Valuation-Informed Indexing #259
by Rob Bennett
There’s one good thing about having your views challenged frequently (as mine are by my Buy-and-Hold friends). Smart criticism forces you to think harder. Thinking harder helps you to learn.
I wrote a column here a few weeks ago arguing that, since it is entirely possible today to make reasonably accurate predictions of long-term stock returns by using the mountain of research showing that the valuation level that applies today tells us much about where stock prices will be ten years from now, we all should be doing that. A Buy-and-Holder argued in the comments section that we cannot be entirely precise even with long-term predictions. I agreed with that point. But then I found a point that I don’t believe I have ever advanced before forming in my brain and showing up on the computer screen before me.
I compared what investing analysts do with that doctors do. A doctor cannot give precise predictions of how long it will take for a disease to kill his or her patient. Yet doctors still make such predictions. They say: “You have six months to live unless you undergo this operation.” Why? Don’t they worry that it is possible that the patient will live only five months or perhaps will not die until seven months have passed? That’s what Buy-and-Holders do. They argue that since it is not possible to make precise predictions, we should not make any at all.
Doctors appreciate that the goal is to help the patient and that you can’t do a good job of that without making the best predictions you are able to make. I see now that, when I have argued the case for making long-term return predictions, I have often often presented the case in too defensive a manner. It’s not just that it is okay to make predictions or that predictions can have value. Predictions of stock returns are every bit as required as predictions re how long a patient will live if he or she does not undergo surgery. It is irresponsible for investing analysts not to use valuations to make long-term return predictions.
The full truth here is that we all make predictions in the investing advice we offer. The difference between Buy-and-Holders and Valuation-Informed Indexers is not that the former group abstain from making predictions while the latter group engage in the practice. It is that the latter group makes predictions in an above-board manner while the former group do it in a behind-the-scenes way that makes it harder for the investors listening to the advice to see what is going on.
It could be said that the reason that the Buy-and-Holders got the safe-wthdrawal-rate numbers wrong back in the day when they were touting their infamous “four percent rule” is that they failed to make return predictions; thus, they left the impression that the same safe withdrawal rate could apply for retirements beginning at all sorts of different starting-point valuations levels. But that’s not the entire story. The deeper truth is that the Buy-and-Holders were using the same return prediction for all retirements. That is, they were assuming that the average long-term return of 6.5 percent real applies both at times of high valuations and at times of low valuations.
The Buy-and-Holders were not being responsible by avoiding predictions that can never be entirely precise. They were making predictions. All that they were refraining from was making accurate predictions. By refusing to make generally accurate but also somewhat imprecise predictions, they forced themselves into circumstances where they made wildly inaccurate but unstated predictions. It would have been far more responsible for them to have acknowledged that return predictions must be made by those advancing investment advice even though we do not possess the ability to make entirely precise predictions.
There was a poster at the Bogleheads Forum who made this point in a powerful way back in the days before I was banned from that site. He said (I am paraphrasing): “I wouldn’t think of going into a bank and saying ‘I will have one Certificate of Deposit please’ without first checking out the rate being paid. So why should I be willing to purchase stocks without first looking at the valuation level that applies and thereby informing myself of the range of long-term returns that applies to my purchase?”
Buy-and-Holders try to fool us into thinking that predictions that lack perfect precision should not be made. It’s not so. All investment advisors should make the best return predictions that they are able to make. They should of course let people know about the caveats that apply even with long-term return predictions. But it is irresponsible to fail to make the best predictions possible.It is only by showing readers and clients how much the long-term return changes as valuations increase that we can bring it home to them how critical it is to always focus on the valuations question when making stock-buying decisions.
Rob Bennett’s bio is here.