What Kind of Investor Are You?

The other day our friend John at Married With Debt hosted a guest post from Rob Bennett of Passion Saving.  You might remember John from our collaboration on the relative taxation of Presidents Obama and Bush.  Rob, on the other hand, is a bit of an enigma in the Personal Finance world.  On the one hand, he has very interesting theories on safe withdrawal rates and buy and hold investing based on market valuations.  On the other hand?  He weaves a tale which makes the stories of Alexander Litvinenko and Gareth Williams seem somehow tame by comparison.  I’m not going to touch that further than describing it (Google around if you care), but there is precedence for  disruptive financial theories causing anger.  Let’s tackle the merits of Rob’s arguments, shall we?

No Comment. (Wikipedia)

Divide Yourselves Into Groups…

I really hate fence sitting, but if you get to the end of my arguments you’ll recognize I spilled lots of digital ink just to sit on a virtual fence.  Bear with me as it’s going to take a couple articles to spell everything out.

A Bit On Investor Psychology

Even though I’m about to (slowly) explain why I’m undecided as to an exact course, note that people often complain when I make things too black and white (or binary, if you prefer).  I get it – there are various shades of gray.  I mean some of this article to be self-assessment, so categorize yourself in the correct way and draw your own conclusions on where you sit.

The way I see it, there are four types of investors: High Information/High Emotion, High Information/Low Emotion, Low Information/High Emotion and finally Low Information/Low Emotion.  Here’s how they break down:

  • High Information / High Emotion:You’re an investor who pours through the research, has read all the books, digests as much as you can on the internet and looks over financial reports.  However, when it comes time to trade you can be too quick with the trigger – a glance at your trading history reveals panic sells, piling into rising stocks, and maybe some brief flirtations with momentum investing and technical analysis (likely with poor results).  Basically, you know a lot about the market but your emotions get the better of you on the transaction side.
  • High Information / Low Emotion: Like the HI/HE investor, you devour all the information that exists on stocks and valuations and alternative investments.  You can hold court in any conversation about investing strategies and know your way around a balance sheet.  Unlike your HI/HE buddy, you are very deliberate when it comes to buying and selling – only making moves when you can verify something using certain valuations and never selling based on emotions.
  • Low Information / High Emotion: You get most of your investment ideas through conversations with friends, tips heard at various places of business, and by reading “Top 10 Lists” of stocks.  You’re very into the stock market, but don’t know much about valuation, hedging, and probably wouldn’t be able to keep up on an analyst call.  However, you care deeply about retirement, tend to have certain parts of your portfolio tank, and are quick to want to move to cash in a downturn.
  • Low Information / Low Emotion: (I’d be surprised if many of you read this article!) You don’t know much about the stock market, mutual funds, or securities, and the funny thing is you don’t care much.  You may or many not participate in a 401(k), but you can’t tell a Roth IRA from a 529 (and will walk away from someone trying to ask about them).  Hi, from the rest of us above, please try to get your emotions up to ‘medium’.  Thanks.

Did you identify yourself there?  Good.  Find which of the four categories you best fit into, because it makes a huge difference to the investments you should pick.  From my anecdotal experience, I would say that most people fall into category 3, Low Information/High Emotion investors.  They worry lots about having a retirement when they are too old or sick of working, but they are much better at their day jobs than investing.  None of these categories are meant as an insult – the truth is, for LI investors, you probably made a conscious or subconscious decision to not increase your financial knowledge.

“You’re Unique.  Just Like Everyone Else.”

Great.  I just proved to you that different people are different.  Here’s the point of that little exercise:

“Different Investors Require Different Approaches While Investing.” -PK

You’ve now categorized yourself in one of the four categories above, or at least found the category which is closest to describing you.  Now you can figure out the general style of investing which is right for you.

  • Low Information / Low Emotion: If you can’t light a fire under yourself, you should at least try to get inspired long enough to make sure you’re getting all of the investment perks available to you through work: 401(k)s, Stock Purchase Programs, Share Grants, Options, and all other forms of ‘free money’.  Ask a trusted smart coworker (or if your plan comes with advice, ask there) where to put your allocations.  Also consider a Roth or Traditional IRA.  Thanks for reading – we’ll see you in ten years when you’ve amassed a lot and are curious about the next step.  You’ll be fine.
  • Low Information / High Emotion: First off, try not to worry too much about the general ups and down of the market, your real estate, and mutual funds and bonds.  If there is a total 100% drop in a huge asset class like the stock market we’ve got bigger problems than our retirement savings (haha).  For you, you’re best off putting some layer of separation between you and your funds.  Consider a Financial Adviser or a passive strategy and a simple portfolio with some sort of stock/bond mix.  Yep, buy and hold is usually a good option for an investor like you.  Try not to worry too much about volatility – the market may have lost its value in the recent recession, but hey, it’s almost back.
  • High Information / High Emotion: Congratulations!  You have what it takes to delve into investing a little deeper; you just need to keep your emotions in check.  Use your considerable knowledge of valuations to determine a good investment mix for yourself.  Think serious about avoiding individual stocks or options – know that while your knowledge is considerable, you should use some mechanical system to choose your entry and exit points.  Stop losses (trailing or otherwise), limit orders, and certain option trading strategies are perfect for you – just try to keep your itchy trigger finger on your mouse away from the buy/sell screen on your brokerage window!  If you can’t?  Consider staying away from individual stock and bonds.  You can still apply your knowledge to other forms of investments…
  • High Information / Low Emotion: Call it what you will, but you know this personality type when you see it – smart and indifferent.  If you find yourself in this category?  Congratulations.  You’re set up to be a good investor.  Your biggest issue is cockiness – you might have an track record which looks good, but if you blow up you’ll tend blow up hard.  Limit your bet sizes, watch your arrogance while trading, and always keep learning.  Of all the classes it’s most important that you never get stuck with certain biases… always keep reading and absorbing new information into your repertoire while investing.

