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Stock Investing Without All the Drama

February 8, 2011 · 13 comments

in Personal Finance

This is a guest post from Rob Bennett.  Rob created the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here.

I could do without all the drama.

How about you?

I need to invest in stocks. Only stocks offer long-term returns big enough to finance a comfortable middle-class retirement.

But the elation of bull markets and the depression of bear markets — I would be happy to leave that nonsense behind.

I’m looking for a way to invest in stocks that makes sense for the typical middle-class person. I’ve been studying this question on a full-time basis for nine years now, and I think I’ve found a better way. The purpose of this Guest Blog Entry is to share with you what I’ve learned.

In the old days, investing in stocks was a difficult business. You had to study all sorts of things relating to individual companies. Did the company hire good managers?  Were profit margins in its industry too low?  Did the company have a good pipeline of new products? And on and on. Trying to Invest effectively was like taking on a second job.

Then came index funds. With index funds, none of that hard work is necessary. Buy an index fund and you get a mix of all the good and bad companies.  So there’s no chance that you will get stuck with only losers. So long as the U.S. economy remains sufficiently productive to support the average long-term stock return of 6.5 real, you are set.  And the U.S. economy has been doing that for 140 years now, as far back as we have records.

There’s still one problem, however.

Buy index funds and you avoid the risk of picking bad stocks. But you take on another kind of risk — the risk of investing heavily in stocks at the wrong time. That 6.5 percent return is only an average. There have already been three times in U.S. history when stocks have provided an average 20-year return of 0.7 percent (including dividends).

Those who pick stocks effectively can do well even during bear markets. Indexers cannot. When the market does poorly for long periods of time, indexers get killed. Invest heavily in stocks at times when the long-term return is lower that what is available from money market accounts and you will be working well into your 90s.

Is there a way to avoid investing heavily in indexes at times when the long-term return is likely to be poor?

There is.

Spend 15 minutes looking at the historical stock-return data and it jumps out at you what causes those 20-year time-periods when stock indexes provide tiny returns — insane levels of overvaluation. It stands to reason, doesn’t it?  Cars don’t provide a good value proposition when they are insanely overpriced.  Nor do houses.  Nor does anything else. Price always matters. Could it be that the universal rule applies when buying stocks too?

I think it does. There have been four times when the price of the U.S. market rose to two times fair value. On the first three occasions, we saw 20 years of poor returns (including a stock crash and an economic crisis each time). The fourth occasion was January 2000, when stock prices rose to levels far in excess of those that brought on the Great Depression . And sure enough this time too we have seen a stock crash and an economic crisis and many years of poor returns.  I am beginning to detect a pattern.

I advocate Valuation-Informed Indexing, a new approach to indexing. With this approach, you don’t stay at the same stock allocation at all times. You adopt one stock allocation for times when prices are moderate (perhaps 60 percent stocks), a second stock allocation for times when prices are low (perhaps 90 percent) and a third stock allocation for times when stock price are high (perhaps 30 percent).

You lose far less than Buy-and-Holders in stocks crashes (which only take place starting from times when prices are high). That means that you have a lot more money to invest in stocks at those times when long-term returns are mouthwateringly high. The end result is that over an investing lifetime you earn far higher returns while taking on dramatically less risk. Investor heaven!

Please don’t feel that you need to take my word for whether it works or not. Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, has posted preliminary research showing that “Valuation-Informed Indexing provides more wealth [than Buy-and-Hold] for 102 of the 110 rolling 30-year periods” in the historical record.

I make available at my web site the tool you will need to follow this approach. The Stock-Return Predictor is a stock valuation calculator that performs a regression analysis of the historical stock-return data to reveal the most likely annualized 10-year return for the S&P 500. It shows that, at the prices that applied in 1982, the most likely annualized 10-year return was 15 percent real while at the prices that applied in 2000 the most likely annualized 10-year return was a negative 1 percent real.

Are you able to identify one stock allocation that makes sense in both sets of circumstances? Neither am I. The sane thing is to go with different stock allocations in wildly different sets of circumstances.

