?

I reread this thread this morning and felt that I had not responded to this particular question.

One of the analytical errors made by the Buy-and-Holders (because of their belief in the Efficient Market Theory) is to think that changes in stock prices are caused by economic events (like a natural disaster). Valuation-Informed Indexers (because of their understanding of Shiller’s research) do not believe this. We believe that it is investor emotions that cause changes in stock prices in the short term and that the economic factors become the determining factor only after the passage of 10 years or so. We believe that the market is ultimately efficient but not immediately efficient.

A natural disaster might cause stock prices to plummet. It does not follow that there has been some loss of productivity as a result of the natural disaster. The reality is that natural disasters often lead to increases in productivity. A natural disaster can permit a society to begin a rebuilding process that was much needed and leave it in the long run far ahead of where it would have been had the natural disaster not taken place.

The same natural disaster can cause stock prices to drop, to increase or to stay the same, depending on where valuations stand at the time the natural disaster takes place. If the natural disaster takes place at a time of high prices, it will almost surely cause a price crash. At times of high prices, investors are secretly worried that prices will fall at any moment and they will take a natural disaster as a reason to get out of stocks. But a natural disaster that takes place at a time of rock-bottom valuations (a P/E10 of 7) can cause a bull market to begin. In those circumstances, investors see the natural disaster and say “things can’t get any worse than this!” and start moving into stocks.

Rob

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avatar Mike

I disagree. In both scenarios you assumed the last 20 years had positive gains. Your scenario is a poor model of as you never get a consistent 20 years unless you time the markets, which is impossible without a time machine.

You also ignore the real investor psyche. Real investors reduce investments in down markets, but i will concede that not all do. In 2008 and 2009 I doubled my 401k contributions to take advantage of my young age and low prices.

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avatar Rob Bennett

Thanks for stopping by, MIke. I am certain that your concerns are shared by many.

In both scenarios you assumed the last 20 years had positive gains.

It wouldn’t be fair to assume gains in one scenario and not in the other, would it? Anytime you run a test of something, you need to hold everything other than the thing being tested stable. There’s no other way to get a reasonable read.

But you can change the rules of the test by going to the Reality Checker yourself and entering all sorts of scenarios. You can enter hundreds of them. You will always get the same general result (the specifics will certainly change, of course, when you run different sorts of tests).

The reason why the general result is always the same is that the principle being illustrated always holds — price drops lower stock prices and lower prices are always better for people buying stocks than higher prices. I don’t mean to be insulting, Mike, but it is logically impossible that there could ever be an exception to that rule. Are you able to think of anything you buy where higher prices are better for the buyer? Low price is always a good thing for buyers. That rule works with stocks as well as with everything else.

Rob

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avatar Mike

As a practicioner of dollar cost averaging, I have not been adversely affected as my mutual funds NAVs have gone up. I am way ahead.

I will concede that lower prices are good for buyers, especially dividend reinvesting. My real issue was the design of your scenarios. Of course, how doesyour thesis stand up when it comes time to sell? I like to buy low and sell high, really high.

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avatar Rob Bennett

unless you time the markets, which is impossible without a time machine.

The idea that there is some sort of difficulty involved in timing the market successfully is the biggest and most dangerous myth of stock investing, Mike. I can assure you that there is zero truth to this one.

Market timing is easy. Just go with a higher stock allocation when prices are low and with a lower stock allocation when prices are high and you will always end up far ahead as a result of doing so. You can check this with the historical data. We have 140 years of data and there has never yet been a time when timing in this way didn’t work. It is not possible for the rational human mind to imagine how there ever could be such a time.

All the confusion on this point stems from the assertions you often hear from “experts” that “timing never works.” Those assertions are rooted in a wealth of academic research showing that short-term timing doesn’t work. There has never been a study showing that long-term timing doesn’t work. Every study of long-term timing shows that long-term timing always works. How could it not? Long-term timing is just paying attention to the price of the thing you are buying (stocks). Could it ever not work to pay attention to price when making a purchase?

The difference is that, with short-term timing, you are expecting to see benefits from your allocation change in a year or two. I agree with the experts that this never works. The research shows this.