So, About That Buy And Hold Stuff?

Isn’t it crazy the diversity in personalities represented in the stock market?  We all see some aspects of ourselves in the above investors.

If you divide yourself into either of the low information categories, I would suggest sticking mostly to buy and hold principles.  If you dabble too much in speculative investments or individual stocks and bonds (or worse, IPOs,futures, derivatives and options!) you’ll quickly find yourself falling behind the curve financially.  Remember: on a long time frame, specifically over 20-30 years, stocks have almost always outperformed bonds.  Over a career, you’ll be okay even if you give up a little bit of that maximum return.  Just make more by concentrating on your job, okay?

So, high information people, still with me?  The odds are, yes, you can probably optimize your portfolio to a high degree – and potentially achieve better returns than you are receiving currently.  For a high information investor who is willing to put in the work, look to Warren Buffett (duh), Ed Thorp, Peter Lynch, Ben Graham, David Dodd, Irving Kahn, and Walter Schloss.  Heck, even Bill Gross.  I’ll get into that – and the Efficient Market Hypothesis – in my next post.

So, wait, but don’t hold your breath… I’ll get back to safe withdrawal rates and buy and hold soon.

What type of investor are you?  Do you agree with my assessments?  What sort of things do you do to cover for your weaknesses?

 

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Comments

  1. says

    Heh, its interesting how your list of investors to follow is, with the exception of Gross, very old or dead. Interesting how that works out – the old guys took the show. And, not surprisingly, they’re all value-oriented investors with some leeway for Lynch, who scores in the value range for recommending investors buy the best businesses in sectors not in the public spotlight. I think we can bend the rules a bit to put him in the value camp.

    As for what kind I am, I can be a bit of all four. Sometimes I like the low-information side thinking, “well at least the earnings yield on the broader market is still higher than Treasuries, so I guess I’ll hang on!” Other times I get in the zone and completely learn an industry from top to bottom on a 10pm-3am research session. Those are always fun.

    I think the best way to kill emotions is to stay away from your account during open hours. And, most importantly, have a pre-determined entry and exit price. Buying under the very open-ended belief that “this stock will go up!” but never quantifying a value at which you think it is fully-valued makes it far easier to be reactionary. (This is just one of the reasons I think technical traders that you mentioned are more likely to be high-emotion traders – there’s little emphasis on intrinsic value.)

    • says

      Sheesh – just started looking through the Rob Bennet article on PE10. Heh, props to him for putting up a battle on the topic…even if it’s unlikely to even begin to change someone’s mind.

      • says

        I hear you – this is a three part series, sort of (consider it a loose one). I knew I couldn’t cover everything in a single post, so I had to start with the psychology.

      • says

         Rob Bennett (aka Hocus) has been banned from just about every personal finance forum.  His passion (no pun intended) for his passion investing gets carried away and he ends up threatening people’s lives.  At which point, he is shown the door and claims he is the oppressed (of course, he claims it is because his investing ideas are different and there is a conspiracy theory amongst just about everyone but him to shut him up, but in reality it is because he makes forums unusable by spamming every little comment – all this makes for great entertainment once you’ve gone through the best of craigslist). 

        The reality is, if you subscribed to passion investing when it first came out in the mid 90′s, you would have avoided stocks like the plague and would find yourself sneaking into your neighbor’s yard to steal the meal they left for their cat.   

        • says

          Well, whatever the case may be with his history (I seriously don’t have any information on this), it is nice to see some thoughtful discussion about investing regardless of the balance. The truth is, if you were to listen to common thought, you would believe that you could be “above average” in anything as long as it isn’t investing. Why should it be that investing is the only skill/talent/whatever in which an individual can never be better than average. It makes no sense.

          For the record, I neither subscribe to the ideas of valuation-informed indexing on the basis of a PE10, nor buy and hold investment strategies. If anything, I’m inclined to believe in selecting securities based on valuation, and then holding for as long as possible so as to allow the market time to agree with me. I think there’s room for both views, and I think it is entirely possible for individuals to outperform the index in the long-haul. 

        • says

          Rob Bennett (aka Hocus) has been banned from just about every personal finance forum.  
          ALWAYS at the demand of Buy-and-Holders, Bichon. I was the most popular poster at the entire Motley Fool site on the day before I put forward my first post on investing. If you look at the “People Are Talking” section at the home page of my blog, you will see that I have received more words of praise from more experts in this field than any other personal finance blogger I can think of. In about half of the cases in which I was banned, I received apologies from the site administrators banning me. In several cases, the site administrators banning me said that they loved learning about Valuation-Informed Indexing, that they thought it was the most important idea being advanced in the investing field. What does it tell you about Buy-and-Hold that they went ahead and banned me anyway?

