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Are Stock Gains and Losses Real?

This is a guest article by Rob Bennett, a personal finance journalist and author of the blog A Rich Life. 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.

You naturally get worried when you see the value of your retirement account drop. Most experts say that you should ignore the ups and downs of the market. But that’s hard. We all want to be sure that we are on track to meet our retirement goals.

The purpose of this article is to offer more detailed and more balanced advice that what is usually put forward by the experts. It is true that there are some circumstances in which it really is best to tune out the market noise. However, recent academic research shows that there are other times when stock price drops should be a serious concern.

There are six sorts of stock price changes you will experience and letting you know the proper way to react, given how stocks have always performed in similar circumstances in the past.

Situation one: Losses incurred at a time when stocks are selling at fair value prices

Say that stocks are priced at fair value (that’s a P/E10 value of 15). Should stock price drops be a concern?

No, not at all. Losses experienced from price drops starting from fair-value prices are always recovered over the next 10 years or so. So these are strictly temporary setbacks.

In these circumstances, the experts are absolutely right. The worst thing to do following a price drop starting from fair-value prices is to sell your stocks. That turns those temporary losses into permanent losses. You want to hold the stocks until the losses are recovered.

Situation two: Gains incurred at a time when stocks are selling at fair value prices

What if you instead see gains starting from a time when stocks are selling at fair-value prices? Are the gains temporary too?

Probably not.

U.S. companies generate enough productivity to support annual gains for the broad stock indexes of 6.5 percent real. So the market price is constantly moving upward. So long as your gains are not more than 6.5 percent real, those gains are not temporary but are yours to keep.

Even if the gains are more than 6.5 percent per year, there probably is not much cause for concern. The average 6.5 percent return for U.S. stocks is good enough that price changes that lower that number a bit for the future don’t cause serious problems for investors. So what if your returns in future years will be only 5 percent real or only 4 percent real? That’s still better than the return you could earn in alternative asset classes. You still want to keep your money in stocks.

Situation three: Losses incurred at a time when stocks are selling at super-low prices

These are the times when you want to be certain to be heavily invested in stocks. You can’t lose. Once prices are already low, they can’t go any lower. If prices remain at the same valuation level, you will obtain that average 6.5 percent return. If they move up to fair-value price levels (they always do in the long term), you will see a return far better than that.

There’s only one problem. Prices only go to super-low levels when most people are so scared about their financial futures that they are not willing to pay a fair price for stocks. You will be hearing lots of stories in the media at such times that the entire economy is about to collapse. You want to try to tune that stuff out.

If the economy really does collapse, there is no good investment class. So you wouldn’t be losing anything by being in stocks, If the economy recovers, those in stocks will generate more wealth in 10 years than they could in 20 years of investing at other sorts of time-periods. Do not get caught up in the gloom and doom!

Situation four: Gains incurred at a time when stocks are selling at super-low prices.

All gains incurred at times of super-low prices are yours to keep, even gains far above the 6.5 percent average return figure. This remains true until stocks are again selling at fair-value prices. So enjoy the ride up! You earned it by managing to tune out the gloom and doom message threatening to throw you off the horse.

Situation five: Losses incurred at a time when stocks are selling at super-high prices.

This is the circumstance in which I disagree with the advice offered by most experts in this field. Losses suffered starting from super-high prices are never recovered. When you pay more than a fair price for stocks, a portion of your money is going to the purchase of stocks and a portion is going to the purchase of cotton-candy nothingness. Prices always return to fair value. So these price drops are not so much losses as they are the market coming to recognize phony gains experienced at an earlier time for what they really are.

Situation six: Gains incurred at a time when stocks are selling at super-high prices.

Stocks are dangerous when they are selling at super-high prices. Gains experienced at such times just make the stocks you are holding that much more dangerous to hold. Investors going with high stocks allocations in such circumstances are living on borrowed time.

Photo: Images_of_Money

Published or updated March 15, 2012.

About the author

Rob Bennett's "A Rich Life" blog 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. Rob Bennett created the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. View all articles by .

{ 20 comments… read them below or add one }

avatar 1 Anonymous

In some cases I find this article confusing, in others cases I find it dangerous. First the headline: Are gains and losses real? Well, if you’re a seller – yes they are. If you’re talking about your income statement gains are real income, but if your looking at your balance sheet they’re already accounted for. Each scenario assumes a starting point that should be understood before you can understand the outcome. In example, look at situation 4. This assumes that you are buying the stock and don’t all ready have any (if you had bought before wouldn’t you have lost money if it’s at a low point?) and there are no gains upon purchase, they appear only over time. Gains are only realized when you sell, regardless of what’s on your balance sheet. Cash flow and value should never be confused.

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avatar 2 Ceecee

This topic is so difficult. Some stocks just defy logic… continuing to rise when the company has no real profits. And I agree with SteveDH, gains are only real gains when you sell. I have found out in the last four years that the stock market is not for the faint of heart.

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avatar 3 Anonymous

I’m grateful for your comment, Steve. You are not the first person to describe my investing beliefs as “dangerous.” A good percentage of the people reading these words agrees with you and that viewpoint needs to be represented in any constructive discussion about the two ways of thinking about how stock investing works.

