The Power of Puzzles to Point Us to Investment Truths

The Power of Puzzles to Point Us to Investment Truths
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At a little before 9:00 a.m. on May 13, 2002, I performed a final check of the words to a post that I was planning to put to the Retire Early discussion board at the Motley Fool site. The board was comprised of people hoping to retire in their 50s or in some cases in their 40s. There were almost daily discussions there of the safe withdrawal rate concept; people did not want to delay their retirements unnecessarily but of course they did not want to put them at risk by leaving the workforce too soon either. I was going to question the study that people there relied on to determine whether or not they had saved enough to pull the cord. That study stated that the safe withdrawal rate was 4 percent at all times; it did not include an adjustment for the valuation level that applied on the day the retirement began. I was going to suggest in my post that such an adjustment was required to get the number right.

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A Safe Withdrawal Rate That Varies

The reaction that I have seen to that post in the 18 years since has changed my life. I had little interest in investment issues at the time. I had participated actively at the board for three years without addressing investment questions. Instead, I wrote about saving strategies. But learning how to save effectively had left a big impression on me. I had come to believe that it was important to get full value for my dollar when buying cars and sweaters and bananas and it had always bothered me that most experts in the investment advice field downplayed the importance of getting value for one’s dollar when buying stocks.

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Market timing is a bad idea, they maintained. It didn’t make sense to me. So I decided to run the idea of a safe withdrawal rate that varies past my friends at the Retire Early board and see how they reacted to it.

They reacted strongly, it would be fair to say that much. I have never seen so many positive reactions to my work. Not only have I had thousands of ordinary investors tell me that I am the first person who talked about stock investing in a way that made complete sense to them. I have even had big-name experts offer effusive praise.

I worked for 16 months with Wade Pfau on research that we co-authored that shows that market timing (the long-term variety, not the short-term variety) always works. Wade holds a Ph.D. in Economics from Princeton University and he told me that I taught him things about stock investing that he never learned while taking his courses in the subject. That shouldn’t be possible. But that is far from the only case in which something like that happened.

I am now close to finishing a book on stock investing that I will call Investing for Humans: How to Get What Works on Paper to Work in Real Life. Each time I finish another chapter I am amazed at how much my understanding of the subject has broadened and deepened over the years. I certainly do not consider myself an expert in this field in any general sense. But I do consider myself an expert re one very important niche topic -- the many far-reaching implications of Robert Shiller’s research showing that valuations affect long-term returns and that therefore the market is not efficient.

I have also seen lots and lots and lots of negative reactions. And I have been banned at so many places on the internet that I have lost count of them. I have been banned at sites at which the site owner had praised my work to the skies. Beat that one, you know? I see the bans as evidence that I am on to something important. Otherwise, the reactions would not be so intensely defensive. In any event, I think it would be fair to say that that May 13, 2002, post sent me on an amazing journey.

Buy-and-Hold Retirement Studies Missing Valuation Adjustments

What kills me today is that I was still a Buy-and-Holder on the day that I advanced that fateful post. I had come to believe that the Buy-and-Hold retirement studies were in error because they did not contain valuation adjustments. But I loved the Buy-and-Hold concept. What I loved was that it was rooted in research. I trust the scientific process as a means of getting to the truth. I thought that the error that was made in the retirement studies was a one-off that would be corrected quickly once it was brought to life (I even thought that there was a small chance that I was overlooking something in my tentative conclusion that the studies were in error).

It was only after I saw the defensive reactions of a good number of Buy-and-Holders that I came to believe that the strategy itself was rooted in error and that in a deep sense Buy-and-Hold is not a scientific approach at all (please understand that I believe that the Buy-and-Holders are sincere in their belief that it is).

I often wonder what caused me to go down this path. I think that the biggest thing is that my mind sees a logic puzzle as something that simply must be solved. Once I become convinced that there is something about the conventional understanding of a subject that doesn’t add up, I just cannot let it go until I figure out what is going on. The fact that the retirement studies lacked a valuation adjustment perplexed me. I thought about it and thought about it and thought about it until I finally had no choice but to work up the courage to ask about the bewildering puzzle in a public place and see if there were some smart and kind people who could help me out.

Stock Investing Is A Highly Emotional Endeavor

Then the negative reactions that my question provoked placed a new and even stranger puzzle before my eyes. Why did questioning of the Buy-and-Hold dogmas cause such hysterical reactions? The short answer to that one, I came to see over time, is that Shiller is right that stock investing is a highly emotional endeavor, not a 100 percent rational one (as it is imagined to be by the Buy-and-Holders) at all.

Scores of such puzzles have been brought to my attention over the past 18 years. Sometimes the puzzles are a source of frustration. When you think that you are close to figuring a subject out, the discovery of new puzzles can be annoying. But it has been my experience that it always pays off to accept that the discovery of a new puzzle as a sign that you have not yet come to a complete understanding and need to dig deeper. Certainty can yield a temporary feeling of satisfaction. But it is confusion that brings on the learning experiences that offer great long-term rewards.

Rob’s bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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