          Why does Buy-and-Hold make the investors who follow it so darned emotional? Is that not a fair question to ask? Never once in the 10 years has a Valuation-Informed Indexer asked that a Buy-and-Holder be banned. Yet we have seen HUNDREDS of cases in which Buy-and-Holders have insisted that all Valuation-Informed Indexers be banned (I am not the only one who has been banned and there are hundreds of posters who at one time posted in support of my ideas and then silenced themselves when they learned about the bans [these people were effectively banned from posting their sincere views]).

          Honest discussions are held on the internet every day of the week on thousands of different topics. We talk about movies and politics and fashions and no one gives a thought to the reality that people with different beliefs express different points of view. But, as you point out, most Buy-and-Holders find this widespread community norm of our society 100 percent unacceptable when the subject is their favorite investing strategy.

          Huh? What’s wrong with this picture, Bichon?

          I think that the intense defensiveness of the vast majority of Buy-and-Holders tells us that something is very, very, very wrong with this investing strategy.

          Rob

    • says

      Nowadays they’d be at a hedge fund charging 2 and 20 and we wouldn’t hear of them, or something. Something about old school value just seems more innocent, haha.

      Of course, how do we know? We could have a bunch of Buffetts in the next Generation we need to pay attention to.

      I think that if you know what an earnings yield is you probably aren’t low information – but, of course, the categories are broad enough that there is a lot of leeway. Earnings yield is one metric I do love – but this reading will take you down the road of PE10, FWIW.

      Yeah – a good point. Kill those emotions by not giving yourself the chance to be emotional!

      • says

        I don’t think there’s anything wrong with earnings yield as it relates to individual stocks. However, I do think to some extent that active indexing (especially the broad indexes) is kind of silly given how the components change over time. Err, if the S&P500 index were made up of 50% airlines or bulk dry shipping companies (pretty much the worst businesses in the world), who cares how you decide how much to invest? You’re going to lose your shirt any way you slice it.

        I love earnings yield almost as much as free cash flow yield on the basis of an individual stock. Indexes? Meh – too many variables to use one calculation for a decision. 

        But, hey – whatever. This is personal finance, right? It works for me

    • says

      I think the best way to kill emotions is to stay away from your account during open hours. 
      I think I have a better way, JT.

      The idea behind Valuation-Informed Indexing is that the investor should always do what is in his best interests. So, when a super-safe asset class like TIPS or IBonds or CDs offers a higher long-term return than stocks, the investor should lower his stock allocation.

      Say that we provided tools to help people do this and we stopped all the promotion of the Buy-and-Hold “idea” that one should never change one’s stock allocation. People would then change their stock allocations as needed to keep their risk profiles roughly constant.

      That changes everything.

      The problem with the stock market today is that it is dysfunctional. Think about how the used-car market works. The dealer wants the car to go at a high price, the buyer wants the car to go at a low price. They haggle. They meet somewhere in the middle. The market does a good job of getting the price more or less right.

      Now consider the stock market. Most of us are net buyers of stocks (many retirees are net sellers, of course). So most of us should be hoping for lower prices so that we can get more for our money with our stock purchases. But how many of us do that? When was the last time you heard someone heavily invested in stocks cheer a price drop?

      A market cannot function if everyone is pushing for the same thing. The stock market is a car with no brakes. That’s why we have crashes! Cars without brakes always crash. Once we persuade large numbers of people that  a Buy-and-Hold strategy can work, we leave the market no other way to get prices back to fair-value levels other than to crash. So we get a crash (and the economic crisis that inevitably follows from it).

      All of this drama is 100 percent avoidable.

      If we teach people that there are some circumstances in which stocks offer a good buy and others in which they do not, people will go with high stock allocations only when stocks offer a good buy. Magic follows from that. Once people know that they need to respond to price increases with sales, stocks can never become overpriced again. Overpricing brings on sales and sales bring an end to the overpricing.

      Market prices are self-regulating. So long as we do not encourage Buy-and-Hold. Once large numbers of people come to believe that Buy-and-Hold can work, the market becomes dysfunctional and we see price crashes and economic crises. 

      Stock investing does not need to be emotional. It is the Buy-and-Hold “idea” that makes investing emotional.

      And stock investing does not need to be risky. The data shows that investors who open their minds to the possibility of changing their stock allocations in response to big price swings reduce the risk of stock investing by 80 percent by doing so. Virtually all stock investing risk can be traced to promotion of the Buy-and-Hold “idea.” It is not Rob Bennett that says that, it is the academic research and the historical data that says that.

      So we can today overcome the emotionalism of investing. Through research!

      Rob

  2. says

    Did you just quote yourself? 

    I say there are three types of investors.  Indexers, fundamentalists and technicians.   And anyone of those can be stick dumb or nobel prize winners (albeit, winning the nobel has been devalued in the last couple of years). 

    I enjoy indexing.  

    • says

      I did – it’s part of my master plan to cite myself as a source at some point. The best part? I didn’t say that quote before the article, I made it up mid-article when I asked myself for a quote. How’s that for meta?

      Indexing is definitely the way to go for most people. Every time I trade an individual stock and succeed I wonder if I’m building up to some horrible disaster, haha. Am I just carrying biases and luck along? Perhaps. Time will tell.