Can I describe briefly the two models for understanding how stock investing works and why making a decision as to which one to follow leads to such different strategic choices?

The model that is dominant today is the Buy-and-Hold Model. That model is rooted in the research of University of Chicago Economics Professor Eugene Fama. It posits that stock prices are determined by each day’s economic and political events. If this model is correct, all that you say in your comment is correct and all that I say in the article is wrongheaded.

The minority-view model is the Valuation-Informed Indexing Model. That model is rooted in the research of Yale University Economics Professor Robert Shiller. It posts that stock prices are determined by investor emotion. This is the model that I use to guide my thinking. Your comment does not make sense to someone who follows the Shiller model (I of course mean no personal offense with this observation).

Why are the two models so different?

Under the Fama model, prices are set each day. What happens today doesn’t affect what happens tomorrow and what happens this year doesn’t affect what happens next year or ten years from now or twenty years from now.

Under the Shiller model, today’s prices are being set by things that happened 15 years ago and ten years ago and five years ago as well as by what happens today. Long-term returns are predictable in this model. Under this model, some types of losses will be remaining in effect for many years and others will not be and by looking at the valuation level that applies today we can identify which type of loss it is we are suffering today. Losses suffered at some valuation levels will hurt us for many years to come. Losses suffered at other valuation levels are trivial; they will remain in effect for only brief periods of time.

This stuff is confusing. But it is also very important. If Shiller is right (I obviously believe that he is), Shiller’s findings will someday go down in history as the most important findings in the history of investment research. Shiller’s findings change everything we once thought we knew about how stock investing works for the long-term investor.

My hope is that we are going to see a national debate of these issues in days to come. I certainly don’t want anyone believing in these ideas based on my say-so. But I would like to see people exploring the ideas, insisting on hearing both sides of the story, and over time developing an informed understanding of both models.

Anyway, that’s the idea here. Thanks again for taking the time to share your sincere thoughts and concerns with us all. I of course wish you the best of luck with whatever investing strategies you elect to pursue.


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avatar 4 Anonymous

Thanks for responding. Although I can grasp the theoretical properties of both Fama and Shiller I’m more focused on the accounting and effects of investment strategies. But first, let me describe the house I live in. I’m retired and have saved fairly consistently for many years. My in income today is comprised of Social Security, Pensions, and investment income. Investment income (not value change) makes up about 7% of my total income. That said I’m have always been a buy and hold investor. The most “selling” I ever did was in 2006/2007 just prior to retirement when I made a concerted effort to reduce risk. Great time to dump stocks but I must confess that it was a “Time-of-life” thing more than investing know-how. (dumb luck might apply as well) Regardless, both theories apply to whatever gains and losses I’ve had to account for over the years but they differ mostly in what caused them. The accounting, however, is straight forward. The only thing that got me through 2008 (without resorting to strong pharmaceuticals) was the belief that my income statement was adequate and I could emotionally account for value losses as “just a balance sheet issue”. Trust me, once you get to retirement the income statement rules!!

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avatar 5 Anonymous

The accounting, however, is straight forward.

Your comment is perfectly fair and balanced and kind and thoughtful, Steve. I hope you won’t think I am being argumentative if I venture forth my person opinion that the accounting here might be less than entirely straight-forward.

Say that you had planned all your life to retire at age 65 and that you determined that you would need a portfolio value of $1 million to pull it off. Say that you turned 60 in the January 2000 and that you had $900,000 in your portfolio at the time.

That would make you feel pretty good, wouldn’t it? You would have been close enough to your goal that with new contributions and gains on the old ones and compounding on those gains, you would expect to hit the target. So all was looking well. Perhaps you would even loosen up a bit, moving to a larger house or buying a second car or taking a two-week vacation rather than a one-week vacation.

Now look at the scenario from the standpoint of someone who believes that overvaluation is a real phenomenon (overvaluation is a logical impossibility under the Fama model — that’s why Buy-and-Holders stay at the same stock allocation at all price levels). Stocks were priced at three times fair value at the time. That means that the true, lasting value of that portfolio was not $900,000, but $300,000. You have only five years to go and you are $700,000 short of your target. Panic city!

Whether you count for the effect of valuations or not makes a big, big difference. None of the numbers we use in any area of stock investing analysis are right in the event that Shiller’s research on valuations is correct. There was an article about this published in Money magazine with the title “What If Everything You Thought You Knew About Stock Investing Turned Out to Be Wrong?” I think that says it well.

I believe that is it this accounting problem that caused the economic crisis.

Stocks were overpriced in 2000 by $12 trillion. I noted above that even the Buy-and-Holders acknowledge that we always return to fair value with the passage of about 10 years of time. So those paying attention in 2000 knew that by 2010 our economy would be losing $12 trillion of buying power. Are you able to imagine any scenario in which a consumer economy could lose $12 trillion of buying power and not collapse? I am sure not able to do so.

We need to get the numbers right. All of our retirement hopes and all of our hopes of surviving this economic crisis depend on it. But the reality here is that in 30 years no one has been able to offer an effective challenge to Shiller’s findings. It is my belief that what is happening is that this change is so big that our minds just cannot process it. Most of us are suffering cognitive dissonance and trying to hang on to our belief that the pre-Shiller model really does make sense and really can work in the real world.

