Understanding Stocks — Podcasts on Risk, Valuations & Dangerous Investment Myths

There is only one reason why understanding stocks is hard for most of us. The trouble is that the people that most of us think of as “experts” are employed by firms that make money from the selling of stocks. There is a heavy pro-stock bias to the conventional wisdom in this field. This causes huge amounts of confusion for millions of investors.

understanding stocks

The simple reality is that stocks are like anything else that can be bought or sold. They offer an amazing value proposition at some prices, a strong value proposition at other prices and a terrible value proposition at still other prices. The key to understanding stocks is understanding stock valuations. Buy stocks only when they are selling at reasonable or low prices and you will never go wrong. Buy stocks when they are selling at insanely high prices (as they have been in recent years — this article was posted in December 2011) and you will suffer a wipeout.

This article offers brief descriptions of three RobCasts that address the fundamentals that you need to comprehend to develop a sound understanding of stocks. Robcast #41 addresses the issue of valuations. Robcast #95 tackles the issue of risk tolerance. Robcast #172 describes 30 myths about stock investing that can steer you wrong if you are not put on notice of the analytical errors in which they are rooted.

Understanding Stocks / RobCast #41 — Bogle and Valuations (Please click on the title to gain free access to RobCast #41).

Robcast #41 makes the following points:

1) The stock market had mispriced stocks by $8 trillion in the days prior to the 2008 crash. That is the real reason we have all lost so much money. The economy is not to blame. The problem is that we continued investing heavily in stocks even when they were insanely overpriced.

2) It is nonsense to think it is okay to go with the same stock allocation when stocks are priced at two times fair value as you went with when they were fairly priced. Buy-and-Hold can never work for so long as stock valuations continue to shift wildly. Stocks are more dangerous when highly priced. So you need to go with a lower stock allocation at such times.

understanding stock investing

3) Buy-and-Hold advocates told us to buy stocks after the crash because they were “cheap.” But is it that stocks were cheap after the crash or that they were insanely overpriced prior to the crash? If it is the latter that is the case, the experts should have been telling us to lower our stock allocations prior to the crash. We would all of course be better off today if they had done so.

Understanding Stocks / RobCast #95 — Risk Tolerance in the Real World (Please click on the title to gain free access to RobCast #95).

RobCast #95 makes the following points:

1) The stock crash has caused many middle-class people to lose confidence in stocks. This is a terrible mistake. Stocks are wonderful. Give up on stocks and you will delay your retirement by many years. What we need to give up is our belief in the crazy idea that it is okay to stay at the same stock allocation at all times (Buy-and-Hold). We all should be going with lower stock allocations when stocks are selling at insanely high prices. There’s no other way to keep your risk profile roughly constant.

2) Money concluded after the crash that stocks are more risky than we realized. No! Stocks are a low-risk asset class for those willing to lower their stock allocations when prices reach insanely dangerous levels. It’s not stock investing that’s risky. It’s Buy-and-Hold investing strategies that make stock investing risky for many.

getting smart about stocks

3) John Greaney gets the optimal stock allocation wrong because he fails to consider the effect of valuations. The reality is that there is no one optimal stock allocation. The optimal stock allocation varies with changes in stock valuations.

Understanding Stocks /RobCast #172 — 30 Investing Myths in 60 Minutes (Please click on the title to gain free access to RobCast #172).

RobCast #172 makes the following points:

1) Buy-and-Hold is not a scientific approach to investing. It once was. There was academic research supporting the strategy in the 1960s and 1970s. But Yale Economics Professor Robert Shiller published research discrediting Buy-and-Hold in 1981 and there has been no effective response by Buy-and-Holders to Shiller’s findings in the past three decades. So Buy-and-Hold is discredited science.

2) Stock price changes are not random. They are highly predictable. Long-term returns are always good starting from moderate prices and long-term returns are always poor starting from high prices. So Dollar-Cost Averaging (buying the same amount of stocks at a variety of different prices) does not make sense.

3) Investing experts are influenced by the fact that they make so much money persuading people to buy stocks at all times. Legitimate experts would tell people both when stocks are worth buying and when they are not.

