Why Stocks Crashed

Stock prices are at a level today (this article was posted in October 2007) that virtually assures that people will be asking in days to come why stocks crashed. When the price crash comes, we will all be caught up in whatever disaster it is that is being widely cited as the cause of the stock price crash. I thought it would be better to write my explanation of why stocks crashed now, when I can think more clearly about the factors that made the upcoming (who knows when!) price drop inevitable.

The first reason why stocks crashed is that stock prices rose too high in earlier years.

Why Stocks Crashed

There are two big factors that determine stock prices. One factor is economic value. Stocks are worth something, and whenever the going price goes too far above or too far below fair value, the fair-value price exerts a magnetic pull on the going price until the going price reverts to the mean (the fair-value price). The other factor is investor emotion. Emotional investors can for a time push stock prices wildly above or below fair value. The economic-value price always prevails in the end, but it can take some time for this to happen. Emotional prices have been known to remain in place for 10 years or even a bit longer.

Given these realities, you can pretty much rule out seeing a a stock price crash when prices are low; where are prices going to fall to when they are already low? You can also pretty much (but to a lesser extent) rule out having to worry about why stocks crashed when you buy stocks at moderate prices. There could be a fall from a fair-value price to a low price. But given the reality of reversion to the mean (or reversion to fair-value), soon after stock prices fall from moderate levels to low levels there is going to be pressure building up for them to return to fair-value levels. Questions about why stocks crashed and then stayed crashed come up only after stocks have traveled to very high levels.

The fair-value stock price is a P/E10 level of 14. The P/E10 level of the S&P 500 was 44 in early 2000. A price crash of major proportions became all but inevitable at that point. Even after eight years of poor stock returns we are today at a P/E10 level of 29. People really shouldn’t be asking why stocks crashed when we find ourselves back at more reasonable price levels. The better question is why stocks didn’t crash a lot sooner.

The second reason why stocks crashed is that people grew weary of the self-deceptions needed to keep prices from falling hard.

We set ourselves up for a stock price crash way back in July 1995, when the P/E10 level went to 23. That’s when the bull market went positivlootingly bonkericious. The historical data has been available both to investors and to the experts who advise them for all the years since. So how is it that only now are we asking why stocks crashed?

It’s because stock investing is primarily an emotional endeavor and only secondarily a rational one. When stock prices are high, investors want to be told that that’s not a problem. Experts primarily concerned with maintaining their popularity with investors are generally willing to tailor their message to respond to customer demands. Starting in 1995, we developed new ways of interpreting what the historical data says, ways less accurate than those generally employed at times of moderate prices but more reassuring to investors enticed by the big price jumps into going with stock allocations far above what the historical data reveals as prudent at high price levels.

We told bigger lies. That’s what I am saying in the paragraph above when you boil away all the excess verbiage.

Why We're in an Economic Crisis

Human are the deceitful animal. We are liars, it’s always been so and it always will be so. We are not only liars, however. We are truth-tellers too. That also has always been so and also always will be so. Whenever you develop too much confidence in your fellow humans to tell the truth, you set yourself up for being taken in by a whopper. Whenever you become so cynical as to expect from your fellow humans nothing but lies, you set yourself up for being surprised by a show of George Washington-like honesty.

We’ve all been telling lots of big lies about stocks for a long time now. We’ve grown tired of it and have come again to see the appeal of looking at stock investing in honest ways. That’s why stocks crashed.

The third reason why stocks crashed is that we got ahead of ourselves in our economic expectations.

When stock prices crash, experts often point the finger at some economic development or another. The reality is that the causation often runs in the opposite direction. When we tell lies about what stocks are worth, we are also telling lies about what our portfolios are worth. When stocks are selling for a price double their fair value, the fellow with a portfolio properly valued at $300,000 is receiving a portfolio statement in the mail telling him that his stocks are worth $600,000.

He spends more.

Wouldn’t you spend more if you came to believe that your portfolio value was $300,000 greater than what it was in reality?

When we all spend more, the wheels of economic growth turn faster. But the artificial spinning of the wheels of commerce brought on by inflated stock prices cannot last. Telling tall tales about the value of our stock portfolios is a temporary fix to our economic troubles.