The encouraging news (I hate to be a downer!) if that, if Shiller is indeed right, we now know how to reduce the risk of stock investing by 80 percent. Almost all of the risk of this asset class comes from ignoring valuations. If we could find a means to get the word our to people, we could for the first time in history offer ordinary middle-class people a virtually risk-free way of investing in a high-return asset class. When we pull that off (I am a natural-born optimist!), I believe we are going to see the greatest period of economic growth in out history as we all become reassured of our long-term financial security.


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avatar 6 Anonymous

And I agree with SteveDH, gains are only real gains when you sell.

Please note my comment to Steve above as a prefatory response, CeeCee. I’ll zero in on the particular point you raise here in my response to you.

Stocks are always moving in the direction of fair value. This has been so for 140 years now. Even John Bogle, who is the King of Buy-and-Hold, says that Reversion to the Mean is an “Iron Law” of stock investing.

So, when stocks are priced at three times fair value, as they were in 2000, we know that the long-term direction of prices is down and down hard. Compare that to how things stood in 1982, when stocks were priced at one-half of fair value. At that time, the long-term direction of prices was up and up big-time.

Now —

Suppose you suffered a loss in 1982. Would it mean anything? It would not. That loss would be countered by gains greater than the loss within a short amount of time. That loss was trivial.

But suppose you suffered a loss in 2000. The historical data shows that it could take 30 years for you to make up that loss. Why? You bought stocks when they were priced at three times fair value. Huge losses were in effect “priced in” to the shares you purchased.

Stocks always do well in the long term when priced at fair or low prices. There is not one exception in the historical record. Stocks always do poorly in the long term when priced at super high prices. Again, there is not one exception in the historical record. I view this reality as the most important reality of stock investing (one that the “experts” on Wall Street very much do not want us to know about, I might add).

People should not just be looking at the nominal drop in portfolio value and making a determination that “this is bad.” It might be bad. But it depends. If the loss comes at a time when stocks are priced to continue to lose value for many years to come, you are going to be stuck with that loss for a long, long time. But if the loss comes at a time when stocks are priced to rocket forward, the loss is not worth getting worried about. In those circumstances, the loss is a trivial event.

Or at least so says the Shiller model for understanding how stock investing works.

Thanks much for your comment and please take care, CeeCee.


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avatar 7 Anonymous

This entire article leans on the parenthetical definition of fair value “(that’s a P/E10 value of 15)”. Since it’s in a parenthetical I guess that means you don’t have to prove it?

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avatar 8 Anonymous

Since it’s in a parenthetical I guess that means you don’t have to prove it?

It has to be proven, Steve. But we can’t prove every point made in ever article in every article published. The question “What is the Fair Value P/E10 Value?” is a good topic for a separate article.

I write three weekly columns on the Valuation-Informed Indexing model. I just wrote a column for the site on this precise question. Unfortunately, it is not up yet. It will be going up in a week or two if you want to look for it.

There is a large body of work that addresses this point. Shiller discusses the fair-value P/E10 level in his book “Irrational Exuberance.” Shiller puts the fair-value P/E10 number at “16.” I think that number is slightly to the high side because it was developed by taking the average of all the P/E10 values we have seen through history. We are today living in the wake of the largest bull in history and stocks are still markedly overpriced today. If you assume we will be returning to fair-value prices in days to come, that price drop will pull the average P/E10 value down to 15 or 14. So I use “15.”

Does it matter that much?

You come to the same basic result if you use 14, 15, or 16.

We don’t today know everything about stock investing with 100 percent precision. But we know a lot more than we did 30 years ago or 50 years ago. My view is that we should be making use of the knowledge we possess today while continuing to try to add to our knowledge base as we become able to in days to come.

Is there another P/E10 value that you view as a more accurate fair-value number than my suggested “15”? I am not God. No one has to accept my number on my say-so. No one should even give thought to doing such a foolish thing.

I wish that these issues were discussed more openly and more frequently. If they were, all investors would possess the background needed to form their own views as to what is the correct fair-value P/E10 number. It is my view that no one should invest one penny in the stock market prior to doing that.

To buy stocks without knowing whether the price at which they are being sold is fair or not is like buying a used car without checking to identify whether the dealer is quoting you a reasonable price or not. I personally would never dream of doing such a thing. And we all have a lot more riding on our stock-buying decisions than we do on our car-buying decisions.


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avatar 9 Anonymous

It has to be proven, Steve. But we can’t prove every point made in ever article in every article published. The question “What is the Fair Value P/E10 Value?” is a good topic for a separate article.

Sure, but you can hyperlink that statement to an article supporting it.

My problem here is that it’s an iceberg of an assumption.

“(that’s a P/E10 value of 15)” assumes
1) That stocks have a fair value
2) That that fair value can be determined
3) That the metric to determine it is P/E10
4) That the correct number for that metric is between 14 and 16.