WIth long-term timing, you understand when you make the allocation change that it may not pay off for as long as 10 years. This approach to timing never fails. It provides the investors who employ it far higher returns at dramatically reduced risk. Investors willing to engage in long-term timing typically enable themselves to retire five years sooner by doing so. In some cases, long-term timers (Valuation-Informed Indexers) can retire 10 years sooner.

I believer that coming to understand the difference between short-term timing (Bah! Humbug!) and long-term timing (Less RIsk! Higher Returns! Investor Heaven!) is the key to becoming a successful long-term investor. Google the term “Valuation-Informed Indexing” and you will find lots of Guest Blogs that I have written at various places making the case for us all shifting from Buy-and-Hold strategies to VII strategies.

Thanks again for stopping by, Mike. Again, I know from experience that these questions are on the minds of a large percentage of the people reading this blog entry. I wish you the best of luck with whatever investing strategies you elect to follow!

Rob

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avatar Rob Bennett

As a practicioner of dollar cost averaging, I have not been adversely affected as my mutual funds NAVs have gone up. I am way ahead.

When you say that you are ahead, I am not sure what you mean, Mike.

Have you compared where you are today with where you would have been had you seen price drops in the early years of your investing lifetime?

I don’t see how you could be ahead as the result of seeing price gains. Price gains would have increased the amount you were paying for stocks in all the following years. I am not able to get my head around how that could have helped you.

Can you give specific numbers and then provide the specific numbers that would have applied in the event that you had seen more price drops? I think you will see that you would done better if there had been price drops.

Rob

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avatar Rob Bennett

My real issue was the design of your scenarios.

I understand. That’s why I created the calculator. With the Reality Checker, you can examine hundreds of different scenarios. I encourage people to do that. The more you examine, the more the point will be brought home.

I can only discuss one or two scenarios in a single post. I tried to keep things as stable as possible in the two I was comparing because that is the fair way to do it. But it wouldn’t have changed the basic point if I had set things up in other ways.

Of course, how doesyour thesis stand up when it comes time to sell? I like to buy low and sell high, really high.

The rules are the opposite for sellers. Just as losses help us all when we are in our 20s and 30s and 40s and 50s, gains help us when we are in our 60s (presuming that we will be selling our stocks to finance our retirements).

In any market, low prices help buyers and high prices help sellers. The stock market is not different in this respect from any other market. Those of us in the process of buying stocks (that’s the vast majority of people reading this blog entry) should be rooting for price drops. Price drops help us all out in a big way.

When you look at the numbers, you learn that price drops are a bigger help than big returns. There are cases in which those who experience returns far less than the average long-term return can retire very early so long as they experience big losses in the early years.

But in the years just before retirement, you want big gains (because then you are a seller of stocks, not a buyer). Sellers should always want high prices. The interests of sellers are the opposite of the interests of buyers.

Rob

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avatar razmaspaz

Hi Rob, I’m back. :) I think the issue is with the fact that yeah, that flat line is great until the day you retire, then you need it to move up sharply. That’s great for me, I get 500% or whatever on my whole portfolio, but for the guy who exited the market the year before, he got nothing. Now it would be unrealistic to expect that you exit the market in a 100% sell everything move, so it sort of renders that argument moot, but I know from our previous discussion, what you really want is steady 6.5% real growth. That means everyone wins, every time.

The unknown here is if that is possible. Lets say for arguments sake that long term market timing is possible, and everyone buys into it. I still don’t think you eliminate the valleys and peaks because you get people who don’t want to “play by the rules” and chase the quick buck. Greed, greed, greed. I don’t know the percentage or the influence of retirement investors vs institutional investors but I have a feeling that in any given day the institution moves the market more than the retiree. Then how do you overcome irrational individual activity? It becomes a question of process vs emotion.

I would contend (and your research sort of shows) that bubbles are caused by emotional investing, so how do you eliminate emotion and greed when we are by our nature emotional investors and have been for centuries? Maybe long term timing on an individual basis can insulate from that, but it won’t normalize the market.

I’ve been thinking about this a lot lately, and I don’t really understand how this practice differs from making small regular investments over time, and re-balancing your portfolio to say 60/40 stocks/bonds every year. What is so telling about your research that it makes this better than a “modified” buy and hold that has pretty much been best practice for the last 30 years?