The longer the temporary fix continues, the more dependent we become upon it. Eventually, we can’t keep things going forward even with the benefit of the artificial stimulus. At that point, thing begin to slip into reverse. When the artificial stimulus is as big as the one we employed in the wild bull of the 1990s, there’s a lot of reverse movement possible.

The correction of the artificial push becomes a big artificial obstacle to economic growth. The economic downturn caused by a loss of confidence in high stock prices becomes a cause of even lower stock prices, which becomes a cause of even lower economic growth. And so on. The happy cycle of higher stock prices and faster economic growth becomes an unhappy cycle of lower stock prices and slower economic growth once the tipping point is reached.

The fourth reason why stocks crashed is that many middle-class workers need stocks to offer strong long-term returns once again.

Why not just call the whole thing off?

Stock price crashes are universally hated. Why not just continue the process of deceiving ourselves about the realities? Why not leave stock prices where they are when they are high? Why not leave the artificial economic stimulus in place?

There’s a very good reason.

Why There's Talk of a Second Great Depression

You like to see a strong long-term return on your investing dollar, don’t you? At normal prices, U.S. stocks offer a long-term return of about 6.5 percent real. At the prices at which stocks sold in October 2007, that is lowered to about 3.5 percent real (assuming no price drop). If you pay double what an asset is worth, you obviously cannot expect to see the same return from it as you would see if you paid fair value.

The only way to get the long-term return for stocks back to where it needs to be for today’s middle-class investor to be able to finance a comfortable retirement by age 65 was for prices to fall hard. That’s another reason why stocks crashed.

The fifth reason why stocks crashed is that some economic or political event took place which served as a plausible justification for a crash.

I suggest above that the economic or political event that most experts cite when explaining why stocks crashed is not the true cause of the price crash. The reality is that the price crash was inevitable once we allowed prices to get out of control. A price crash was an accident waiting to happen.

All that is so. It does not follow that the event commonly cited as the reason why stocks crashed did not play a role in the price crash.

Say that the cause being cited is a recession. A recession really does cause companies to generate less earnings. Lower earnings translate into lower stock prices. It’s not that what the experts are saying is entirely not so. It’s that they are not telling the story in the way you need to hear it to know how to invest effectively in the future.

When the P/E10 level is 29, the coming of a recession almost surely causes a price crash. When the P/E10 level is 14, the coming of a recession might cause a moderate price drop. When the P/E10 value is 8, the coming of a recession might not have any effect at all. The coming of a recession might even have a positive effect at a time when the P/E10 level is 8; that price level is so low that it is almost impossible for prices to go too much lower and the outbreak of a recession at that price level might persuade investors that every bit of possible bad news had already been experienced and that prices from that point forward could only go up. That spike in confidence about future stock prices could be the cause of an immediate price jump as investors competed with one another to get back in early.

When a drunk slams his car into a lamppost, it could be said that the cause of the accident is that a lamppost happened to be placed in the spot where his car was headed. It would not be entirely untrue to say that the lamppost caused the accident anymore than it would be entirely untrue to say that the recession (or whatever) is what caused the stock price crash. The deeper reality, though, is that a drunk driver is going to end up in an accident of some sort sooner or later. And a P/E10 level of 29 is going to drop hard in a price crash of some sort sooner or later.

We cannot avoid recessions (or terrorist attacks, or oil shortfalls, or housing slumps, or whatever development is being widely cited as the cause of the price crash). However, we can avoid recessions causing big price crashes by doing what we can to see that stock prices never again travel to the crazy levels we collectively permitted them to travel to in the late 1990s.

The sixth reason why stocks crashed is that the stories told to justify the excessive prices of earlier years grew increasingly unbelievable.

Why You Need to Delay Your Retirement

Stock prices got so high in the late 1990s that they just couldn’t go up anymore. The money used to finance those outsized gains wasn’t printed up by Milton Bradley. It was borrowed from the investors going with high stock allocations in subsequent years and receiving returns far less than what it appropriate for those investing in a high-risk asset class.

For a time, most investors pretended not to notice. Memories of the wild bull were fresh enough to keep them from asking hard questions about the half-truths that caused the absurd price leaps. We continued to believe in the conventional approach to buy-and-hold even though it didn’t seem to be working so well anymore. We continued to believe that stocks are always best for the long run even though our common sense was putting troubling thoughts into our heads. We continued to believe that long-term timing does not work despite occasional feelings of doubt as to whether we should stick with such high stock allocations.