Even the statement “What is the Fair Value P/E10 Value?” includes the first three assumptions. It’s a loaded or “Plurium Interrogationum” question (Latin for “many questions”). The classic loaded question is “Have you stopped beating your wife yet?” That question is really two questions: Did you ever beat your wife, and if so, do you still do so? Similarly, the question “What is the Fair Value P/E10 Value” is really (at least) two questions: “Is there a Fair Value P/E10” and “If so, what is the Fair Value P/E 10?”

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avatar 10 Anonymous

Similarly, the question “What is the Fair Value P/E10 Value” is really (at least) two questions: “Is there a Fair Value P/E10″ and “If so, what is the Fair Value P/E 10?”

We agree on this, Steve.

My guess is that the point re which we might disagree is on the question of whether the Buy-and-Hold Model is rooted in similar but different assumptions. It is my view that the fundamental premise of each model is an assumption. Then everything follows logically from that in both cases, and you end up in two wildly different places.

Buy-and-Hold assumes investor rationality. This is why the market is said to be efficient. It is in the best interests of investors to set stock prices properly. So the people who developed the Buy-and-Hold Model assumed this to be so. It’s not a crazy assumption. I can see where they are coming from. The problem from my perspective is that the research of the last 30 years discredits this assumption. (PE/10 should be a meaningless number if the market is efficient and it isn’t. P/E10 does a very good [but not perfect] job of predicting long-term returns.)

The VII Model assumes that valuations matter and that, thus, the market is not efficient. The assumption is rooted in research but I do agree that there is a bit of an assumption here. You can’t say anything about investing if you are not willing to make some sort of assumption on the most fundamental question — what causes price changes.

Price changes are either the product of investor rationality or investor emotion or some combination of the two. No one can ever know with 100 percent certainty which it is. We cannot ask the market what it is that is influencing it. We have no choice but to make an assumption. We all have the same data to look at. There’s no dispute over the data. The dispute is over which interpretation of the data is correct.

I certainly do not say that Buy-and-Holders should change their interpretation so long as they continue to believe in it. So long as you believe, you need to make the case, Steve. However, I do think that it would be helpful if some Buy-and-Holders would make an effort to be less dogmatic (I don’t mean you, Steve). I have been in circumstances in which Buy-and-Holders have said that their views are “proven” or are the product of “science.” No.

There’s science involved. But the science is always being applied to the root belief, which is an assumption. If you use the other assumption (which is at least as legitimate as the Buy-and-Hold assumption), you get very different results from the application of a scientific process to the root assumption.

Are stock price changes caused by rational investor reactions to daily economic and political developments?

Or are stock prices caused by emotional investor reactions to things (specifically, overpricing) that happened as far back as 10 and 15 years ago?

That’s a question that I believe everyone in this field should be talking about today. Whether we get that one right is going to determine whether we recover from this economic crisis or not, in my assessment.

I am grateful to you for the helpful back and forth, Steve. I obviously can only put forward my own case with conviction. So it is a big help for those listening to hear your take and thereby to become able to benefit from a presentation that is at least balanced in an overall sense.


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avatar 11 Anonymous

Rob – thank you for the PRACTICAL application of the valuation informed strategy. The concept is not that hard. People get caught up in the details, which really don’t matter much. We disagree on several minor points (indexing, is PE10 the best measure?) but the concept and strategy is so sound, that in my mind, it is irrefutable. Investors need to grasp the concept of how important valuation is in determining future returns. Everyone can make there own variations of how they implement the concept.

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avatar 12 Anonymous

the concept and strategy is so sound, that in my mind, it is irrefutable.

Oh, great! Now you are forcing me to play devil’s advocate and argue the case against my own idea. Thanks a lot, pal! (I am joking around, of course — I am grateful for your kind words, Ken.)

There is a sense in which I agree with you that the ideas here are simple and all but irrefutable. However, I can tell you that, based on 10 years of experience trying to make the case to tens of thousands of middle-class people, I know for a rock-solid fact that there are lots of good and smart people who have a hard time letting this in.

I can give evidence from my own life story. I am the person who discovered the errors in the Old School safe withdrawal rate studies (I posted on them on the morning of May 13, 2002, at a Motley Fool board and in the ten years since numerous big-name experts, including the authors of some of the studies, have acknowledged that I was right). Today, as a result of investigations I have been involved in following from the SWR matter, I am a critic of Buy-and-Hold. But you know what? If you had asked me on the morning of May 13, 2002, whether I was a Buy-and-Holder, I would have responded with an enthusiastic “Yes!”

We have a limited understanding of how the human mind words. The idea here is indeed simple but it is also fundamental. I have come to believe that it is very hard for the human mind to process fundamentally new ways of thinking about a subject. We form paradigms of understanding so that we don’t need to rethink basic points each time a question comes up. When something threatens the paradigm, we reject it out of hand because we view challenges to the paradigm as threats.

And you know what? We are generally right to do this! Most challenges to our paradigms really are faulty. So as a general rule we really are better off rejecting bold new ideas as being more trouble than they are worth.

However, every now and again there is a new idea that really does change the world in a very big and positive and life-affirming way. I am 95 percent convinced, based on ten years of working this 10 hours a day, seven days a week for 10 years, that this is such a case.

