Valuation-Informed Indexing #370

By Rob Bennett

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Last week’s column argued that the biggest problem with the Buy-and-Hold strategy is all the questions it takes off the table. It’s not just that Buy-and-Holders increase risk and diminish their long-term returns by refusing to take price into consideration when buying stocks, it’s that, once investors buy into the Buy-and-Hold strategy, they refuse even to look at the numbers showing them how much they are hurting themselves by walking this path. Once a decision is made to ignore valuations, an investment strategy becomes a runaway train. Each time valuations rise even higher and an investor’s circumstances worsen, he reassures himself that there is no need to take valuations into consideration and becomes more emotionally attached to his belief in that idea. Following a Buy-and-Hold strategy encourages an ever-strengthening and ever-more-addictive dogmatism.

That’s the macro picture. My focus this week in on the way in which following a Buy-and-Hold strategy causes investors over time to keep themselves in the dark re lots of micro issues as well.

My interest in the flaws of the Buy-and-Hold strategy began when I pointed out to a discussion-board community that the Buy-and-Hold retirement studies do not contain valuation adjustments and thus get the numbers wrong (Robert Shiller published peer-reviewed research in 1981 showing that valuations affect long-term returns). A number of years back, I developed the first retirement-planning calculator (“The Retirement Risk Evaluation”) that takes into consideration the valuation level that applies on the day the retirement begins. It of course generates numbers very different from the numbers generated by the Buy-and-Hold calculators. For example, the safe withdrawal rate was 1.6 percent at the top of the bubble according to my calculator while it is always 4 percent according to the Buy-and-Hold retirement calculators.

When I was developing the retirement calculator, it occurred to me that it would be helpful for investors using it for me to include some features not included in the Buy-and-Hold calculators. My calculator permits investors to examine how the safe withdrawal rate changes in response to a lowering of the stock allocation. It permits investors to compare the safe withdrawal rate obtained by investing in stocks with the safe withdrawal rate obtained by investing in super-safe asset classes like Treasury Inflation-Protected Securities (TIPS). It permits investors to examine how much of a difference it makes to plan a retirement that is sure to have at least one dollar remaining in the portfolio at the end of 30 years (this is the assumption used in the Buy-and-Hold studies and calculators) versus one that is sure to have 50 percent (or some other percentage) of the starting-point portfolio amount remaining.

The questions examined in my calculator but ignored in the Buy-and-Hold calculators are important strategic questions. It amazes me that they have not been studied in depth for years. I have come to the conclusion that the reason why we have as a society held back for many years examining many important strategic investing questions is that our belief in the core tenets of Buy-and-Hold has put us in a frame of mind in which examining these questions seems pointless or even troubling.

Take the question of whether an aspiring retiree should look for what withdrawal rate works using an assumption that his portfolio will at the end of 30 years have $1 remaining or will retain 20 percent of its original value or 50 percent of its original value or 100 percent of its original value. My calculator permits the investor to examine each of these possibilities. The safe withdrawal rate obviously becomes a lower number for a retiree seeking to retain 100 percent of portfolio value than it would be for a retiree seeking to retain only $1 (this is the assumption used in the Buy-and-Hold calculators). For those who retired at the top of the bubble and going with an 80 percent stock allocation, the number drops from 2 percent to 1.1 percent.

Are there investors who see it as important that they retain 100 percent of their portfolio value in retirement? I believe that there are. This certainly is not the common situation. Most retirees are willing to take a chance of losing much of their portfolio value over the years in return for being able to retire sooner and of course a lower withdrawal rate translates into a longer wait until the retirement begins. But there are of course some retirees who possess enough in the way of assets that their primary concern is passing those assets along to heirs or to charities and who want to be sure not to take an annual withdrawal large enough to jeopardize their ability to pass along the entire starting-point portfolio value at their death.

We have had safe withdrawal rate studies and calculators for many years now. Why do they not all provide this sort of information?

I don’t think that Buy-and-Holders are comfortable thinking that the safe withdrawal rate can ever drop as low as 1.1 percent. I think that we don’t have these calculators because most of us would prefer not to know the numerical realities.

Of course the people who design Buy-and-Hold calculators would not include valuation adjustments in their calculators and thus would not generate such shockingly low numbers. But the numbers that their calculators would generate would obviously be lower than 4 percent for cases in which the aim was to retain 100 percent of the initial portfolio value than they would be for cases in which the aim was to retain $1 in the portfolio. Again, I think that the preference is to not know. Even a safe withdrawal rate of 3 percent strikes  a Buy-and-Holder as shocking, given that the average long-term return for stocks is 6.5 percent real.

I don’t mean to suggest that Buy-and-Holders are aware of their desire not to be confronted with the numerical realities of stock investing. That’s not true at all. Buy-and-Holders love to discuss numbers; there’s nothing they like more. But certain numbers -- numbers casting doubt on whether stocks are always the best asset class in which to be invested -- cause Buy-and-Holders emotional distress. Those numbers we avoid (I say “we” because as a society we have been so immersed in the Buy-and-Hold model for understanding how stock investing works that it is the language of the Buy-and-Hold model that we speak when we speak about stock investing).

As we move on from our belief that the Buy-and-Hold model does a good job of explaining the core realities of stock investing, there will be scores of strategic questions that we will be able to explore in much greater depth than we have ever explored them before.

Rob’s bio is here.