Until we didn’t.

Things changed. The middle-class went crazy for stocks because stock prices went crazy. When prices dipped to levels that were not quite so crazy, our confidence in the crazy salesperson slogans used to con us in earlier days weakened. Stock prices built on an emotional foundation do not last. That’s why stocks crashed.

The seventh reason why stocks crashed is that enough became persuaded that a crash would not happen to make it possible.

The roots of the stock price crash lie in the excessive confidence we came to have in stocks in the middle and late 1990s. So long as we were wary that a crash was coming, prices remained at reasonable levels. When we stopped worrying that a price crash was possible, we made one inevitable.

When you stop worrying that you will experience car trouble if you don’t regularly check the oil, you get car trouble. A moderate amount of worrying can be a good thing. It’s easy to overlook the value of worry. A healthy worry can keep bad things from happening. I feel more at ease seeing that an investor is a bit worried than I do seeing that she is totally carefree.

The eighth reason why stocks crashed is that that’’s what they are supposed to do.

Winter follows summer.

It’s a cycle.

That explanation of why stocks crashed probably sounds glib if you are one of those who lost large amounts of accumulated wealth in the big price drop. I apologize for sounding glib.

Why Political Debates Have Become So Divisive

There’s a point to my simple and straightforward explanation, however. The true reason why stocks crashed really is that the price drop is part of a natural cycle. The “experts” who are more concerned with being popular than with telling it straight misled you. I cannot get you your money back. The best that I can do is to tell you the true simple and straight story so that you can avoid having this sort of thing happen to you again. Please try not to get too angry at those trying to help. Your anger is better directed at the word games regularly practiced by those that the conventional media put forward as investing “experts.” It’s the garbage they have been feeding us for a long time that is the cause of the suffering now causing us to view plain statements of straightforward truths as glib and unfeeling gibes.

Extreme bull markets are not a good thing. They are a deception. Deceptions hurt people. You are one of the people who got hurt. You are a victim of the most out-of-control bull market ever experienced in U.S. history. The lesson you need to learn is never again to trust the nonsense gibberish put forward by “experts” when stock prices go to Koo Koo Cloudland. You’re too smart to be taken in by that sort of thing.

Don’t give up on stocks. That would be a mistake. Stocks are a wonderful asset class.

All that you need to give up on is the fantasy view of stock investing that became popular during the wild bull. The U.S. economy has been strong enough to support an annualized real return for U.S. stocks of about 6.5 percent for a long time now. There’s a good chance that a return somewhere in that neighborhood is going to continue to apply in the future.

When you see returns going far above that, know that something is up. Know that things have gotten out of hand and take some money off the table. Then you won’t get burned when the natural and inevitable cycle of stock prices that has always applied in the past applies again in the future.

Stock prices go up, stock prices go down. Change your stock allocation accordingly, and you won’t find yourself asking the next time we all experience this natural and inevitable cycle why stocks crashed.

That’s what stocks do. That’s why stocks pay so well for those who have learned how to navigate the emotional minefields.

 

Stock Panic Up Close and Personal

I want to quit now.
But I just can’t split now.

–The Miracles, “You’ve Really Got a Hold on Me.”

We have seen stock panic playing out in real time in comments made on investing discussion boards in recent years. This article explores the behavioral finance implications of comments set forth in the Investing Discussion Boards Ban Honest Posting on Valuations! article.

Stock Panic Comment #1 — “Never in the history of the Diehards forum has one poster, always making civil and well thought-out posts, managed to irritate so many without anyone being able to articulate a good reason as to why.” (Comment #1 in the earlier article)

Reaction to Bad Stock News

Mephistopheles presents us with a puzzle to solve with the words quoted above. My take is — it’s because we are talking about numbers.

The bull of the 1990s was built on numbers. Middle-class investors know to be afraid of stocks when prices get too high. They understand that something that sounds too good to be true probably is not true. Middle-class investors are impressed by numbers-based arguments, however. Numbers arguments have a special status in our society. Many do not pay attention to word-based arguments. They respond: “Show Me the Numbers!”

The Great Safe Withdrawal Rate Debate is a debate about numbers. We have taken all the numbers-based arguments that were used to argue that stocks are always best for the long run and flipped them. When you ignore valuations in your calculations, stocks always look best. When you factor in valuations, stocks do not look like a good long-term choice at times of high valuations.