We need to proceed with warmth and affection and respect for those coming at this from the other point of view. The Valuation-Informed Indexing Model would not exist but for the many amazing and wonderful and life-affirming contributions of the Buy-and-Holders. We owe the Buy-and-Holders our gratitude. We do have to point out where the Buy-and-Holders got things wrong when we come to believe that they go things wrong. But we have to remember that we are all on the same side. Everyone wants to know how to invest effectively. If we pull together, we will accomplish great things. If we give in to temptations to engage in antagonisms, we could hurt our mutual cause in serious ways.

I apologize for getting so philosophical. But this is a very big deal. I think people need to be exposed to these words.

What is happening here is that our economic system is doing what it does well once again. Our system has produced amazing advances that have enhanced all of our lives on many occasions in history. We have cars today and heart transplants and ipads and all these sorts of things because there were people who were not satisfied with where things stood at earlier times and got off their butts and learned about new ways of doing things. When chances to take huge leaps forward appear to us, we want to take advantage of them. These are win/win/win arrangements.

I think that is what we have with Shiller’s research and the work that has been done in the past 10 years exploring its many exciting implications. We have to try to take an historical perspective and accept that earlier innovations were also met with skepticism and even scorn. The people who made a living in the buggy-whip industry did not like that car concept one tiny little bit! We have to bend over backwards and try to understand where people are coming from and why they are alarmed and what they need to know to be able to make the first few small steps in a new direction. It’s the early steps that are scary. After taking those, people are usually able to handle the rest on their own.

The biggest thing lacking in these discussions is examination of the huge positives. This is not about telling people that their portfolio values are going to decline in days to come. What we have here is a new way to invest that permits people to earn far higher returns at greatly diminished risk and that stabilizes our economy. We ALL benefit from that and it is a very exciting development. We all need to somehow overcome our relatively petty concerns about what is going to happen next week or next month or next year and take the big picture view of all this.

If we do that we are going to find ourselves heading off to some truly amazing places. Many people think that the laws of investing cannot change in a big way. They are wrong. We live in a dynamic society. The potential for big, positive change is our birthright. Achieving big change always has some difficulties attached to it. We need to work up the confidence and optimism to just sail up over those rocky waves and push ourselves to the other side, from which we will someday all look back and laugh in wonder at why it took us so long to do the obvious, good and right and constructive thing.

Those are my thoughts, anyway. Thanks much for your warm words of encouragement, Ken. You keep on doing what you you do, man.


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avatar 13 Anonymous

Thanks Rob! Keep up the good fight.

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avatar 14 Anonymous


Thanks for writing again here. It was a good read.

I do have a couple of questions. First, I assume that since you advocate Valuation-Informed Indexing, you must advocate that investors move some or all of their money out of stocks when prices get to be, as you call it, “super-high.” My questions about this are, what’s your definition of “super-high” in terms of the P/E10, the metric you use? Also, how much do investors move out of stocks? A certain percentage based on how high the P/E10 is, or all? When you move your money out of stocks, where does it go? Do you advocate a mixture of cash, bonds, and alternatives, or perhaps other stock indices?

On to something separate. I like the idea of Valuation-Informed Indexing, but I also like the idea of Valuation-Informed investing in individual stocks. This is something I do with about 5% of my small, but growing portfolio. The practice has treated me very well so far. I recognize that individual stocks carry greater risk, but they also have the possibility of greater returns as well. Where do you stand on this? In fairness, I should say that I’ve been picking stocks (with about 5% of my portfolio) since late 2009. It’s not a long track record, but I’ve done very well so far.

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avatar 15 Anonymous

Thanks for your kind and encouraging words, Josh. I am going to put up a number of posts in response because you have asked a number of questions and they are all good and important ones.

what’s your definition of “super-high” in terms of the P/E10, the metric you use?

The fair-value P/E10 level is 15. The lowest we ever go is to about 7 or 8; that’s where we were in 1982. I describe anything above 25 as “insanely high.” We have gone above 25 four times. On each of those four occasions we have experienced a price crash and an economic crisis. There was only one time prior to the late 1990s when we went into the low 30s; that was in the months prior to the onset of The Great Depression. In January 2000, we went to 44, entirely uncharted waters.

There is virtually zero risk to stock investing when we are below 15. The thing to remember here is that, for years in which we stay at the same P/E10 level, you are earning a real return of 6.5 percent real. So, if we remain at 15 for 10 years, you are doing great. On the other hand, if we drop below 15 for a time, the future returns goes to something above 6.5 percent real (at the price levels that applied in 1982, the most likely annualized 10-year return is 15 percent real). That puts the odds even more in your favor. So you can’t lose at those valuation levels.

The 6.5 percent real return that applies at fair value is good enough that, so long as prices do not get too out of hand, stocks continue to offer a strong long-term value proposition when they creep a bit above that. If you stayed at a high allocation up to 20, you would do fine. You would be taking on more risk for less return that you did at fair-value price levels, but you would still be getting adequate compensation for the risk you were taking on.

I think of 21 through 24 as the warning track. Whether you want to be heavily invested in stocks at those price levels or not depends on your risk tolerance. It’s possible to do well at those price levels. It’s also possible not to do well. It depends on the return pattern which happens to turn up, which we cannot predict. At those sorts of price levels, you have to make a judgment call.