For background on my development of the Valuation-Informed Indexing model for understanding stocks, please take a look at the “About” page for my A Rich Life blog.

Investing Secrets: 20 Investing Insights from the First 54 Months

This article offers brief descriptions of 20 investing insights developed during the first 54 months of The Great Safe Withdrawal Rate Debate and identifies my level of confidence in each insight.

Money Secrets

(A) Insights in Which I Have Almost Complete Confidence:

Investing Secrets — (1) Investing is Primarily an Emotional Endeavor and Only Secondarily a Rational Endeavor

The internet discussion board is a particularly valuable communications medium for determining the extent to which investors rely on reason to form their investment strategies. The first 54 months of discussions show beyond any doubt that emotion dominates over reason for most investors. This is presumably less so during times of reasonable stock prices than it is at times like today.

This finding should undermine your confidence in all of the conventional investing wisdom of today. Today’s conventional wisdom is rooted in Modern Portfolio Theory, a model for understanding stock investing that assumes that investors are engaged in the rational pursuit of their own self-interest. To the extent that this is not so (it is not so to the extent that investors’ reason is clouded by emotion), today’s conventional wisdom is leading you astray.

Investing Secrets — (2) Safe Withdrawal Rate (SWR) Studies Using the Conventional Methodology Get the Number Wrong

I had 90 percent confidence in this one on the morning of May 13, 2002. I have 99 percent confidence in it today. I don’t think it is possible to know anything with greater than 99 percent confidence. My confidence that we put a man on the moon is only 99 percent. The odds of someone persuading me at this point that the conventional studies get the number right are roughly equal to the odds of someone persuading me that we have not yet put a man on the moon.

Investing Secrets — (3) Long-Term Market Timing Works.

If the market were efficient, investors would sell stocks when valuations got too high. The usual rule is that people buy more stocks when prices get high. That’s certainly been the case in the most recent bull market. The claim that long-term timing cannot work because the market is efficient does not stand up to reasoned scrutiny.

Investing Secrets — (4) Most Middle-Class Investors are Overinvested in Stocks Today (This Article Was Written in November 2006).

Investing Secrets

When I used to cover tax bill markups for a living, the first question that reporters would ask when someone came out of one of those secret meetings to go to the john was “What’s the mood in there?” If some enterprising reporter were to look at the transcript of The Great Safe Withdrawal Rate Debate to determine what the mood is among those heavily invested in stocks today, the word that would come back is: “ugly.” Many of today’s stock investors respond to questions about the long-term efficacy of their investing strategies with sourness and defensiveness. That’s not an encouraging sign.

Investing Secrets — (5) P/E10 Provides Valuable Insights

I’m known at the Vanguard Diehards board as “the P/E10 Guy.” I get the feeling that some think that the first step in my development of the Valuation-Informed Indexing approach was looking at P/E10, that I saw what it said about the long-term value proposition of stocks at today’s prices, and then took it from there. It’s not so. My starting point was reading John Bogle’s book. He explains why valuations have always affected long-term returns, and always will. Please send your nasty letters and postcards to Bogle, not me. It’s really all The Big Guy’s fault.

It was John Walter Russell’s idea to use P/E10 to quantify the extent to which Bogle’s insight stands up to scrutiny. It turns out that it stands up to scrutiny exceedingly well (better than Bogle himself generally lets on — those who have been paying close attention can probably guess why).

Investing Secrets — (6) The Efficient Market Theory is a Gravely Flawed Theory.

I don’t know how it is that the Efficient Market Theory won the confidence of a good number of Ivory Tower Eggheads (but not of one Robert Shiller, thank the heavens!). My guess is that this theory was viewed in a positive light because it makes it so much easier to perform research. Efficient Market Theory assumes all the tricky stuff (the stuff relating to human emotions) out of the question. As Church Lady would observe — How convenient!

It turns out that there are problems that follow from assuming away tricky but critically important stuff. The investing insights you develop from your research don’t apply in the real world. What a conundrum!