Oops!

Most investing “experts” are Numbers Guys. They are the sorts of people who like things hard and concrete and real. They made a huge mistake in failing to see the error of the way in which the numbers were being reported in the 1990s. This mistake was carried over in thousands of articles, thousands of books, thousands of speeches. Admitting the mistake is a big emotional hurdle for them. They very much do not want to admit the mistake.

Numbers-based arguments give them no choice. If the new numbers are right, the old numbers are wrong. It’s that simple. Numbers are stubborn, uncompromising things.

It’s that simple and that complicated. The “experts” got the numbers wrong. It’s easy to demonstrate this; all you have to do is to look at the historical stock-return data using an analytically valid methodology. The hard part is finding a way by which the “experts” can save face while acknowledging their grand blunder.

It’s not the people presenting the new numbers who are making the “experts” feel bad. It is the “experts” themselves who torture themselves with their personal knowledge of how much financial damage they have done to those who have paid heed to their faulty advice.

If this were a small mistake, those who made the mistake would feel comfortable acknowledging it. If this were a difference of opinion, they could permit the airing of alternate viewpoints. This is a case where people widely recognized as “experts” got important numbers not just wrong but wildly wrong. To acknowledge the numbers errors, they need to be able to acknowledge that they are not quite the “experts” that they are widely perceived to be. That requires a level of grace that some of them unfortunately do not yet possess.

It would be a good thing not only for us but for them too for them to accept the realities. It would take pressure off of them. There is room in InvestoWorld for more than one type of expert. There is room in InvestoWorld for experts who sometimes make mistakes. Still, it is emotionally hard for the “experts” of today to say out loud that they got a good number of pretty darn important points terribly, terribly wrong.

Stock Panic Up Close and Personal

The controversy is not an intellectual one. There are no intelligent arguments for reporting numerical calculations wrong. The controversy is an emotional one — the all-too-human reluctance to saying the words “I” and “Was” and “Wrong.”

The first step to getting to a better place is accepting that investing itself is primarily an emotional endeavor and only secondarily a rational endeavor. So long as we discuss these matters using the language of reason, we cannot get to first base. The problems are emotional in nature. Emotions do not respond to rational argument.

Trying to “make sense” of the “arguments” put forward in defense of the Old School studies is a futile endeavor. The studies do not serve any rational purpose. The Old School safe withdrawal rate studies are exercises in rationalization. Their purpose is not to discover realities, it is to supply surface-plausible justifications for taking actions decided on before the studies came into existence.

One side is putting forward reasoned arguments. The other side is giving vent to emotional pain. The two sides are speaking different languages. The New School advocates are seeking insights as to how best to invest for the long run. The Old School defenders are seeking to alleviate the emotional pain they feel when confronted with the realities of the message of the historical stock-return data.

Stock Panic Comment #2 — “It looks like a bunch of new people logged in for the express purpose of antagonizing one guy…. C’mon Morningstar. Remove those users.” (Comment #2 in the earlier article)

I was shocked when Greaney first began posting abusively. I was shocked again when a good number posted in defense of him. I was shocked yet again when Motley Fool failed to take action after the problem was brought to its attention. And I was shocked still yet again when Morningstar too failed to take action after the problem was brought to its attention.

Both Motley Fool and Morningstar have rules published at their sites that protect us from abusive posters. Why have they not been enforced?

Financial considerations probably play a role. When stocks are at the price levels at which they reside today, realistic examinations of the effect that valuations have always had on long-term returns are not popular. There is no question whatsoever but that there are posters who would have left both the Motley Fool board and the Morningstar board in the event that the posting rules that apply at those boards had been enforced in a reasonable manner. If these two corporate entities had honored their promises to the people who built their boards, they would have experienced some short-term financial pain for doing so.

It’s hard for me to accept that that’s the entire explanation, however. Both the Motley Fool board and the Vanguard Diehards board were in time destroyed by the abusive posters. There were large numbers at both boards who expressed a desire that honest and informed posting on the valuations topic be permitted. My strong sense is that both of these corporate entities acted against their long-term financial interests in failing to enforce their posting rules.

Why? Because their site administrators are flawed humans.

My guess is that the site administrators have money invested in stocks. My guess is that the site administrators are experiencing the same fears about their long-term financial security that many other middle-class investors are feeling today. The defenders of the Old School studies have never been able to find any effective “argument” for their case other than to deluge boards at which it is questioned with brutally abusive posting. A site administrator who enforces the published rules of his site causes the defense of the Old School studies to fail.