The alternative would be to gradually reduce your stock allocation with each uptick in valuations. Most people want to make as few allocation changes as possible and there is no need to make more than one allocation change once every 10 years on average; that will give you 80 percent of the benefits of this. But the theoretically pure approach would be to check the P/E10 level once per year and to make a small change in allocation if there was a small change in valuations. That way you would avoid the judgment calls (but you would incur more transaction costs).

The thing that throws many people is that they imagine different valuation levels popping up randomly. They think “I don’t want to have to change my allocation level one year and then change it back and then change it back again.” None of that is necessary. Valuation levels are NOT random! They follow a clear, data-demonstrated, long-term pattern.

Prices ARE random in the short-term. There is no correlation between today’s P/E10 level and the P/E10 level that will apply in six months. But in the long term valuations ALWAYS (for 140 years now) follow the same general pattern. They go gradually upward for about 20 years and then down for about 15 years. So we had highs in 1900, in 1929, in 1965 and in 2000. We should be hitting a new high in 2030 or 2035.

So you don’t need to make many changes. If you went with a high allocation in 1975, that remained appropriate through 1995. If you went to a low allocation in 1996, that remained appropriate through today. You had to make only one allocation change in the time-period from 1975 through 2012 — that’s 37 years! You could have done a bit better using a more fine-tuned approach. But the 80/20 rule applies here — you get 80 percent of the benefits with 20 percent of the work. The extra benefits you get with fine tuning are relatively insubstantial.

I feel a need to stress that last point. People get caught up in the details and worry that they will do something wrong. The details don’t matter much. Just keep it simple and you will do fine. Get too fancy and your chances of messing up increase. There’s no particular need to get fancy and the benefits of taking that path are so small that it is generally not worth the trouble.

The benefit here is a counter-intutive one. People think “how is making one allocation change going to help me that much?” The only way you will see it is if you go through the historical data yourself (or use a calculator based on the historical data — I have one at my web site called “The Investor’s Scenario Surfer”). If you miss one crash, you not only get the benefit of not losing that amount of capital, you also get the benefit of decades of compounding on that money. At the end of 30 years, the dollar benefit is huge. There are some cases (not common but not super rare) where the portfolio size at the end of 30 years for the Valuation-Informed Indexer is double that of the Buy-and-Holder.

Since crashes come every 30 years or so, we are ALL going to live through at least one and perhaps two of them. Picking up this sort of benefit permits you to retire five to ten years sooner, according to the data.

The trick here is that you are betting on a sure thing. Stocks always crash when prices go to insanely high levels. They MUST crash. Once investors become unwilling to lower their allocations, a crash is the only means by which the market can perform its function. It is the function of a market to set prices properly. When large numbers of investors adopt Buy-and-Hold strategies, all price discipline disappears from the market. It is through crashes that the market preserves itself to live another day.

The short version of all this is that the key is not to get everything 100 percent right, the key is to do SOMETHING in response to high prices. Doing anything other than being non-responsive to big price swings puts you ahead of 90 percent of stock investors, including the majority of the “experts” in the field. A middle-class person who spends zero time studying stocks and buys only index funds but is open to lowering his stock allocation when prices reach insanely dangerous levels will get better long-term returns than the vast majority of those who spend all their free time studying this stuff.

This is the big one. This one factor has more influence on your lifetime return than all the other factors that people talk about in hundreds of books and articles and slideshows. Get this one right and you almost cannot fail. Get this one wrong and you almost cannot succeed. If you spend some time looking at the numbers (I have been doing this on a daily basis for ten years now), you will just be blown away by how big this turns out to be.


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avatar 16 Anonymous

Also, how much do investors move out of stocks? A certain percentage based on how high the P/E10 is, or all?

Getting your stock allocation right is the most important factor in determining whether you prove to be a successful long-term investor or not, Josh. So I always hesitate a bit to answer this question. I will answer it and I of course acknowledge that it is an important question with great practical significance. My hesitation is rooted in my belief that this is so important a question that I hate having it be just me addressing the point.

This question is so important that we all should be spending 80 percent of the time we direct to investing topics to analysis of this one question. How much should we lower our stock allocations in response to price increases or increase them in response to price drops?? In my ideal world, you wouldn’t see bloggers addressing this every now and again. It would be the first order of business just about every day. Thousands of smart people would be giving their takes. As a result we would all be much better informed and we would all be making far better choices.

It is because of an historical anomaly that we don’t all follow this practice today. Had Shiller published his research in 1971 instead of 1981, the title of the book published in 1974 would have been A Valuation-Informed Walk Down Wall Street and we would all be Valuation-Informed Indexers today. I say this to place things in context. I will offer my take on the question you asked. But please understand that that is all it is. You deserve to be able to hear lots of people a lot smarter than me addressing this question on a daily basis and from lots of different angles.

I strongly oppose the idea of ever taking all of your money out of stocks. My partner John Walter Russell used to call this “Idiot Switching.” It is this sort of practice that has given the concept of market timing a bad name. People must understand the difference between short-term timing and long-term timing to make any sense out of what I am saying. So I will describe that to explain why you never want to take all of your money out of stocks.