  3. says

    My whole goal as a financial advisor was to help people recognize what type of investor they are but then to morph their strategy based on their goals and what portion of the portfolio we were discussing. Like Bichon, I enjoy indexing, but I’m not 100 percent indexer. I also have a portion of the portfolio where I’m HE/HI, but that’s my “go baby go” portfolio. Tomorrow I’m discussing how I purchased a high yield bond mutual fund. I’m not a big fan of funds, but this was the right fit for the job. So, what type of investor am I? I try to tailor my style to the job at hand.

    • says

       I think the fact that so many people find themselves in a Low Information category is one of the bets arguments for a Financial Adviser – you’re hiring someone to have the information, so you can continue doing what you know.  Comparative advantage at its best!

  4. says

    Is there a no information no emotion option?  Seriously, I used to stress alot about what I invested in.  Checked prices on everything daily.  In the end, I made bad choices (usually about when to sell, sometimes about what to buy).  I have tamed the emotions and settled in to purchasing only when a compelling case for a stock is made.

    • says

       Haha, sounds like low to medium information to me!  The fact that you are waiting for a compelling case – and I assume that means some sort of valuation – makes me suspect you are creeping into the high information category.

  5. says

    Hmm.  I think I’m medium/medium lol.  I wouldn’t say I know a lot or do a ton of research but on the other hand I think I know a fair amount about investing so I wouldn’t consider myself low information.  I used to let my emotions get in the way when I was trading and that never ended well, so I had to learn how to keep my emotions in better control.

    • says

      No shame in being between two categories on this one – the importance is figuring out what style of investing is right for you, heh. What steps did you use to keep your emotions in check?

    • says

      Not necessarily – you should pop over to the second article and steal one of the passive strategies to invest! There is no reason that you ‘need’ to get heavily involved in the ins and outs; at some level it’s possible that we’re just flipping coins and getting lots of heads (although I hope that isn’t true).

  6. says

     Rob, on the other hand, is a bit of an enigma in the Personal Finance world.  On the one hand, he has very interesting theories on safe withdrawal rates and buy and hold investing based on market valuations.  On the other hand?  He weaves a tale which makes the stories of Alexander Litvinenko and Gareth Williams seem somehow tame by comparison.  I’m not going to touch that further than describing it (Google around if you care), but there is precedence for  disruptive financial theories causing anger.  Let’s tackle the merits ofRob’s arguments, shall we?

    Very nicely done, PK.

    It’s almost impossible to write a balanced treatment of the process aspects of the first ten years of The Great Safe Withdrawal Rate Debate. You pulled it off with these words. On top of that, you made me (and I trust some others) laugh.
    That’s the good stuff!

    Rob

    • says

      Thanks Rob! I’m glad I have this soapbox to respond to your post over at MwD. I’ll get to your other comment (and possibly, comments) later, but the Day Job beckons.

      Thanks for commenting!

  7. says

    if you get to the end of my arguments you’ll recognize I spilled lots of digital ink just to sit on a virtual fence.
    My take is that this is where many fair-minded people will be coming down for a good bit of time yet.

    Most people have a hard time appreciating how fundamental a challenge it is that I am presenting to Buy-and-Hold. I am not saying that Buy-and-Hold is a little off. I am saying that it is the purest and most dangerous Get RIch Quick scheme ever concocted by the human mind.

    Now –

    Before people freak out re the “extremism” of that comment, please let me add that I do not think this is so by intent. I love the Buy-and-Holders. John Bogle is a hero of mine. The Buy-and-Holders are good and smart people who made a perfectly understandable mistake. The research that they needed to get it right was not available at the time they developed their strategy. 

    So I do not think that I am being unfair or harsh in my criticism. It just so happens that there were important things that we did not know at the time that Buy-and-Hold was developed and that we do know now that must be incorporated into the model for there to be any realistic hope whatsoever that it could ever work for any long-term investors. 

    I ask that people please consider the word that is used in the subtitle to Shiller’s book. The subtitle refers to Shiller’s findings as “revolutionary” That means that they change everything. Every last thing that we thought we knew about stock investing has been overturned in recent years. Now we need to get about the business of acknowledging the mistakes we made and of building a  model that actually works.

    Think about how people responded when we learned that it is the earth that revolves around the sun rather than the other way around. This shocked people. It couldn’t be true! Everyone “knew” it was the other way around! People were imprisoned for giving voice to the new findings. 

    Wasn’t that silly? Wasn’t that a terrible mistake?

    If Buy-and-Hold is legitimate, it will stand up to questioning. If Buy-and-Hold cannot stand up to questioning, we need to dump it fast. Any idea that cannot be discussed in a civil and reasoned way is not fit for consideration by a free people, in my sincere assessment.

    But given how hard the Buy-and-Hold idea has been promoted in recent decades, it is going to take some time for people to come to a full appreciation of its flaws. People will change their minds in stages. I obviously have stronger views than just about anybody else because I have been exploring the dangers of Buy-and-Hold on a full-time basis for 10 years now. People are not going to be able to pick up on everything I have learned by reading one or two or three blog posts. But, if we pursue these questions in good faith, everyone will come around in time or else I will discover that I am wrong and I be the one to come around. The goal that we all share is to get to the truth.

    The first step is to launch a debate on the Personal Finance Blogosphere. That will get a learning process going. That will benefit us all. We cannot even get that process moving forward until we convince a number of good and smart people to be willing to state publicly that they are on the fence re Buy-and-Hold. Then the debate will get even more stimulating (in a good way!) and we will learn even more exciting stuff together. Hearing some people say that they are on the fence is a big step up from what I was hearing a few years ago.

