Valuation-Informed Indexing #245

by Rob Bennett

Rob Arnott said something amazing a number of years back. He said: “Returns are for the most part a matter of simple arithmetic. Much of our industry seems fearful of basic arithmetic of this sort.”

Why would that be? We all want to invest effectively. If we could all invest more effectively just by performing some simple math, why wouldn’t we perform it?

Six reasons.

1) Accepting what the numbers say means we got it all terribly wrong for many years. For many years, people have believed that it is economic developments that cause stock price changes. If that’s so, the numbers that Arnott is referring to (numbers that show that stocks offer a better value proposition when prices are low than they do when prices are high) should not be of any consequence (since only unpredictable economic developments should affect the value proposition of stocks). There are no words harder for the humans to pronounce than the three simple, one-syllable words “I” and “Was” and “Wrong.” We all would have begun using Arnott’s powerful math had we not in earlier days come to a confident conclusion that it could not possibly do what it so clearly really does do.

2) The consequences of getting it wrong are frightening to consider. It’s not just that we got it so wrong for so long. Those who follow baseball have come to accept in recent decades that you cannot tell how good a hitter is by looking just at his batting average; walks need to be given more consideration than they were given in earlier days because it is getting on base that matters. The mistake made in the investing field is harder to acknowledge. Poor investing advice causes failed retirements. It’s hard to imagine a life setback worse than running out of money in your old age, when it is too late to take effective action to reverse the negative effects of the mistake. We didn’t just mess up when forming our old ideas about how investing works. We messed up re something that matters a great deal to all of us.

3) The mistake is so fundamental that it affects every strategic question. Baseball is still baseball when you consider walks as well as hits when determining whether a baseball player is good at his job or not. Accepting Arnott’s simple math changes everything. You cannot get your stock allocation right if you don’t use Arnott’s math. You cannot engage in effective retirement planning if you don’t use Arnott’s math. You cannot engage in effective risk management if you don’t use Arnott’s math. Investing analysis performed without making use of Arnott’s math is something close to worthless. Who wants to acknowledge having made such a mistake?

4) The mistake is an obvious one. The price we pay for things affects the value proposition we obtain from the purchase. That’s what Arnott’s math is telling us. It’s something that is so in every market that exists — the stock market, the sweater market, the banana market. So we feel stupid for once believing that the stock market was different. There are historical reasons why we made the mistake. Still, it looks like a stupid mistake once the realities being pointed to by Arnott click in.

5) The realities seem too good to be true. Arnott’s math possesses an amazing power to make stock investing safe and simple and profitable. The usual human reaction to advances this big is to dismiss them as too good to be true. The peer-reviewed research in this field shows that we can reduce the risk of stock investing by 70 percent by accepting Arnott’s math. “Um — sure we can.” That’s the reaction that most of us have to hearing about what the numbers really say.

6) We can’t go back in time and do it right. If you started investing at age 25 and you hear about Arnott’s math when you are 55, you need to accept that you have been doing it wrong for 30 years to begin doing it right now. It hurts to realize how much wealthier you could be today had you learned about the realities years earlier. The logical truth is that you are better off doing things right as soon as you learn what works and writing off those earlier years as an unfortunate learning experience. But your accumulated savings are the work product of years of effort and determination. The emotional reality is that no one wants to write off three decades of investing experience as the result of a wrong turn.

Arnott is right that stock investing will become a lot easier than it has ever been in the past once we acknowledge the mistakes we made in earlier days that have been revealed by the basic mathematics that has been employed in the peer-reviewed research of the past 34 years. The part that we have as a society been struggling with for a long time is that humans are not information-bit processing machines. We struggle emotionally with great truths and it is the truths that bring about the greatest advances that cause us the most struggle.

Rob Bennett recorded a podcast titled Liberals Both Hate and Love Rational Investing, and It’s the Same With Conservatives. His bio is here.