The only downside to the Valuation-Informed Indexing strategy that I am able to identify is that it takes most of the drama out of stock investing. You don’t get that hyper feeling during bull markets because you go with a low stock allocation when stocks are priced to crash. And you don’t get that fearful feeling during bear markets because you never see huge chunks of your retirement money disappear in a flash.

If you need more drama in your life, try to squeeze in more frequent trips to the movies. The purpose of investing should be to obtain good returns at low risk. Valuation-Informed Indexing is the most sensible choice for the typical middle-class investor.

From Kris:  Have you ever tried Valuation Informed Indexing?    Or do you prefer to make your own ‘mutual fund’ which comprises of a mix of stocks you select and purchase?  Or, do you hate stocks and prefer bonds/gold/cash/T-bills/etc?


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{ 10 comments… read them below or add one }

MoneyCone February 8, 2011 at 10:25 am

Very interesting approach! I’m always open to new ideas that doesn’t dismiss fundamentals. I will check this out.

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Rob Bennett February 8, 2011 at 11:36 am

Thanks for your kind words, MoneyCone.

The intent here is to make sure that the fundamentals are being given due consideration. I think of Valuation-Informed Indexing as a combination of the most important insights of Bogle and Buffett. Buffett’s focus on the fundamentals is what works best. But the typical middle-class investor needs something as simple as Bogle’s indexing approach. To make indexing work in the long term, you need to include consideration of the value proposition being offered at different price levels. That’s Valuation-Informed Indexing.

I’ve been exploring this on a full-time basis for nine years now. The best overview of the materials available on VII is at the “About” page for my blog:

http://arichlife.passionsaving.com/about/

Please let me know if you find any significant flaws. I want to let people know about those in the event that helpful people like you turn things up.

Rob

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retirebyforty February 8, 2011 at 4:05 pm

So how did you do over the last 9 years? I assume better than SP500.
Valuation informed indexing sounds good to me. This will work really well in retirement IMO.

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Keep it Simple February 8, 2011 at 12:22 pm

I need to invest in stocks. Only stocks offer long-term returns big enough to finance a comfortable middle-class retirement.

But the elation of bull markets and the depression of bear markets — I would be happy to leave that nonsense behind.

The problem is that you don’t get the big long term returns without the elation of bull markets and the depression of bear markets.

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Rob Bennett February 8, 2011 at 2:49 pm

Thanks for stating the other point of view, Simple.

We all need to hear both sides to be able to make sense of this.

Rob

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Rob Bennett February 8, 2011 at 4:34 pm

So how did you do over the last 9 years?

I got out of stocks in the Summer of 1996, RetireByForty. Yes, I am up. I was in CDs that were paying a real return of 5 percent real in the late 1990s (stocks were paying returns of 20 percent and up in those years). Then I locked in TIPS and IBonds paying a real return of 3.5 percent real.

The real benefit to this is in the long-term. I have run hundreds of 30-year simulations. The magic of Valuation-Informed Indexing is that sooner or later it almost always goes ahead (there are rare exceptions when quirky returns sequences turn up). Once you go ahead of Buy-and-Hold, the magic of compounding takes over and turns that small differential into something big over the course of 30 years or so. It is almost impossible for Buy-and-Hold to catch up because the Valuation-Informed Indexer is also invested heavily in stocks when prices are moderate.

In my tests, VII beats Buy-and-Hold in 90 percent of the 30-year returns sequences. In the few cases in which Buy-and-Hold does better, it is by a small amount. VII sometimes does better by a large amount. I have seen cases where the VII portfolio is more than double the size of the Buy-and-Hold portfolio at the end of 30 years. That’s not the norm, but it does happen.

What people miss is how big the power of compounding returns can be in the long term. Anything that gives you a virtual lock on gaining an edge sooner or later turns into a big deal over the course of an investing lifetime because compounding causes that differential to grow and grow.