Investing Secrets — (7) The Most Popular Experts Have Failed Us in a Big Way.

I’m talking about Bogle. I’m talking about Clements. I’m talking about Bernstein. I’m talking about Burns. All of these guys have provided us some fantastic insights. All have also dropped the ball on more than one or two occasions. It took me a long time to work up the courage to say so. But I finally came to the conclusion that there is no good purpose served by failing to do so.

You better shape up soon if you know what’s good for you, fellows! Hocus is on the case.

(B) Insights in Which I Have Strong But Not Complete Confidence

Investing Secrets — (8) Today’s Stock Investors are Highly Fearful About How Stocks Are Going to Perform in Coming Years.

What You Need to Know About Investing

There is a wealth of evidence backing up this insight in our Trial Transcript — er, I mean, in our Post Archives. You need to be careful, though. Community members who possess the greatest emotional balance have often been intimidated into silence by the loudmouth know-it-alls. Today’s investors are fearful, but they are not quite as fearful as you would be led to believe if you read only the posts of the sorts of posters who seek to dominate discussions. Things are not great. But they’re not nearly as bad as surface appearances suggest.

Discussion-board debates provide powerful insights into how investors are feeling about their investment choices. It’s often a mistake to take things at face value, though. That’s why I include this insight in Category (B) rather than Category (A).

I have hopes that we will be hearing a broader range of perspectives in coming chapters of The Great Debate.

Investing Secrets — (9) We Are Now in the Early Days of a Secular Bear Market

For the secular bull to resume, we would need to go to valuation levels higher than we experienced in January 2000 (the top of the great bull of the 1980s and the 1990s). The P/E10 was 44 in January 2000. It is 27 today. That’s a lot of ground to cover. We may well go up a bit before we resume the long ride down to normal valuation levels. But I doubt that we are going to make it all the way back to the valuation levels that applied in January 2000.

The Summer of 1999 is over. It ain’t coming back.

Investing Secrets — (10) We Are Within Five Years of a Major Price Drop.

It’s not possible to predict short-term market moves. It’s not possible to predict short-term market moves. It’s not possible to predict short-term market moves.

I know the rules. Still, it’s hard to imagine that we can remain in the Twilight Zone indefinitely, isn’t it?

Do you remember that David Bowie song entitled “Five Years”?

Five years — My brain hurts a lot.
Five years — Because that’s all we’ve got!

Maybe that’s why some are going with Prince’s advice to party like it’s 1999 even though we all know perfectly well somewhere deep down inside that it really isn’t anymore.

Investing Secrets — (11) P/E10 is a Strong Valuation Assessment Tool

We know for sure that research using P/E10 offers valuable investing insights. I don’t think that we can quite say yet that we are absolutely certain that P/E10 is a strong valuation assessment tool. It’s sure looking more and more that way all the time, though.

Investing Secrets — (12) The Campaign of Terror DId Us Great Damage.

Investing Insights

We’ve seen the best of this new communications medium and we’ve seen the worst of this new communications medium. Things could have gone a lot better. There’s no denying this obvious reality.

I’m a cockeyed optimist (stubbornly so). I say that things also could have gone a lot worse. So long as we do not deny the bad side of things I see no reason why we should not permit ourselves to focus on the good side of things. In this case, that might be the only way to avoid going absolootingly complicatunably bonkericious.

And we don’t want that.

Investing Secrets — (13) Most of the Big-Name Experts Are Afraid to Shoot Straight re the Risks of Owning Stocks Today.

There is not one reason why experts hold back from reporting all of what they know. There are several. The primary reason appears to be the one that Scott Burns identified in his column from the Summer of 2005 — they’re afraid of us! We shouldn’t let them off the hook. It’s their job to tell it straight regardless of what hits they have to take as a consequence of doing so.

We should make an effort to clean up our own act too, though. That’s something that is totally under our control. If they’re scared, we’re scaring them. Let’s take a good hard look in the mirror. Let’s ring in some changes at the start of the new year. Let’s resolve to become better and to do better.