    Rob

    • says

      Thanks for assuming I’m fair-minded!  I always work from the assumption I’m just as biased as anyone else – which is why I’m going to audit my own returns next week.

      Rob, I do think your ideas are interesting, but without a fund (likely with a lockup period), I wonder how easy it is for my low-information investors to get into a strategy like this.  Consider that for something to beat the market, the odds are that the strategy is either unrecognized (possible, but less likely) or too hard (also possible).  Even if a LI investor implements the strategy, what’s to say he’ll be motivated enough to watch PE10?

      10 years is a long time – and if you have had success in that time (2002 – end of the tech bubble), congrats!  I promise I won’t forget about this topic, even if I don’t, you know, post about it all the time, haha.  But!  Let me get to some of these other comments you left for me on the other articles and reply in more detail.

      • says

        without a fund (likely with a lockup period), I wonder how easy it is for my low-information investors to get into a strategy like this.  Consider that for something to beat the market, the odds are that the strategy is either unrecognized (possible, but less likely) or too hard (also possible).  Even if a LI investor implements the strategy, what’s to say he’ll be motivated enough to watch PE10?
        Either everybody is going to go to Valuation-Informed Indexing or no one is, PK.

        If no one makes the switch, we go into the Second Great Depression. I’m not a doom-and-gloomer. I’m just reporting what the numbers say. It was a P/E10 of 33 that caused the Great Depression. This time we went to 44. Our free-market economic system cannot survive the continued promotion of Buy-and-Hold. The stock market has become too important to too many people in recent decades.. We need to figure this investing stuff out and start getting it right.

        If we all make the switch, implementing these ideas will be as easy as pie. They will tell you on the radio when they report the latest S&P and Dow numbers whether stocks are priced too high or not. It will be on all the web sites. It will be in all the books and magazines. Employers will hand out literature to their employees when they sign up for Section 401(k) plans spelling out the dangers of Buy-and-Hold. It will be in all the textbooks.

        People tend to think of VII as just one more strategy that will get thrown into the mix with all the other strategies. That’s not what this is. The new strategy is the result of a FINDING that is the opposite of what we THOUGHT about how stock investing works before we made the discovery. The only odd thing here is that we should have made the change when we first learned of the finding. For marketing reasons, we did not. The bull market complicated things from a marketing perspective.

        Now that the bull is over, more and more people are opening their minds to the need to make the change. If you polled financial planners in secret today, my guess is that more than 50 percent would want to make the switch. But none of them can make the switch on their own. If its one guy going off the reservation, he is shunned and he cannot make a living.

        But. as things continue steadily downward, people will see that there is lots of money to be made giving up-to-date and truly effective investing advice. As this becomes a money-making thing rather than a shun-causing thing, more and more will sign up and eventually we will reach a tipping point where no one will want to be associated with Buy-and-Hold anymore.

        Many bloggers are afraid to get behind this today because it is not yet super popular. The other way of looking at it is that you have the chance to be a pioneer by getting behind it today. I’m the ultimate pioneer! I got on board 10 years too early! I obviously didn’t plan it to happen that way. I became caught up in an exceedingly strange set of circumstances. So I took a licking. But I’m still ticking!

        Rob

        • says

          I caution you though: P/E has two terms. You can reduce price or earnings can grow faster than price in order to get a better ratio. I’m not of the opinion we’re headed into a second great depression – if we double dip, I imagine it’ll be similar to the first dip rather than 1929.

          The first Great Depression had a massive liquidity crisis spurring it on. Say what you want about Bernanke today, but I don’t think liquidity is a concern.

          Oh, and on the “Many bloggers are afraid to get behind this today because it is not yet super popular” point – I’m definitely a value guy. I just happen to apply it to individual stocks. I also have nothing to prove and no politics to deal with; I’m “just” an Engineer who cares way too much about this stuff (I’ll let Cameron toe the party line). As an aside I don’t think DQYDJ cares about contrarianism, haha!

          • says

            I’m not of the opinion we’re headed into a second great depression – if we double dip, I imagine it’ll be similar to the first dip rather than 1929.
            You’re in good company, PK.

            My view is that your thinking on this question is influenced by the fact that just about everything we hear on this question is rooted in pre-Shiller economic thinking. The ideas that economists have about what caused the Great Depression and the really bad recessions were developed in earlier days, when we did not know what we know today.

            I have looked at the record. We have had four economic crises since 1870. Each of them was preceded by a P/E10 value of 25. We have never experienced a P/E10 value of 25 and not experienced an economic crisis.

            That’s an amazing coincidence.

            Some might say that’s all it is.

            But is ALSO fits the theory perfectly. If overvaluation is real, a P/E10 signifies a market in which TRILLIONS of phony money is slushing around. Millions of people are buying houses who cannot afford them because they believe the numbers on their portfolio statements. Millions of people are buying cars who cannot afford them because they believe the numbers on their portfolio statements. Millions of people are going on vacations they cannot afford because they believe the numbers on their portfolio statements.

            If overvaluation is a real phenomenon (and there is now 30 years of academic research showing that it is), you would EXPECT a P/E10 of 25 to always cause an economic crisis. And, when we look at the record, we see that that is just how it has always played out. For 140 years now. We haven’t yet seen one exception to the rule.

            Rob

          • says

            But why PE10? If the business cycle is true, and it likely is… why PE10?