Short-term timing is guessing where prices are headed in a year or two. Guessing is dumb. That’s why short-term timing never works.

Long-term timing is evaluating long-term value propositions. Stocks offer a better deal at some prices than they do at others. So it makes all the sense in the world to change your stock allocation from time to time. You obviously don’t want to go with the same stock allocation when the long-term value proposition is poor as you do when it is strong.

Now —

If you cannot know where prices are headed in the short-term, you don’t want to be placing extreme bets. Stocks were insanely overpriced in 1996. There were people who shorted the market as a result. They had their heads handed to them. Stock prices soared in 1996 and 1997 and 1998 and 1999. We do not know where prices are headed in the short term. This important insight was brought to us by the Buy-and-Holders. I view it as the second most important insight ever advanced in the history of investing analysis (the most important is Shiller’s insight that long-term timing is required of those seeking to keep their risk profile roughly stable).

So extreme moves are out. You never know what is coming over the next few years. But moves of some kind are very much in, You want to keep your risk profile roughly stable. Since stocks are far more risky when prices are high, you MUST change your allocation in response to big price shifts to have any realistic hope of doing okay in the long term.

My approach is to compare what I can get from a risk-free asset class like TIPS or IBonds or CDs with what I can get from stocks. I have a calculator at my site (“The Stock-Return Predictor”) that performs a regression analysis on the historical data to reveal the most likely annualized 10-year return starting from any P/E10 level. I believe that I should be compensated for taking on the risk of stock investing. So I generally demand that stocks provide at least two percentage points of added return before I am willing to invest heavily in them.

The extreme examples are 1982 and 2000.

In 1982, the most likely annualized 10-year return was 15 percent real. No other asset class came close. So you wanted to go with a high stock allocation.

In 2000, the most likely annualized 10-year return was a negative 1 percent real. TIPS and IBonds were paying a risk-free return of 4 percent real. So it didn’t make sense to go with a high stock allocation. Do the math on that case and you will see why VII is so powerful. The difference in return is 5 percentage points real for 10 years running. That’s a total differential of 50 percent of your starting-point portfolio value! Earn that sort of differential just once in an investing lifetime and you are going to be able to retire many years sooner. You earn compounding returns on that differential for decades to come.

There are a variety of ways to make the allocation shifts. One simple approach would be to go with 90 percent stocks at low prices, 60 percent stocks at moderate prices and 30 percent stocks at high prices. Wade Pfau researched how a VII portfolio following that rule compares to a Buy-and-Hold portfolio and found that the VII portfolio beat the B/H portfolio in 102 of the 110 30-year rolling time-periods in the historical record, sometimes by very large margins.

As noted above, you could also do 75/50/25 or whatever else floats your boat. The key is making some change. The key is not adopting a Buy-and-Hold mindset, which blinds you to the reality that the valuations factor is by far the biggest factor in long-term investing success.

90/60/30 might do a bit better under the existing historical record but that might change in the future. We know for certain (at least some of us do!) that some change is going to beat no change. So a good starting point is to become willing to make some change and then over time perhaps engage in some fine-tuning as our knowledge of how stock investing really works continues to grow and expand.


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avatar 17 Anonymous

When you move your money out of stocks, where does it go? Do you advocate a mixture of cash, bonds, and alternatives, or perhaps other stock indices?

I am a simple man with simple dreams, Josh. My view is that the key to long-term investing success is having almost perfect confidence that you possess a deep understanding of what you are invested in. The reason why this is so important is that all investing choices will appear dubious at times. It is only by sticking with good choices for the long term that you gain a realistic hope that they will pay off. So you MUST have strong confidence in your choices.,

VII pretty much guarantees you a long-term return of a good bit more than 6.5 percent real. We know that that is the long-term average stock return. And we know (from Pfau’s research and elsewhere) that the return for VII is far higher than the return for B/H. It follows that the return for B/H must be a good bit less than 6.5 percent real and the return for VII must be a good bit higher than 6.5 percent real.

I can meet my goals with a long-term return of 6.5 percent real. So I don’t need anything else. I look at stocks as my growth engine. My aim is to have as much money in stocks as possible. I look at the non-stock portion of my portfolio as a choice that permits me to own more stocks over the course of a lifetime. The more money I take out of stocks at times of high prices, the more money I have available to invest in stocks when stocks offer a strong long-term value proposition.

This is key. I hear people say all the time “I can’t see investing in TIPS when they are only paying 1 percent real, Rob.” It doesn’t matter! You are not buying the TIPS for the 1 percent real return. You are buying the TIPS so that you will be able to buy more stocks when stocks are priced to pay a good long-term return. Earning a 1 percent return for three years and then a 15 percent return for seven years is a very, very good deal. People get hung up on the 1 percent business. It doesn’t matter! Your focus should always be the long-term return you obtain, never the short-term return you obtain.