Investing Secrets — (14) The 4 Percent Real Return Available at the Top of the Bull on 30-year Treasury Inflation-Protected Securities (TIPS) Represented a Once-in-a-Lifetime Opportunity

I saw it at the time. But even I didn’t pull the trigger until the rate had dropped to 3.5 percent real. Humans are social animals. We need to hear the value of our insights confirmed by others to work up the courage to act on them. True fact.

It might be best not to mention this to the eggheads. It unsettles them to hear that people are beginning to catch on to how investing works in the real world.

Investing Secrets — (15) Investing in Stocks That Pay High Dividends Is a Good Way to Deal With the Problem of Overvaluation

When stock prices go down as much as they need to go down for us to find our way back to reasonable price levels, the prices of just about all stocks go down. Stocks that pay big dividends offer some downside protection, however. If you must invest in stocks at times of extreme overvaluation, at least be sure to take some precautions.

The mothers and fathers of college-aged sons and daughters no doubt understand the sort of message that I am ever so gingerly seeking to put forward here.

Okay, I’ll say it — Don’t Be a Dope and Mess Up Your Life!


What I meant to say, of course, is that making a shift in your portfolio that places a greater emphasis on stocks that provide a nice solid income-stream come rain or come shine doesn’t sound like such a terrible idea at this particular point in time.


Investing Secrets — (16) Most Middle-Class Investors Are Seeking a Better Understanding of the Realities of Long-Term Stock Investing

Emotionally Healthy Investing Strategies

The first 54 months of discussions have been contentious. How’s that for a crafty use of understatement (my favorite literary technique)?

There is a group of investors that is highly defensive about what it believes it has learned about investing by listening to today’s most popular “experts.” That group is not the majority. The majority wants to learn. The majority is reluctant to speak up to the defensive loudmouth minority, however. Many investors today allow themselves to be intimidated by those who pretend to a knowledge and confidence that they do not truly possess.

That’s my take, anyway. I’m reasonably confident of that one. We should be able to fill in more details as things move forward.

Investing Secrets — (17) Most Middle-Class Investors Earn Long-Term Returns from Stocks of Less Than 6.5 Percent Real

The average long-term annualized real return from stocks is about 6.5 percent. To earn this return, investors need to hold the same amount of stocks at times of high and low prices. The middle-class increases its stock ownership when prices are high (this is when experts tell investors that stocks are safe) and decreases its stock ownership when prices are low (this is when experts tell investors that stocks are risky). It follows that, as a group, middle-class investors must be earning long-term returns of something less than 6.5 percent, perhaps a good bit less.

We have not yet found data confirming this insight.

Category (C) — Insights in Which I Do Not Today Possess Strong Confidence

Investing Secrets — (18) Attaining Greater Diversification Than What Can Be Attained By Investing in a Broad Index Fund Helps With the Overvaluation Problem

There is reason to believe that investing in value stocks helps in some circumstances. There is reason to believe that investing globally helps in some circumstances. There is reason to believe that investing in small-cap stocks helps in some circumstances.

Investing Secrets — (19) There is a Small Group of Wealthy Investors Which Earns a Good Bit More From Its Stock Investing Than the 6.5 Percent Average Annual Real Return Earned by the S&P Index

Money Making Money

Middle-class investors buy more stocks when prices are sky-high (that’s when most experts are telling people that stocks are a safe investment). Middle-class investors sell a lot of stocks when prices are low (this is when stocks offer the best long-term value proposition, according to the historical stock-return data). Whoever it is who is buying stocks from middle-class investors when prices are low and who is then selling stocks to middle-class investors when prices are high must be earning a long-term return a good bit higher than the average 6.5 percent real. Intuitively, it would seem that it is a small number of wealthy investors who benefit from the misperceptions of the middle-class about how stocks perform in the long run.

We have not yet found data confirming that this is so.

Investing Secrets — (20) P/E10 is the Best Valuation Assessment Tool

P/E10 appears to be the best valuation assessment tool. There are others that are effective. Tobin’s Q works well in some circumstances. The Gordon Equation works well in some circumstances. P/E1 provides too many false reads to be viewed as a reliable tool, but there are times when it provides a rough-cut approximation of the valuation level for stocks.