            I highly doubt that you’re going to prevent any crises with PE10 investing – you could have another Real Estate led recession like the one we just had – which was more severe than all the other recessions since the Great Depression. Just because we mastered one asset class (*if* it’s the case, but I’m skeptical) doesn’t mean we’ve eliminated the human propensity to blow bubbles.

          • says

            Just because we mastered one asset class (*if* it’s the case, but I’m skeptical) doesn’t mean we’ve eliminated the human propensity to blow bubbles.
            I think it does, PK.

            The real estate bubble was caused by the stock bubble. The stock bubble put $12 trillion of funny money in people’s pockets. That made them think that they could afford larger homes. So naturally they bought larger homes. 

            The root problem is treating funny money as real. We should stop doing that. It is impossible to engage in effective financial planning for so long as you treat funny money as real.

            The business cycle too is affected by the funny money. Even the election of Presidents is affected by it. Here’s a column I wrote in which I used the P/E10 level that applied at the time recent Presidents came into office to predict how successful their presidencies would be:

            http://deathby1000papercuts.com/2010/11/predicting-presidential-success-using-the-pe10-stock-valuation-metric-investing-the-new-rules/

            If you come in with a high P/E10 value, you are going to be blamed for a bad economy because the inevitable drop of the P/E10 value is going to suck trillions of dollars of spending out of the economy. If you come in with a low P/E10 value, you are going to be very popular because the inevitable rise in the P/E10 value is going to cause huge economic growth.

            Shiller’s research eliminates the human propensity to blow bubbles. That’s the great advance. We are now ready for a new form of capitalism, a Capitalism 2.0. This is a form of capitalism with far more stable growth and with much greater rewards for middle-class people (because they will get to enjoy the benefits of stock investing without having to take on the risks that applied in the past).

            This is all good stuff. It is a win/win/win/win/win. What Buy-and-Holders don’t like is that they will have to acknowledge that they got some things wrong in their First Draft effort at developing a research-based strategy. That’s a small price to pay for the huge economic growth we will see once we are all enjoying higher returns at greatly reduced risk.

            Bubbles are optional. There is no law that says that there must be bubbles. P/E10 lets us show people with numbers how long they delay their retirements by investing in bubbles. Most people have a desire to act in their self interests, so, once people learn what the research says, they will elect for selfish reasons to destroy all bubbles before they get started.

            People often seem shocked that such great advances are possible. I wonder why people thought it would be a good idea to perform investing research in the first place. Wasn’t the idea all along to learn things that would permit great advances? My view is that, now that our research efforts have paid off so handsomely, we should go ahead and take advantage of what we have learned. What is the downside?

            Rob

          • says

            From Tulip Bubbles to Tech an dReal Estate Bubbles – you’re not going to be able to eliminate the human desire to get rich quickly just by pointing to some valuation metric. If PE10 was better known, there would still be people dedicated to getting around it – falsifying earnings and the like. I don’t think bubble are optional, and I do think they are usually only obvious in retrospect.

            Like you said, you moved out of stock in 1996. If you had stayed in stock until 2006 you would have made a lot more money than your method. The issue? Opportunity cost. Every time you leave the index, you need to know that the alternative has a shot to outperform. Yeah, maybe stocks seem undervalue d- but if you switch to something silly, what’s to say that won’t do worse?

            And no, I can’t accept the end of bubbles. That’s too much hyperbole. I think PE10 might be good to help guide your portfolio allocation, but ending bubbles and speculation? It’s not going to change human nature…

          • says

            From Tulip Bubbles to Tech an dReal Estate Bubbles – you’re not going to be able to eliminate the human desire to get rich quickly just by pointing to some valuation metric.
            Pointing to the valuation metric alone won’t do it. But we shouldn’t stop at pointing at the valuation metric.

            We now use studies to tell people the safe withdrawal rate in retirement and get the numbers wildly wrong. Why not calculate the safe withdrawal rate accurately? That would show people the dangers of following Buy-and-Hold strategies and the benefits of following research-backed strategies. 

            It’s the same with asset allocation. Say that people have a choice of three stock allocations: (1) high (for low prices); (2) moderate (for moderate prices); and (3) low (for high prices). Buy-and-Hold guarantees that their allocations will be wrong two-thirds of the time (any of the three choices is wrong when either of the other choices is the right choice). What if we permitted businesses to form that would give people the tools they need to know their proper allocations? Those businesses would make lots of money by helping people and millions of investors would become able to retire years earlier. Businesses now giving Buy-and-Hold advice would switch over to providing research-backed investing advice.

            We could give employees accurate information when they sign up for 401(k) plans. We could have books that explain how to invest effectively for the long term.  There was a fellow who asked the editors of Money magazine shortly after the economic crisis began: “What would it take for you people to change your advice?” What if the editors at Money took the hint and started running articles giving accurate investing advice?

            There IS a human desire to Get RIch Quick. We are 100 percent in agreement re that one, PK. But there is also a human desire to overeat. But don’t we permit people to try to help people with their overeating problems rather than insist that everyone in the field encourage the greatest amount of overeating possible? There are people who gamble too much. But we don’t always encourage those people to gamble even more. There are people with sex addictions. We don’t as a society say that no one should ever point out the dangers of sex addictions.