It is not “rational” to permit abusive posting to destroy a discussion board when the published posting rules protect those seeking to build the board through constructive posting. But it does not generate an immediate good emotional feeling to see a theory in which one is emotionally invested shown to be wrong.

Dallas Morning News Columnist Scott Burns has argued that the stakes in our discussions are small. I do not agree with Scott on this point. I think that the actions we have seen site administrators for large corporate sites take shows that the stakes are high indeed. I think that Scott was right at an earlier time when he said that the reason why we have not yet seen much discussion of the New School findings in the general media is that: “It is information most people don’t want to hear.”

Stock Panic Comment #3 — “That is the way the heavy fist works. You make a few examples and everyone falls into line.” (Comment #3 in the earlier article)

The typical middle-class investor does not check out the methodology of every study cited to him. He employs shortcuts. He assumes that the people endorsing the studies checked them out before endorsing them.

This is reasonable behavior. It is also dangerous behavior when employed in the investing area.

The words quoted above explain why. We learn through a process of interaction and questioning. There is no one person in the world who knows everything. So, in most areas, certain people put ideas forward and then those ideas are evaluated by others and new insights are developed from the discussions and so on and so forth.

What Happened to My Money?

This is not how it works in the investing area, at least not in the handling of the most fundamental and most important questions. The question of whether the market is efficient or not is a question that has been taken off the table. The claim that the market is efficient cannot be defended with logic. Yet it possesses a strong emotional appeal for so long as prices remain as high as they are today. Therefore, questioning of the claim has been widely prohibited.

I know it sounds like I am kidding, but I am not. I never would have believed this myself back in the days before May 13, 2002. But I have no choice but to believe what I have seen with my own eyes. What I have seen is that the words quoted above describe not just what happens on discussion boards, but what happens in InvestoWorld in general. Dubious assumptions are not subjected to healthy debate.

I’ll give one striking example of how the let’s-put-our-fingers-in-our-ears-before-we-become-aware-of-the-realities phenomenon evidences itself. William Bernstein (author of The Four Pillars of Investing) put a post to the Vanguard Diehards board saying that he did not believe in the macro version of the Efficient Market Theory. That theory is a core belief among the “leaders” of that board, so Bernstein’s comment should have set off a firestorm. Do you know what happened? Nothing. There was no response to Bernstein’s post.

There was no direct censorship practiced. I checked. I put up a thread myself a day or two later making note of the Bernstein comment to prove to myself that anyone who cared to was able to post observations on it. People had the ability to respond. People elected not to respond.

Why? I cannot see into other posters’ hearts and heads. I can tell you what I believe. I believe that most middle-class investors are intimidated by phrases like “Efficient Market Theory.” They do not understand clearly what it means, and they are concerned that if they ask basic questions people will think they are stupid. These concerns are not entirely unjustified. I have seen cases in which people asked such questions and were indeed characterized as stupid for having done so. Heck, I have been called names myself thousands of times!

People are not dumb. People are smart. They are smart enough to pick up on hints as to what questions may be asked and what questions may not be asked. Once they figure out which questions may not be asked, they stop asking.

Not good. This must stop. The investing game is not a game played with Monopoly money.

You know what’s dumb? It is these “theories” that cannot be defended in any rational way that are dumb. The Efficient Market Theory is dumb, as dumb as a bag of bricks.

The middle-class investors who do not question it are not dumb, but they do need to become braver about asking basic questions. And the “experts” who make us feel uncomfortable about asking basic questions need to expand the scope of their expertise until they reach a point at which they feel comfortable encouraging questioning of their claims. True experts are confident enough in their beliefs that they don’t need to rely on “the heavy fist.”

Stock Panic Comment #4 — “The majority opinion rarely needs protections from a constitution, laws or rules. It is the minority opinion that needs to be protected.” (Comment #4 in the earlier article)

Life Savings Gone

This is especially so in the area of stock investing. The emotional pull is to buy stocks when they are popular (which is the worst time to buy stocks, according to the historical data) and to sell stocks when stocks are not popular (which is the best time to buy stocks, according to the historical data). A long-term stock investor always wants to hear the contrarian viewpoint because he needs to hear it to arrive at an emotionally balanced take.