Rob

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Rob Bennett February 8, 2011 at 5:05 pm

Valuation informed indexing sounds good to me. This will work really well in retirement IMO.

Thanks for your kind comment, RetireByForty.

Yes, this is ideal for retirees. People are often impressed that VII can provide a portfolio of double the size of a Buy-and-Hold portfolio at the end of 30 years. But the real magic here is that it does this at dramatically less risk. This is a win/win/win — greater returns and less risk for the investor and a more stable economy for all of us, even non-investors.

My research into this began when I was putting together a Retire Early plan for myself. I looked into the studies that say that the safe withdrawal rate (the percentage of a portfolio that can be used to cover living expenses with virtual certainty that the portfolio will last 30 years) is always 4 percent. It seemed illogical to me to say that the SWR is a constant number if valuations affect long-term returns (as Shiller’s research shows). So I asked for help on a Motley Fool discussion board to figure out the true (valuation-adjusted) SWR.

It turns out that the SWR can drop to as low as 2 percent at times of high valuations and can rise to as high as 9 percent at times of low valuations. We are going to see millions of middle-class people suffer failed retirements in days to come because of the analytical errors in those studies.

Numerous big-name experts have confirmed my findings. But it has been an exceedingly difficult task to get the word out to middle-class investors. There’s a Social Taboo in this field against pointing out errors made by the people who do investing studies. I view this as a terrible thing! I have been speaking out against it for nine years now.

Do you know what the SWR was for retirees going with a 100 percent TIPS portfolio in 2000? It was 5.8 percent. The SWR for an 80 percent stock portfolio (there were people telling retirees that it was a good idea to go with 80 percent stocks at that time) was 2.0 percent. For someone who retires with a $1 million portfolio, that’s the difference between being able to spend $58,000 per year or being able to spend $20,000 per year! That’s every year for 30 years running!

Do you know what Dallas Morning News Columnist told me about my efforts to fill middle-class investors in on the realities of safe withdrawal rates? He said that it would prove to be “catastrophically unproductive” because The Stock-Selling Industry does not want this getting out. He said that I wasn’t the first person to learn about the errors in the retirement studies and that the reason why the media doesn’t report on them is that “It is information most people don’t want to hear.”

They think we’re stupid! They think we’re irresponsible! They think their job is to tell us fantasies that make us all believe that our temporary bull market gains are real rather than the true realities of stock investing.

It’s a bad situation! I think it is going to get better over time and I am beginning to see some positive signs. But there’s a lot going on in InvestoWorld today that is not even a little bit right and retirees are especially vulnerable to being hurt by the fairy tales that are told to middle-class investors by most of the big names in this field.

We need to begin thinking of ways to take care of ourselves, in my view. I would like to see lots of personal finance bloggers working together to get the straight story to people rather than just posting the stuff that comes from the marketing departments of The Stock-Selling Industry as if it were gospel. If we don’t, things are going to get a lot worse in our economy in days to come.

Sorry for the sermon. I have a lot of friends at all of the various Retire Early boards who have been hurt in serious ways by those Old School SWR studies. Not one of them has yet been corrected, by the way. People who google the term “safe withdrawal rate” still turn up links to the Old School studies I have a New School (valuation-adjusted) SWR calculator at my web site) called “The Retirement Risk Evaluator.”

Rob

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Jeepster56 February 9, 2011 at 9:58 am

So wait a minute.

This is 2011. You’ve been 100% out of stocks — including indexes — since 1996?

That’s 15 years of taking whatever the bond market, CDs or TIPS will yield (often and currently less than 2%).

And that is what your studies show made the most sense?

What is your current annualized return on your own retirement portfolio?

The *idea* of buying low and selling high is nothing new, and neither is using a flag to tell you when to do so. Actually doing it takes some intestinal fortitude, though, and I’m curious how you defend not following your own program even as you recommend it for others?

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Rob Bennett February 9, 2011 at 10:57 am

I’m curious how you defend not following your own program even as you recommend it for others?

