by Rob Bennett
Valuation-Informed Indexing #236.
The purpose of last week’s column and this one is to list 20 dangerous investing myths that developed during the Buy-and-Hold Era because of our belief in the findings of University of Chicago Economics Professor Eugene Fama and that were discredited by the research published by Yale University Economics Professor Robert Shiller but that remain popular today.
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11) Stock Returns Are Not Predictable. The correlation between today’s P/E10 level and the price that applies ten years out is strong. We have known this for 34 years now. Our discovery of this is the most exciting development in the history of investing analysis. So why have we been so reluctant to acknowledge the new reality? It’s a counter-intutive reality that short-term returns cannot be predicted and yet long-term returns can be. It seems that predicting the long term should be harder. This strange reality comes about because returns are determined primarily by investor emotion and emotion is an irrational force.
12) You Should Lower Your Stock Allocation As You Near Retirement. If all else could be held constant, this one would be true. But all else can never be held constant. Valuations are by far the most dominant factor on investment performance, dominant enough to cancel out the effect of aging (which should make us less willing to take on large amounts of risk). When valuations are dropping, investors near retirement should be increasing their stock allocations.
13) Young Investors Should Go With High Stock Allocations. Again, this would make sense if all else could be held constant, but the valuations factor can cancel out the risk-is-easier-to-bear-when-young factor. When valuations are high, young investors should go with low stock allocations. The edge that they will gain by doing so will grow over time via the magic of compounding returns, a factor that applies with its greatest force for young investors.
14) The Safe Withdrawal Rate is 4 Percent. Just about everyone in the field acknowledges that the once unassailable “4 percent rule” has been entirely discredited. Few are yet willing to identify the true research-based safe withdrawal rate (SWR). The SWR drops to as low as 1.6 percent when valuations are where they were in 2000. It rises to as high as 9 percent when valuations are where they were in 1982. Like risk, the SWR is not a constant but a variable in the Brave New World of investing analysis brought on by Siller’s breakthrough 1981 finding that valuations affect long-term returns.
15) Valuations Matter But Not All That Much. I have been developing and promoting the Shiller-based model (Valuation-Informed Indexing) for 13 years now. One change that I have seen over that time-period is that there used to be some Buy-and-Hold diehards who argued that the market really is efficient and that valuations thus have no effect. It’s rare to hear someone make that claim today (although Fama still says that he does not believe in bubbles). But while most today acknowledge that valuations matter, few are willing to acknowledge how much they matter according to the 140 years of historical return data available to us to study. SInce valuations is a huge factor and one entirely under the investor’s control (the investor cannot directly control valuations but he can determine their effect on his portfolio by changing his stock allocation in response to changes in valuations), I think it would be fair to say that understanding valuations is 80 percent of what it takes to be a successful long-term investor. It is hard to imagine how an investor who got the valuations aspect of the story right could do poorly in the long run and it is hard to imagine how an investor who got the valuations story wrong could do well in the long run.
16) Cash-Like Asset Classes Are Only for Holding Money That You May Need Within the Next Five Years. Cash is a strategic asset class. Most investors look at the nominal return provided by cash-like asset classes and conclude that these asset classes do not provide returns high enough to finance an old-age retirement. The proper way to look at things is to understand that money protected from loss during a time when stock prices are high can be put to use earning high returns after stock prices return to moderate or low levels. Money that produces a return of 2 percent real for three years followed by a return of 15 percent real for seven years is money contributing in a big way to a lifetime retirement-financing plan.
17) Stocks Are More Risky Than Bonds. Investors who are open to adjusting their stock allocations in response to big valuation shifts thereby reduce the risk of stock investing by nearly 70 percent. For those investors, bonds are more risky than stocks.
18) It Is a Coincidence That the Crash of 1929 and the Great Depression Began at the Same Time. The price crash was the primary cause of the Great Depression. When stock prices crash, trillions of dollars of spending power disappear from the economy. When consumers are no longer able to spend to the same degree as before, hundreds of thousands of businesses fail. Millions of workers lose their jobs. The conventional view has it backwards. It is not that bad economic times bring on stock crashes. It is that stock crashes (which inevitably follow price bubbles) bring on economic crises.
19) It Is Hard to Say What Caused the Economic Crisis That Began in Late 2008. It is easy to say. Every bull market that we have seen since 1870 led to an economic crisis. Every economic crisis was preceded by a bull market. The correlation could not be stronger. The hard thing is to emotionally accept that this is so. It hurts us to acknowledge that the four economic crises we have seen since 1870 could have been avoided by us practicing more responsible stock investing strategies. That’s especially so re the most recent crisis since this is the first one that took place at a time in which we had available to us decades of peer-reviewed research showing us how things work. If the economic crisis ends in The Second Great Depression, it will be the first entirely optional Great Depression that we have had to endure.
20) Investors Pursue Their Self-Interest in a Rational Way. Not today they don’t. Investing is a highly emotional endeavor today. This should change soon. It is by learning about the findings of the past 34 years of peer-reviewed research that we can all develop the ability to pursue our self-interest in a rational way. We are on the threshold of coming to terms with the 20 dangerous investing myths that for so long have been holding us back and achieving some amazing advances. The good news of the past 34 years is 50 times more good than the bad news of the past 34 years is bad.
Rob Bennett recorded a podcast titled It’s Not a Conspiracy, It’s Cognitive Dissonance. His bio is here.