Valuation-Informed Indexing #183

by Rob Bennett

We all like to think of ourselves as independent thinkers. In most cases, we are flattering ourselves. Humans are social animals. What we see others think about a subject affects what we think about a subject.

My experience is that this is very much the case in the investing realm. When there is a bull market going on around us, we tell ourselves (and convince ourselves) that we believe that stocks are a good investment choice. But the primary driver of that belief is our observation that lots of others believe this. That’s why markets crash. When the others stop believing, we stop believing. Then prices head south quickly.

I have three stories to tell that illustrate how this works.

The first involves me. I put forward a post at a Motley Fool discussion board on the morning of May 13, 2002, saying that the Old School safe withdrawal rate studies got the numbers that millions of us were using to plan our retirements wildly wrong. The problem with the studies is that they do not include an adjustment for the valuation level that applies on the day the retirement begins. The board community split in two. One faction was saying that the discussion that followed my post was the most important discussion we had ever had at that board. The other was saying that I was as dumb as a box of rocks and should burn in hell for even suggesting that there was anything wrong with the retirement studies.

At the close of the third day of discussions, I put forward a post saying that I now saw that I was wrong and apologizing for the trouble I had caused. My views on safe withdrawal rates have since been confirmed by some of the biggest names in the field. So I am often asked today what the story was with that crazy apology. Did I really believe that I was mistaken? Was I pretending? Or lying? What the heck was going on?

I still have good recall of the confused thoughts that were jumping around in my brain that night. I was confident that the studies were in error. It just isn’t possible that a study that doesn’t include a valuation adjustment could get the numbers right given that we know that valuations affect long-term returns. But logic wasn’t all that was in my head. There were lots of people whom I liked and respected who were very, very, very sure that the studies were just fine and that I was the one who was in the wrong. When you hear numerous people saying the same thing, it gives you pause.

It’s not just me.

There was a fellow who posted at the Vanguard Diehards board (now the Bogleheads Forum) who told a similar story. His posting name was “Earnabuck.” Earnabuck didn’t agree with most of my views on investing but be often defended me from personal attacks. Once he told the reason why. He said that he was there at Motley Fool when the controversy was raging and that at the time he thought my critics were right. At some point, he had an epiphany and came to the conclusion that it is not possible to calculate the safe withdrawal rate accurately without making an adjustment for valuations. He pointed out that, if that is so, millions of people will be suffering failed retirements in days to come because of the long delay we have seen in getting those studies corrected.

It’s strange, isn’t it? Earnabuck was a smart guy. The issue is a simple one. The studies obviously don’t contain valuation adjustments — that’s not hard to check. Valuations obviously affect long-term returns — we have known that for 33 years. So why didn’t he appreciate the errors from the start? Why did it take him years to come around?

It was the social pressure. The social pressure interfered with Earnabuck’s ability to think clearly. He didn’t lack I.Q. points. Yet he found himself for a long time on the wrong side of an important investing topic. Because he lacked the ability to reject the crowd and let his own brain do his thinking for him. We all are guilty of this to a far greater extend and far more frequently than we realize.

A similar sort of thing happened when I began my relationship with Wade Pfau, a relationship that resulted in the publication of some very important research about two years later. Wade had learned of me from my posts at the Vanguard Diehards board. He thought that I was on to something important and he wanted to work with me to develop research on Valuation-Informed Indexing. I was of course flattered and honored and told him that I would be thrilled to work with him.

Then I saw the words he posted that day to the Bogleheads Forum about our joint project. I don’t remember the precise wording, but I found what he said highly offensive and I called him out on it. I was prepared to walk away from the partnership if Wade did not make it right. He did. He provided me a full and complete and warm apology and then posted the same words at the Bogleheads Forum, setting things entirely right.

But why had he written the offensive words in the first place? He told me that “I was trying to pay tribute to your insights in what I knew was a hostile environment.” It was social pressure again working its magic. Wade personally liked what he saw in my posts. But he did not like the idea of saying so in clear and clean and direct language among people who very much do NOT like what I say in my posts. So he found a way to rationalize going forward with suggestions that his own beliefs were very different from what they really were. Before being too critical of Wade, we should all ask ourselves whether we frequently engage in similar behavior.

Bull markets are social phenomena. We don’t speak out against them because we are afraid of being ostracized by our friends and neighbors and co-workers and fellow community members. When will it change? When there is a general recognition that we need to explore this sort of topic if we hope to come to possess a clear understanding of how stock investing works in the real world.

Rob Bennett has recorded a podcast titled I Was Wrong: The Bull Market Started in 1975, Not 1982. His bio is here.