One of the things I like about The New School of Safe Withdrawal Rate Analysis is that it forces you to take into consideration both the majority and the minority opinion. Each price jump is a positive in that it adds to your accumulated wealth and each price jump is a negative in that it lowers the safe withdrawal rate. That’s a realistic and balanced way of looking at things.

One of the biggest problems with the conventional way of looking at investing questions is the phony dichotomy between Bulls and Bears. I’m a Democrat and I cannot talk to you because you are a Republican! I’m a Red Sox fan and I cannot have you in my house because you are a White Sox fan! I’m a Bull and I cannot be friends with you because you are a Bear! Yucko!

I am an aspiring early retiree. I would like to achieve financial freedom as early in life as possible. I learn from Bears. I learn from Bulls. I learn from proponents of the majority viewpoint. I learn from proponents of the minority viewpoint. I learn from Humans. That’s what it comes down to.

It’s an extremely controversial viewpoint in InvestoWorld. I think it is fair to say that that’s a problem that all of us who visit InvestoWorld from time to time need to do all that we can to fix.

Stock Panic Comment #5 — “There is a warmth and consolation to be found in the midst of everyone being wrong together.” (Comment #6 in the earlier article)

People are uneasy about investing. First of all, we are not terribly well informed. Those of us who want to retire someday are forced to invest whether we like the idea or not. We have limited time to devote to studying this junk. Most of the books contain lots of big words and mysterious-sounding phrases and lots of tables with lots of scary numbers planted inside them. And the key issue explored in these books is — Risk. That’s just great, you know? We are already worried about our retirements because we have not saved enough and now we are being told to take Risks with the little bits of wealth we have managed to accumulate over the years.

People do indeed need to be reassured about their investing decisions. And it is indeed true that we turn to other humans for reassurance, as the words quoted above suggest. We’ve been doing that since our caveman days.

How do we develop a greater capacity for independent thinking, which is an essential for those who hope to walk the buy-and-hold walk as well as to talk the buy-and-hold talk? We need to come to possess a firm grasp of the basics of how investing works. That’s all it really takes. It is not hard to come to an understanding of the fundamentals. It’s essential that this be done. I recommend that those who do not possess a firm understanding of the basics refrain from investing in stocks until they have come to do so.

We need experts who will shoot straight with us. Bogle’s stuff gets us about halfway there. We need to push the Indexing Revolution to the next stage in its development. The conventional approach to indexing works well in bull markets. We need an enhanced version that works in both bull and bear markets. I have put forward the Valuation-Informed Indexing approach as my suggestion for a constructive Next Step.

Stock Panic Comment #6 — “It’s not what you are saying that seems disruptive, but rather all the dialog that inevitably takes place afterwards.” (Comment #9 in the earlier article)

I Don't Know What to Do

This comment (by Bill Sholar, former owner of the Early Retirement Forum and author of the FIRECalc retirement calculator) sums things up well. I am not able to recall a single case in which an advocate of one of the New School studies put up an abusive post. But it is certainly true that realistic posting on the safe withdrawal rate topic left a whole big bunch of abusive posting “in its wake.”

You figure it out.

I challenge you to come up with an explanation that does not require heavy reliance on the word “emotion.”

The Efficient Market Theory posits that stock investors are 100 percent rational. It’s a lie. Our investing discussions of the past five years prove this beyond any reasonable doubt.

The dominant model of how investing works has been proven a failure. It needs to be replaced by something more realistic. I have suggested the Investing for Humans model, a model that posits that investing is primarily an emotional endeavor and only secondarily a rational endeavor. Where you start from determines where you end up. Those who follow that model will be looking for reassurance from time to time too. The difference is that they will be seeking reassurance re something that makes sense and they will therefore not feel nearly the same level of defensiveness; the reassurance given will be restoring confidence in an emotionally healthy and balanced approach.

Stock Panic Comment #7 — “Some on this board feel threatened by the arrival of hocus and his ideas. They feel a threat to their perceived elite status here.” (Comment #10 in the earlier article)

It is not just the authors of Old School SWR studies who feel threatened by new ideas. Financial columnists who have spent years touting the Efficient Market Theory feel threatened. Advocates of the conventional approach to indexing feel threatened. Authors of books that are rooted in an acceptance of the popular investing ideas of today feel threatened.