I like TIPS and IBonds because they are the perfect counter to stocks, a much better counter than corporate bonds. Stocks are a high-risk, high-return asset class. TIPS and IBonds are low-risk, low-return asset classes. There’s great power in diversification. When you combine TIPS and stocks, you achieve the highest level of diversification possible. You’ve got the rock-solid steadiness of TIPS and the crazy jumpiness of stocks. They go together like chocolate and peanut butter!

CDs can work. I just don’t like not having inflation protection.

Other asset classes are fine if you are willing to study them in great depth before investing in them. Most middle-class investors do not have the time or inclination to do this. So I think most of us should limit ourselves to TIPS and stocks. A return of 6.5 percent real is plenty good enough.

If you invest in other asset classes, you lose focus. You find yourself reading articles about bonds and gold and real estate and who knows what. You should be spending that time learning about valuations (which means learning about the investor emotions that cause mispricings)! That’s what pays off in the long term. I think the reason we hear so much about all the complicated jibber jabber is that Wall Street makes lots of money pushing the complicated jibber jabber. We need to focus on what matters — buying stocks when they offer a good long-term deal and avoiding stocks when they do not offer a good long-term deal.

It’s okay to graduate to higher things once you master the basics. But my view is that the number of us who have mastered the basics is so small today that it is silly even to direct much attention to what such people should be doing. We can move on to the more advanced coursework after we get everyone up to speed on all of the issues relating to valuations and investor emotions. That’s going to take decades! That’s almost entirely unexplored territory at this point!


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avatar 18 Anonymous

I also like the idea of Valuation-Informed investing in individual stocks. This is something I do with about 5% of my small, but growing portfolio. The practice has treated me very well so far. I recognize that individual stocks carry greater risk, but they also have the possibility of greater returns as well. Where do you stand on this?

I think that makes all the sense in the world, Josh.

Bogle’s introduction of indexing revolutionized the field of stock investing. People today have no idea how big a change this was. Everything I am talking about in this thread only became possible with indexing. That’s why this stuff is not well known today. We are in the very early stages of appreciating how Bogle and the other Buy-and-Holders changed our lives for the better in dozens of very important ways.

Once we get to the other side of the Big Black Mountain, never again will middle-class people need to worry about where to invest their money. This is not only going to revolutionize investing. It is going to revolutionize our free-market economic system. I noted above that every economic crisis we have seen since 1900 was caused by our tolerance of high stock prices. We are never going to tolerate those sorts of price levels again. We are going to provide millions of people with the tools they need to invest effectively for the long term and, each time prices get too high, people will sell and bring them back to reasonable levels. So — no more economic crises once we pull out of this one!

So I am obviously a big believer in indexing. It is simple and it works. That’s what most people need. No one needs to go beyond indexing.

That said, picking stocks can pay off. There is more risk for stock pickers. But, if you know what you are doing, you can obtain a nice payoff for putting in those extra hours of work. And of course lots of people enjoy researching stocks, so it is not work for them at all. You are limiting yourself to 5 percent of your portfolio, so the added risk for you is trivial. Also, I think that researching stocks can help you gain a better appreciation of how your investments generate returns than is possessed by many indexers. One downside of indexing is that it makes the investing process a bit abstract and artificial for some.

Valuations of course matter when assessing the prospects of the various companies. But please do not think that the P/E10 metric can have as much power for stock pickers as it possesses for indexers. With individual companies, you need to look at scores of factors to gain a sense of whether the stock represents a strong long-term value proposition or not. With indexes, you only need to look at one factor — the price at which the index fund is selling. All the other factors are neutralized when you buy a tiny share of so many companies because you are getting a mix of the companies with good and bad management and a mix of the companies with good and bad product pipelines and so on.

I believe that Value Investing (Warren Buffett) is the smartest approach to investing. But I believe that Bogle’s work is more important than Buffett’s because middle-class people need a simple approach and Bogle provides that. The problem is that Bogle’s approach is flawed to the core because he developed it before Shiller published his research and has not corrected the mistakes he made in the 30 years since. My aim with the Valuation-Informed Indexing Model is to COMBINE the insights of Buffett with those of Bogle into a package that is as simple as Bogle’s approach but that performs comparably with Buffett’s Value Investing. This is smart and simple and safe investing for the typical middle-class person.


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avatar 19 Anonymous

Thanks for your responses, Rob. Bogle’s book was the first one I read when I started learning about investing, so I’m grateful for his work too. I like the Valuation-Informed Indexing strategy very much. It seems to be very low maintenance, but with lower risk and higher returns than buy and hold. The big problem seems to be with educating people about this stuff, since the average individual investor performs worse than buy and hold.

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avatar 20 Anonymous

Thanks, Josh.

Bogle’s book was the one that got me started on this path. I love the guy. I view him as a hero to the middle-class. All of the Buy-and-Holders are smart and good and hard-working people and we owe them our gratitude.

It has indeed been hard getting the message out; I have scars all over my body. I think the problem is that the jump forward is so big. People are fine with small advances. But they are skeptical of ideas that sound too good to be true. A good measure of skepticism is appropriate and healthy and understandable in such circumstances. So there are some good signs to be found even in the difficulties we face.

We’ll get there. It’s happening. Slowly. Gradually. But surely.

Thanks for helping everyone out by asking some smart questions. I wish you all the best.


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