I don’t understand this particular comment, Jeepster. Of course I follow it. You even say in your own post that I’ve been out of stocks nearly 15 years. Is that not following it?

My money is in TIPS and IBonds earning 3.5 percent real. That return has been beating the return being paid by stocks over that time-period. (Another factor here is that I had only a tiny bit of savings in 1996 and saved very large amounts in the late 1990s. So I lost only a tiny bit from being out of stocks in 1996 and 1997 but obtained a big benefit from being out from 1999 forward.)

I of course understand that the 3.5 percent real return is not available today. That doesn’t mean that there are not super opportunities available today. Every huge bull market in history has caused enough economic destruction to bring stock prices to half of fair value. That’s a 65 percent drop from where we stand today. After that 65 percent drop, the most likely annualized 10-year return will be 15 percent real!

You can get rich in a short amount of time with that sort of return. All of today’s investors have the opportunity to position themselves to obtain that return by protecting their money from the next crash. Even if you earn a return of zero for a few years you are doing great if doing so permits you to earn 15 percent real for 10 years on that money.

You are of course right that the idea of buying low and selling high is not new. The difference is that today we have the academic research needed to know how to go about doing it effectively. Most of the market timers from the pre-Buy-and-Hold days were engaging in short-term timing. The research shows that that never works.

That’s why timing got a bad reputation. We are now seeing that the second huge advance in our understanding of how stock investing works — that long-term timing always works and is in fact required for long-term success — is just as important as the first huge advance. You don’t want to engage in short-term timing. But you must be sure ALWAYS to keep valuations in mind when setting your stock allocation (long-term timing).

My sense is that you are shocked by the length of time (15 years) for which stocks have remained a poor long-term value proposition. Buy-and-Hold was the cause of this. We have had times in the past when a large number of investors came to believe that it might be okay to ignore price when buying stocks (we saw an economic crisis each and every time this happened, by the way). Never before in history, though, have we heard claims that there is something “scientific” about the idea of ignoring price. That’s what Buy-and-Hold brought to the table. That’s why this economic crisis is likely to be longer and more devastating than any of the earlier ones.

I don’t share your belief that it takes “intestinal fortitude” not to buy overpriced stocks. All it really takes is a desire to achieve financial freedom early in life and a willingness to study the academic research and the historical record.

All of us take price into consideration when buying everything else we buy in this Consumer Wonderland of ours. You look at price when you buy a computer or a car or a camera or a comic book, don’t you? Does that take “intestinal fortitude”? The only thing you really need to move to the other side is an understanding that buying stocks is just like buying anything else — price always matters.

It’s not really right to say that a Valuation-Informed Indexer ever takes what CDs or TIPS or IBonds have to offer if what they offer is not appealing. The Valuation-Informed Indexer compares the long-term return being offered by stocks with the return available from the super-safe asset classes. It’s only in those cases in which the super-safe asset classes offer a better deal that you would move out of stocks. At times when stocks offer a better deal, you obviously want to be in stocks.

This is why this always works — you are always in the best asset class available to you at the time. When stocks offer the better deal, you are in stocks. When the super-safe asset classes offer the better deal, you are in the super-safe asset classes. How can it ever not work out to be in the asset class offering the best deal available to you?

The big picture story here is that we have learned two things of huge importance in recent decades. First, we learned why buying low and selling high never worked in the past — people were trying to make short-term timing work and it never works! Then we learned why Buy-and-Hold never works either — it’s just as critical to practice long-term timing as it is to avoid short-term timing.

Now we need to combine the two major insights into a powerful package that gets the investing job done in the real world. That’s Valuation-Informed Indexing! It’s the post-Buy-and-Hold, research-based approach.

I am grateful to you for raising these points, Jeepster. My guess is that there are a number reading these words who have similar questions and concerns. You are helping us all out by getting them out on the table. I hope my responses have helped at least a tiny bit.

Rob

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QUALITY STOCKS UNDER 5 DOLLARS April 4, 2013 at 7:32 pm

The problem with to many investors is that they panic at the drop of a hat.

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