We need to learn more in coming years about the pros and cons of all of these tools.

For those who came in late, here’s the Executive Summary version of our report on what we all learned from the first 54 months of our breakthrough investing discussions —

Don’t Be A Dope and Mess Up Your Life!

How to Invest Wisely — Podcasts on Market Timing, Diversification and Dollar Cost Averaging

Have you ever considered that the “experts” employed by The Stock-Selling Industry might not really want you to learn how to invest wisely? The academic research of the past 30 years (rarely discussed by most “experts”) shows that the key is taking the price being charged for stocks into consideration when setting your stock allocation.

That is, you don’t want to follow a Buy-and-Hold strategy of staying at the same stock allocation at all times. You want to go with a higher stock allocation when prices are good and a lower stock allocation when prices are bad. That’s the secret of how to invest wisely!

how to invest wisely

This article sets forth brief descriptions of RobCasts exploring three key topics: (1) Market Timing — What Works and What Doesn’t; (2) True Diversification; and (3) Dollar Cost Averaging.

How to Invest Wisely / RobCast #12 — Market Timing: What Works and What Doesn’t (Please click on the title for free access to the RobCast)

RobCast #12 makes the following points:

1) There is more confusion about market timing than there is about any other investment-related topic. Most investors believe that market timing does not work. To say that market timing never works is to say that taking the price at which stocks are being sold into consideration when setting your stock allocation might not be a good thing to do. This cannot be.

2) The confusion stems from a failure to distinguish short-term timing and long-term timing. There is indeed a wealth of evidence showing that short-term timing doesn’t work. But there is also a mountain of research showing that long-term timing always works. So it is just as accurate to say that market timing always works as it is to say that it never works.

3) The future of stock investing analysis is learning how to make use of the reality that long-term timing always works to increase returns while reducing risk. Learning as much as you can about how to engage in long-term market timing is the key to becoming a successful stock investor.

How to Invest Wisely /RobCast #160 — True Diversification (Please click on the title for free access to the RobCast)

RobCast #160 makes the following points:

wise investing

1) It is not true that taking on more risk adds to your return. Stocks were more risky in January 2000 than they have ever been at any earlier time in history (because they were more highly priced). But the return provided by stocks in the years since has been terrible. Return is a good thing, risk is a bad thing. You want to add to your return while avoiding risk.

2) Diversification is a wonderful example of why it is not true that there is no such thing as a free lunch. Effective diversification permits you to obtain higher returns while taking on less risk. That’s a free lunch.

3) The idea that bonds are the natural counter to stocks is outdated. Stocks are the best asset class for growth. There are times when you need a counter because the risk of stocks is too great. The proper counter is a low-risk asset class. IBonds and Treasury Inflation-Protected Securities (TIPS) are both better counters than bonds because they are not subject to inflation risk, as bonds are.

How to Invest Wisely / RobCast #142 — Dollar Cost Averaging Is a Loser Strategy (Please click on the title for free access to the RobCast)

RobCast #142 makes the following points:

1) My investing advice is “controversial.” The reason it is “controversial” is that I report the simple reality that, if you pay attention to the price at which stocks are selling before you buy them, you will never go wrong. Pay attention to the price and you greatly increase your long-term return while cutting risk by 80 percent.

financial freedom investing

2) Dollar Cost Averaging is ignoring price. It can never make sense to ignore price. Why do so many experts say it is a good idea? Most of the the people we think of as experts have ties to The Stock-Selling Industry. They are compromised. They are experts in how to sell stocks, not in how you should invest to finance your retirement.

3) Stocks were selling at insanely high prices for the time-period from 1996 through 2011 (with the exception of a few months in early 2009 — this article was posted in December 2011). So Dollar Cost Averaging did not help you avoid overpaying for stocks for 16 years. Dollar Cost Averaging is a marketing gimmick, a trick that keeps middle-class investors poor.