Valuation-Informed Indexing #222

by Rob Bennett

There has been a good bit of controversy in recent days about videos that were discovered in which MIT Professor and Obamacare Architect Jonathan Gruber explained how the people writing the Obamacare law engaged in trickery in their crafting of the law because they did not believe that the “stupid” Americans for whom the law was being written would accept it if it were written in a transparent manner. I have seen a good bit of this sort of thinking in the investing advice field — well-intentioned people come to believe so strongly in the strategies that they promote that they come to engage in deceptions which they rationalize as white lies that must be employed to achieve the greater good of persuading people of the merits of a case that they would not accept if realities were stated plainly.

Does market timing work?

I think it would be fair to say that there is no claim that is so widely accepted among investment advisors than the claim that timing is a bad idea. Timers are ignorant of what the peer-reviewed research says. Timers are being swayed by a Get Rich Quick impulse. Timers always lose out in the long run. Right?

That’s not even close to being right.

There has never been a research paper that obtained peer review that showed that long-term timing (changing your stock allocation in response to big shifts in valuation levels with an understanding that doing so may not pay off for as long as 10 years) does not work. The reality is quite to the contrary. Academic Researcher Wade Pfau and I worked together for 16 months on research that was published in a peer-reviewed journal that shows that investors who are willing to change their stock allocations in response to big valuation shifts thereby reduce the risk of stock investing by nearly 70 percent while obtaining far higher long-term returns. That’s pretty darn amazing. That suggests that the distinction between short-term timing (changing your allocation because of a guess as to where prices are headed within the next year or so) and long-term timing (which in essence is nothing more than the exercise of price discipline when buying stocks) is something that LOTS of the experts in this field should be examining closely.

Few are doing so.

Wade holds a Ph.D. in Economics from Princeton. He knows his stuff. He was amazed when he saw what the numbers show. It shouldn’t be possible at this late date in the history of investing analysis for someone who holds a Ph.D. in Economics from Princeton to be amazed re the discovery of such a fundamental reality. Wade and I had several discussions about this in which he described to me his bafflement that earlier researchers had not studied this question in depth.

I believe that I know what has been going on. I don’t believe that the problem is that most researchers in this field are dumb or corrupt or not able to appreciate why the distinction between short-term timing and long-term timing might be a very big deal indeed.

I have studied this distinction in great depth over the past 12 years. I think stocks are a dangerous and poor-performing asset class when the P/E10 level goes above 25 (where it has resided for most of the time-period from 1996 forward). A number of years back I developed a calculator (“The Stock-Return Predictor”) which performs a regression analysis on the historical return data to reveal to investors the likely annualized 10-year return on a stock investment made at any specified P/E10 level. The calculator reports that, when stocks are priced as they were priced in January 2000, the most likely 10-year annualized return is a negative 1 percent real. IBonds, a risk-free asset class, were at the time offering a return of 4 percent real. So investors who made the switch from stocks to IBonds obtained an increased return of 5 percent real for 10 years running by doing so. At the end of 10 years, they increased their portfolio value by 50 percent of their starting-point portfolio value (presuming a 100 percent stock allocation — please adjust the gain downward to see the percentage that applies for lower stock allocations) by making this one change.

The people who made that change will be obtaining compounding returns on the differential for many years to come. They will be able to retire years earlier or in some cases even decades earlier. And they achieved these results while taking on dramatically reduced risk. Why are there not hundreds of researchers rushing to have studies published exploring this approach? Why are there not thousands of investment advisors rushing to win points with their clients by telling them about it? Why are the personal finance magazines not featuring articles about it on their covers?

I used to post regularly at the Bogleheads Forum, a popular investing discussion board. I told people there about The Stock-Return Predictor and a good percentage of the community that meets there (not a majority by any stretch but a large number of people) showed intense enthusiasm about the concept and asked lots of questions  in their effort to learn more. One of the leaders of the board, the author of a book promoting Buy-and-Hold strategies, became agitated about the message being told by the calculator (he eventually had me banned from the forum). Asked why he was engaging in abusive posting tactics aimed at driving me and those who supported me off the board, he said that my reporting on what the historical data said was “dangerous.”

Some of my supporters said that he did this because he did not want to see questioning of the tenets of his book. That was probably a factor but I do not believe that it was the primary one. The primary influence on this fellow’s behavior is that he believed in Buy-and-Hold. If Buy-and-Hold is the answer, what I say about how stock investing works really is dangerous. I advocate long-term timing. There is no place for timing of any kind in the Buy-and-Hold strategy.

Jonathan Gruber believed that he was helping people when he crafted Obamacare provisions in such a way so that they could not understand what was really going on. The fellow who got me banned from the Bogleheads Forum believed that he was helping the members of that forum when he “protected” them from the calculator that shows them how much sooner they can achieve financial independence if they take price into consideration when buying stocks.

No one knows everything. Gruber doesn’t. I don’t. The fellow who wrote a book on Buy-and-Hold doesn’t.

It’s a mistake for any of us to become too convinced of the ultimate merit of our own beliefs. When we do, we cut off discussions that need to be held for both the promoters of ideas and the people hearing those promotions to develop a deep confidence in them.

Gruber helped his cause in the short term but hurt it in the long run. So did the fellow who got me banned from the Bogleheads Forum.

Strong ideas can withstand questioning and challenges.

Promotors of ideas who avoid questioning of them and challenges to them do not possess a true confidence in them.

And they do harm to their cause when they listen to that voice within that says “just get it done, how you do so doesn’t matter.”

We all should want to discover weaknesses in our ideas as early as possible. Weaknesses always reveal themselves in time. And they do more harm the latter it is that they are discovered. The people who find the flaws in the ideas for which we feel great passion are our best friends even though we are tempted to dismiss them as pains in the neck at the time they are doing so.

Rob Bennett has recorded a RobCast titled “Time Is Not a Four-Letter Word.” His bio is here.