Valuation-Informed Indexing #165

by Rob Bennett

We live in a dynamic society. That means that we see a lot of change. It can make you dizzy at times. It can be scary.

But I see it as being in an overall sense a good thing. We see lots of advances that less dynamic societies do not see. “Change” doesn’t always mean “progress.” But it often does.

Unfortunately, a lot of people who work in the investing field have their minds closed to progress. A popular saying among Buy-and-Holders is: There Is No Such Thing As a Free Lunch. Yuck! Isn’t learning — figuring out how to do things better than you have ever done them before — a free lunch? I love learning, If I were to believe that there is no such thing as a free lunch, I would need to believe that learning serves no purpose. I cannot go there.

I am the co-author (with Wade Pfau, who holds a Ph.D. in Economics from Princeton) of research that shows investors how to reduce the risk of stock investing by 70 percent (you have to give up on Buy-and-Hold and start taking valuations into consideration when setting your stock allocation). High Return/Low Risk Investing — Now that’s a free lunch!

It sounds like I am bragging. I hope it helps if I note that it was things that I learned from lots of smart and good people (including my many Buy-and-Hold friends!) that provided me with the background that I needed to produce that study. I tell you about it not because I want to point to me, me, me. I tell you about it because I believe that the breakthrough achieved will help us all live better lives and so I want everyone to know about it.

How much do you need to retire?

That’s the core question in all investing analysis. People invest to finance their retirement plans. The first step to developing sound strategies is knowing how much you need to acquire. If $10,000 would buy a nice retirement, no one would take on any risk at all. $10,000 won’t do it. So we all know we need to take on risk. But how much risk is appropriate? To know the answer, we first need to know how much we need to acquire to someday be able to leave our jobs and continuing living in a manner acceptable to us.

If what Wade and I show in that paper is true (it is!), you don’t need nearly as much as the smartest minds in this field once thought you needed.

When I was planning my early retirement, I searched the literature to discover a good rule of thumb for how much I needed. The most conservative rule I came across was one that argued that you could count on an annual return on your investments of 3 percent real. Using that rule, you need a portfolio of $1 million to support a retirement calling for $30,000 in spending. The least conservative but still somewhat reasonable rule that I came across argued that you could count on an annual return on your investments of 5 percent real. Using that rule, you need a portfolio of $1 million to support a retirement calling for $50,000. Big difference.

For purposes of my own planning, I elected to go with a rule of thumb in the middle of those two extremes. I used an assumption that I needed a portfolio of $1 million to support a retirement calling for $40,000 of spending. Please don’t confuse this with the controversial (I should know!) 4-percent-rule produced by the long-discredited Old School safe withdrawal rate studies. That’s a different (but obviously related) concept. The question here is — What sort of return can you realistically expect your investments to produce?

The long-term average return on stocks is 6.5 percent real. There’s a temptation to use 6.5 percent as your return assumption. It would be a foolish mistake to do that.

You will not have all your money in stocks. So you will not be earning 6.5 percent real on all of your savings.

And the 6.5 percent return delivered by stocks is delivered in a very uneven manner. Stock returns can be low or even negative for many years. You cannot count on a return of 6.5 percent real for any given time-period. So you cannot use that number in your planning for a retirement that will be taking place in the real world.

I have long believed that an assumption that you can earn 4 percent real annually makes sense (please understand that I am not saying that 4 percent is always the safe withdrawal rate — I very much do NOT believe that).  Today, I believe something better than that. We have achieved amazing advances (rarely reported, unfortunately) in our understanding of how stock investing works in recent years. At this point I believe that the advances are important enough and solid enough for responsible people to start using an assumption of a 5 percent annual real return in their financial planning.

That’s a big, big, big advance. A change in expectations of that magnitude changes financial planning in a fundamental way. How do I justify such a positive change in expectations?

It’s that finding that Wade and I advanced in our paper that stock investing risk can now be reduced by 70 percent. Risk reduces return. Buy-and-Holders don’t get this. Buy-and-Holders think of risk as a good thing. They believe that only risky asset classes can provide good returns. it follows that investors should seek out risk rather than avoid it.

I couldn’t possibly disagree more. I believe that investors should be perusing dual goals of always increasing return to the greatest extent possible while always also reducing risk to the greatest extent possible. Risk is bad. Where there is risk, there will eventually be losses. Losses are setbacks. You want to avoid setbacks. You want to avoid risk.

Now that we know how to reduce risk dramatically, we know how to increase returns dramatically. That follows.

So we can all use higher return assumptions on a going forward basis. If you are willing to take valuations into consideration when setting your stock allocation, you will avoid the losses that send others reeling backwards. Your higher portfolio amounts will compound more quickly. You will reach your retirement goals sooner.

Knowledge of how stock investing works advances over time just as knowledge in all other fields advances over time.

Change is good.

Rob Bennett has recorded a podcast titled Why Liberals Should Oppose the Continued Promotion of Buy-and-Hold Investing. His bio is here.