            Buy-and-Hold has been with us always. That much is so. But we can OVERCOME it if we try. The key is that we need to start trying. And we need to have a broad consensus. It can’t be a small number of us. We need to get all personal finance bloggers involved. Just as we encourage people to resist overspending, we should encourage people to resist Buy-and-Hold marketing pitches.

            Rob

          • says

            Rob, I’m not sure what you’re suggesting here. Do you want us the identify people who have the desire to get rich quickly and send people to “help” them? You don’t think that people who, you know, have profit desires beyond buy and holding or VII can speculate?

            That seems dangerous to me. I’d rather enable people to make stupid (or smart) decisions with their own money. But hey, I’m a free market guy.

  8. says

    I would love to see economics teachers using this information in the personal finance section of their courses. Students could learn to identify their personal investment style and could use that as a basis for beginning investing.

    • says

      You’re too kind!

      I think if they implemented that system it would probably be more to determine how their emotions affected their trading – I imagine that Econ and Finance students are already higher information.

      The other barrier? EMH is still law in those circles, so they probably wouldn’t even get into security valuation, haha.

  9. says

    And no, I can’t accept the end of bubbles. That’s too much hyperbole. I think PE10 might be good to help guide your portfolio allocation, but ending bubbles and speculation? It’s not going to change human nature…
    People thought that it was “human nature” to be illiterate before the printing press was invented. One of the humans invented something that permitted us to change “human nature” for the better. People thought it was “human nature” to listen to Perry Como before the Beatles appeared on Ed Sullivan. On that night, “human nature” changed. I was there (out in televisionland). I remember how it felt to see human nature change. It felt good.

    I don’t disagree that it was human nature to fall for Get Rich Quick investing schemes in the days before we had 30 years of academic research showing us what works. But we now have that research in our hands. That advance permits us to change human nature for the better in profound and far-reaching way.

    The only thing lacking today is the will to do so. Lots of us are thinking that this crisis will pass and things will get back to the way they were, so why admit any mistakes? That’s not what the numbers say. The numbers say that we are headed into the Second Great Depression unless we work up the courage to acknowledge our mistake and move on.

    I think that we are going to gain a consensus that it makes sense to acknowledge our mistake shortly after the next big price crash. Then we will end up being so happy we did so that no one will ever look back at the Buy-and-Hold “idea” for tens of thousands of years.

    We’ll see.

    Rob

  10. says

    Like you said, you moved out of stock in 1996. If you had stayed in stock until 2006 you would have made a lot more money than your method. The issue? Opportunity cost. Every time you leave the index, you need to know that the alternative has a shot to outperform. Yeah, maybe stocks seem undervalue d- but if you switch to something silly, what’s to say that won’t do worse?
    Your point about Opportunity Cost is legitimate and important.

    However, it’s important to understand that there is an Opportunity Cost to following a Buy-and-Hold strategy too. Any allocation choice contains a potential Opportunity Cost. There’s no risk-free zone that is available only to Buy-and-Holders.

    The rational way to address the potential of being exposed to an Opportunity Cost is to take measured steps. Looking at the numbers alone, you might be inclined to go with a zero stock allocation in 2000. But there were some quirky returns sequences that were possible in which you might have lived to regret that choice. So perhaps you should have gone with a 30 percent stock allocation to hedge your bets. That makes perfect sense.

    Going with 30 percent is a huge improvement over sticking with 70 percent as part of a Buy-and-Hold strategy. There’s no rational case that can be made for sticking with the same stock allocation at all valuation levels just because that’s what the people who get rich selling you stocks would like you to do. There’s no one answer that is right for everyone. But mindlessly sticking to a single stock allocation is always a bad choice.

    Rob

  11. says

    I’d rather enable people to make stupid (or smart) decisions with their own money. But hey, I’m a free market guy.
    My view is that there is no free market without free speech.

    I have zero problem with people following Buy-and-Hold strategies if that is what they elect to do, having been permitted to hear both sides of the story. But when people are not permitted to hear both sides of the story, they are not making an informed choice.

    You’ve heard me criticize Fama’s Efficient Market Hypothesis. The full truth is that I believe that Fama was hitting on something of great importance. He was describing how the market will indeed operate once we open the internet up to honest posting on all sorts of investing topics. 

    The market wants to be efficient. But efficiency comes through millions of people acting in their self-interest. Today, people do not know their self-interest because so many of us are afraid to question Buy-and-Hold. Once we put that Social Taboo behind us, there will be an explosion of learning in this field and thousands of new businesses will be formed to help people learn what they need to learn to invest effectively. From that day, forward, we will have an efficient market.

    To understand what is going on, you need to appreciate the chronology. Until the 1960s, there was no sustained academic study of how stock investing works. There were smart people who analyzed particular stocks and made lots of money doing so. But it cannot be said that there was any scientific study of the subject. Nobody knew much of what he or she was talking about when it came to questions about how markets operate.

    Buy-and-Hold was the first research-supported model for understanding how stocks work. The Buy-and-Holders generated hundreds of powerful insights. There’s a lot of good in Buy-and-Hold,  I don’t deny that for 10 seconds. But they got the efficient market thing a little off. The reality is that the market is not automatically efficient. It becomes efficient only after we learn and then teach the realities. We haven’t done that yet. But once we do, there is every reason in the world to believe that the market will become efficient and we will all live happily ever after.