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avatar Rob Bennett

Hi Rob, I’m back. :)

It’s nice to hear your voice again, Rasmaspaz.

I know from our previous discussion, what you really want is steady 6.5% real growth.

Yes, this is indeed what I see as the ideal.

you get people who don’t want to “play by the rules” and chase the quick buck. Greed, greed, greed.

We’re in strong agreement re this one. I would state it even more strongly. I would say that each and every one of us has a Get RIch Quick impulse within us. We all are at risk of being taken in by emotion and messing ourselves up.

I don’t really understand how this practice differs from making small regular investments over time, and re-balancing your portfolio to say 60/40 stocks/bonds every year.

It takes the emotion out of stock investing, razmaspaz.

Valuation-Informed Indexing is emotionally balanced investing. Every price increase has a positive to it (it increases the size of your portfolio) and a negative to it (it lowers your long-term return from that point forward). And every price drop also has a positive to it (it increases your long-term return from that point forward) and a negative to it (it lowers your portfolio balance). Since price changes don’t matter anymore, investors become indifferent to changes in stock prices. The emotion is taken out of investing.

Once we become indifferent to price changes, we will no longer see price changes other than those caused by economic productivity (which causes prices to go up by 6.5 percent real each year). There will never again be another bull market once we get these ideas out to people. Which means that there will never again be another bear market. Which means that in all likelihood there will never again be another economic crisis (every economic crisis we have seen from 1900 forward followed from a huge bull market and there has never been a huge bull market that did not cause an economic crisis lasting many years).

With VII, stocks prices become boring and predictable — prices just go up by 6.5 percent real each year. With price volatility gone, there is no longer any significant risk associated with investing in stocks. We would be getting the huge returns associated with stocks with virtually none of the risk that has historically been associated with this asset class. RIsk is uncertainty. Eliminate price volatility and you eliminate risk. We end up with high returns and close to zero risk — What could be better?

I don’t really understand how this practice differs from making small regular investments over time, and re-balancing your portfolio to say 60/40 stocks/bonds every year.

The difference is that, with VII, there is always a response to any emotion/greed-oriented price increases. Price increases not supported by the economic realities (that is, any price increase of more than 6.5 percent per year) cause investors to lower their stock allocations (because the value proposition of stocks is now not as strong). Those sales cause prices to return to fair-value levels. Market prices are self-correcting so long as we permit investors to learn the realities and thereby to act in their own self-interest.

What is so telling about your research that it makes this better than a “modified” buy and hold that has pretty much been best practice for the last 30 years?

The telling thing is that stock returns are now predictable (for indexers who consider valuations when setting their stock allocations). John Walter Russell did a statistical test to determine how much the starting-point P/E10 level tells us about what the 20-year return will be. The answer is: 78 percent of the 20-year return is “predicted” by the starting-pont P/E10 value. Another way of saying it is that VII eliminates four-fifths of the risk of stock investing.

Buy-and-Holders are always anxious about their portfolios (whether they are willing to acknowledge this or not) because they have no idea where prices are headed. Valuation-Informed Indexers know on the day they purchase stocks what their long-term return is going to be. So there is no reason to get emotional. Emotional price drops don’t scare them because they recognize them as temporary phenomena. Emotional prices increases don’t excite them because they see these too as temporary phenomena.

Valuation-Informed Indexing takes Bogle’s ideas and make them workable in the real world. Bogle tells people to focus on the long term and to stay the course. But it is not possible for humans to do this when they are living through a 10-year or 20–year bear market in which most of their accumulated savings of a lifetime disappears. If large numbers of investors are able to learn about VII, we will never again have a bear market. So this is no longer a problem. And, if we are not able to tell people about the ideas, there is still a benefit for those who follow VII strategies because we know in advance when a bear market is coming (there has never been a runaway bull market that did not lead to a runaway bear market) and we protect our portfolios from its effects.

I am a Bogle guy at heart. All of these ideas are efforts to improve on Bogle’s vision by adding the insights developed by Shiller to what Bogle came up with years before Shiller did his research. I don’t fault Bogle for getting some things wrong; everybody got those things wrong. I only wish that he would be more open to acknowledging mistakes when they are brought to his attention (I have written Bogle three e-mails offering to share with him all that we have learned from our nine years of discussions and have not yet received a response).

Rob

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