In a world in which investing were entirely a rational endeavor this would not be so. All that anyone would care about in such a world would be making money and all would welcome new ideas that checked out. We do not live in such a world.

Humans are not rational. We possess the ability to reason, but we are not robots. I see that as a good thing. I would rather be a human than a robot. In any event, it is clear to me that any investing model that presumes complete rationality on the part of investors will fail. The assumption just does not stand up to scrutiny.

I have an idea as to why the Efficient Market Theory became popular in the first place. It is a comforting illusion (for a time!) to believe that markets are rational and efficient. Things would be so much easier to understand in a world in which all that yucky emotional stuff did not play a role in the decision-making process.

The problem with illusions is that they always go “pop!” It always hurts when they go “pop!” Illusions are comforting in the short-term. They produce pain in the long-term.

All stocks are held by humans. All humans are emotional. We cause ourselves a lot of pain by failing to face up to this obvious and critically important reality.

Here’s Dylan:

<blockquote>Idiot wind, blowing through the dust upon our shelves.
We’re idiots, babe, it’s a wonder we can even feed ourselves.</blockquote>

Early Retirement Forum Comments

It shouldn’t have been left to me, some guy who posts stuff on the internet, to let the Big Shot “Experts” know that stocks are held by humans and that humans are emotional. But that’s the way it happened to play out because — we’re idiots, babe.

Stock Panic Comment #8 — I’m sure that 90+% of posters here would like to see an end to the disruptive posts about hocus. (Comment #11 in the earlier article)

I agree with the point being made here. I have doubts as to whether the percentage is as high as 90 percent. My guess is that about 80 percent of the population of most investing boards would prefer that the published rules be administered in a reasonable manner. In the world outside Planet Internet, Normals may well comprise as much as 90 percent of the population.

The Goons are 20 times more intense than the Normals, however. Most Normals have only a passing interest in learning how long-term investing really works. The Goons see their entire world view being at risk when questions are raised about the beliefs they formed during the wild bull.

This is an encouraging thought. It means that most peoples’ views are not set in stone. The sad side of the story is that it means that large numbers of middle-class investors are likely going to lose large portions of their wealth through little fault of their own. A few ruthless Goons ruin it for a far larger number of non-intense Normals.

Stock Panic Comment #9 — “Some of the disruption is in the form of a Baptist running occasionally into Methodist services, and claiming that some of their beliefs are heresy.” (Comment #12 in the earlier article)

The comparison of investing beliefs to religious dogma is telling.

Stock Panic Comment #10 — “Life is short. Too short for Motley Fool or Mr. Greaney’s incompetence/ethics shortage/whatever ailment interferes with his ability to communicate facts in a straightforward manner.” (Comment #15 in the earlier article)

It frustrates me that people are constantly personalizing these discussions. We should not be talking about Greaney or Sholar or Bennett or Russell. We should be talking about what the historical stock-return data tells us about safe withdrawal rates and the effect of valuations on long-term returns in general.

Why do people do this? I believe it is because the personal stuff is safer ground. The investing realities are scary stuff for people who have constructed retirements by making reference to the Old School SWR studies and for people who have developed their investing strategies by making reference to analyses influenced by the Efficient Market Theory.

Stock Panic Comment #11 — “A rifle is not well suited for close quarters work….” (Comment # 23 in the earlier article)

These words appear at the Motley Fool board to this day. Motley Fool is an investing site.

Stock Panic Comment #12 — “This board has degenerated into something that I can no longer be proud to be involved with.” (Comment #24 at the earlier article)

I sometimes feel this way about InvestoWorld. Do I really want to be involved in something so dirty and so smelly and so ugly and so mean-spirited?

Will Money Lost Following Buy-and-Hold Ever Come Back?

I do. The other side of the story is that I have met hundreds and hundreds of wonderful people during the course of our investing discussions, people who need to know the realities to be able to generate returns that will be used to do wonderful things like send their kids to school and take care of health problems and finance well-deserved getaways.

Investing discussions have become ugly because the Efficient Market Theory denies the human element of the investing equation. Write humanity out of the script and you come up with a movie that is artificial and forced and phony and flat. When investing discussions are uplifting, it’s because of the human element of the story. When investing discussions are ugly, it’s because the human element of the story is being denied.