    What we have today is not a free market. What we have today is crony capitalism. The only reason why so many feel afraid to talk openly and plainly and bluntly about what the academic research say is that The Stock-Selling Industry crushes those who talk out of school. There are enormous pressures to stick to the company line and pretend that there is something to all the Buy-and-Hold mumbo jumbo.

    I see no harm whatsoever in people advocating Buy-and-Hold. First of all, they might be right. I make mistakes too. In the event that I am mistaken, I sure want to know that there are smart and good people out there telling a very different story. Second of all, we need people challenging us to help us sharpen our thinking. Three, having people tell the other side of the story provides balance. So advocacy of Buy-and-Hold is A+ stuff. I love the Buy-and-Holders. They were the pioneers. They are heroes to me.

    What I don’t like is the dogmatism that has come to be associated with Buy-and-Hold in recent years. When a Buy-and-Holders says “we should ban so and so from our board or blog because he challenges our dogmas,” I want to throw up. The beauty of Buy-and-Hold is that it promised to bring science to investing analysis. Dogmatism ain’t science. It is the precise opposite of science. Buy-and-Hold today is the precise opposite> of what it started out to be. I love the original concept, not the monster that Buy-and-Hold has become.

    If we all talk this stuff out, we all will do just fine. Perhaps Buy-and-Hold will prevail. Perhaps Valuation-Informed Indexing will prevail. Perhaps we will come up with some sort of mix. Perhaps there will be some new thing we will all turn to. Who the heck knows? The key is that, once we lift the Social Taboo that today intimidates people from challenging Buy-and-Hold in clear and firm and bold terms, we will all be learning together, we will all be over time advancing in our knowledge of how stock investing really works.

    I view myself as the free-market guy, PK. I have zero problem with the idea of Buy-and-Hold prevailing in the court of public opinion once these questions are subject to honest public debate. But there is nothing honest about the discussions on stock investing being held today. Buy-and-Holders have become ruthless in their efforts to control what can be said about their favorite investing strategy. So long as that remains the case, we don’t have a free market. We are kidding ourselves to think that there can be a free market without free speech.

    Rob

  12. JT says

    The stock market is rarely a source for bubbles. Housing has been the single source for most deflationary market crashes, as it is one of the few things which people are willing to purchase with leverage. Hence, it’s the single largest source for incredible credit expansion, and an equally large source of credit destruction. Look at Japan, the US – it doesn’t even matter just pick a bubble and it was all housing. 

    VII can’t stop bubbles if implemented SOLELY on the stock market. However, if people were apt to consider the relative value of a home to rents – some kind of VII for homes – I think you could certainly stop housing bubbles, and therefore most financial bubbles.

    Whatever it is, the main problem is that the worst ideas are usually part of herd mentality, so what you’re saying is that we just need to get everyone to stop making stupid decisions at the same time as everyone else. Good luck!

    • says

      The stock market is rarely a source for bubbles. Housing has been the single source for most deflationary market crashes, as it is one of the few things which people are willing to purchase with leverage.
      My understanding is that it was the stock bubble that caused the housing bubble rather than the other way around. JT. I could be wrong. I certainly don’t object to people arguing it the other way. I certainly am no fan of housing bubbles.

      I understand your point about leverage. It would be rational for people to inflate a housing bubble more than a stock bubble because there would be more imaginary gains to be realized from it. But I don’t think we can assume rationality in discussions of investing questions. If investors were rational, there would be no bubbles of any kind.

      Bubbles develop because people like imaginary money. Most people don’t think of their houses as the primary source of funding for their retirements. People look to their stock accounts for that. So, when people get worried about whether they have saved enough for retirement, they are drawn to inflating stock prices rather than real estate prices.

      The number that I have seen for the stock bubble is that the amount of imaginary money in 2000 was $12 trillion. I recall seeing an article stating that the loss in the real estate crash was about $4 trillion. I am more confident of the first number (the $12 trillion) than I am of the second number (the $4 trillion). If both numbers are right, I think it would be fair to conclude that the stock bubble was the bigger problem.

      so what you’re saying is that we just need to get everyone to stop making stupid decisions at the same time as everyone else.

      Yes, that is the idea here. We have had four stock bubbles since 1870 and we have had four economic crises since 1870. Remarkably enough, each of the crises followed on the heels of each of the stock bubbles. I understand that lots of people love stock bubbles. But I also understand that lots of people get hurt in economic crises. So I would like to bring stock bubbles to an end. I think that can be done by permitting open and free discussion of what the academic research of the past 30 years tells us about how stock investing works.

      What’s the alternative? We have a Second Great Depression and then years later dig ourselves out of the wreckage and start this craziness all over again?

      That’s what we have done in the past. I don’t think it makes sense to continue doing it. Millions of people have their retirement money invested in stocks. I think we have to start talking about stock investing in a serious way. The academic research shows that valuations are the single biggest factor that determines long-term success or failure. So I think we all should be talking about how to incorporate an understanding of the effect of valuations into our planning.

      We barely survived the First Great Depression. The P/E10 level this time went far, far beyond the levels that caused the First Great Depression. So we are in the soup today to an extent that few are yet willing to acknowledge. I think that stock investing has become too important to the lives of too many people for us to continue with this policy of letting marketing decisions drive all that is said on this topic. I think we need to let some reality in. My personal view is that we have no practical alternative at this point.

      Thanks much for your kind and supportive and encouraging words, JT. I don’t hear those sorts of words all that often. They cheer me when I do. People with loving souls like yours make a difference.

      Rob

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