Stock Panic Comment #13 — “Rob, for a long time, I wondered if you were really a psychologist studying group dynamics.” (Comment #37 in the earlier article)

There is a sense in which this is indeed what I am doing. I founded the Financial Freedom Community because I wanted to create resources by which we all could learn more about how saving and investing really work. Group dynamics is a big part of the investing project. It is largely ignored in the conventional literature. We need to understand better how investors place themselves in groups and then ignore all information bits generated by those not within the approved groups.

I don’t believe that Groupthink is all bad. There’s a reason why we separate into groups. The Vanguard Diehards are interested in learning about and following Bogle’s indexing ideas. They quite properly exclude from their consideration day-trading strategies. Consideration of day-trading strategies would be an inappropriate distraction from the pursuit of their legitimate goals.

Excessive dogmatism is dangerous, however. The “leaders” of the Vanguard Diehards community (my sense is that many members of the community do not support some of the actions of their “leaders”) ruled out all informed discussion of the effect of valuations on long-term returns. John Bogle is one of the leaders in the field of exploration of this topic! It is going too far to rule out consideration of the ideas of the guy who founded the movement to which you belong!

The problem is that Bogle contradicts himself in his writings on the valuations question. He makes outstanding points; it is from Bogle that I first learned how long-term investing really works. But he undermines his explanations with his use of wrong-headed catch phrases like his admonition to “Stay the Course!” Many of his followers interpret that phrase as an admonition not to change their stock allocations in response even to dramatic changes in valuations, a strategy that runs counter to much of what Bogle says about the effect of valuations on long-term returns.

The biggest problem with today’s investing advice is the extreme dogmatism that is employed to block questioning of it. Today’s “experts” are defensive in the extreme. We need more humility. We need experts who do not see a need to portray themselves as knowing everything. We need an openness to new ideas and to alternative points of view. We need less stuffiness and more of a sense of humor. We need fewer tables of numbers and more quoting of song lyrics.

Bogle gets us about halfway there. At the end of one of his books, he makes the point that he too can get things wrong. That’s perfect! Humility really is part of Bogle’s approach and it is when he is humble that Bogle is most effective and most profound. I think it is fair to say, however, that Bogle loses his way at times. If this were not so, the Vanguard Diehards board would never have become what it became in its most abusive and ugly days.

Bogle is responsible for that. Not entirely, of course. He does not control what his followers say or do. But he played a role by being too dogmatic in some of his own statements and by failing to speak up when his most dogmatic followers put forward cartoon versions of his ideas.

I am very much a Boglehead. I am also a Russellhead and a Shillerhead and a Buffetthead and an Arnotthead, of course. I take Bogle at his word when he says that he makes mistakes. That’s the Bogle I love. That’s the Bogle that offers us investing advice that points us to the future of indexing and helps us to overcome the mistakes of indexing’s past.

Stock Panic Comment #14 — “Intercst had a secret to retiring early he didn’t reveal. He freaking invested during the heights of the bull market.” (Comment #41 in the earlier article)

How stocks perform in bull markets is completely different from how stocks perform in bear markets. It could be reasonably argued that we are talking about two different asset classes.

This throws people. It is human nature to look to people who have been successful doing something to learn how to do it yourself. But, with stock investing, those who follow highly irresponsible strategies can achieve good results for long periods of time. The worst rise to the top in extreme bull markets.

Vanguard Diehards

This reality places a burden on the “experts” to do all they can to counter the weaknesses of human nature. We know that people get carried away in bull markets. So we should warn them of the dangers of doing so. Too many experts act like politicians or salesmen, telling people what they want to hear instead of what they need to hear. The experts who earn my greatest respect are the ones who tell it straight even when it’s not easy to do so.

Stock Panic Comment #15 — “I credit hocus for casting well-deserved doubt on intercst’s work. Invaluable and worth being repeated ad libitum. Ironically, I have similar doubts regarding hocus’ proposed strategy.” (Comment #43 in the earlier article)

I object above to the personalization of the debate. Then I offer a comment suggesting that Greaney’s approach to early retirement is irresponsible. What gives?

I am not making a personal comment when I criticize Greaney’s investing ideas.

It is common in other fields for people to offer criticisms of ideas. Baseball reporters often question whether a manager did the right thing or not in calling for a steal. Politicians often question whether a tax incentive is likely to achieve its goals or not. In the investing field, I have seen a great deal of defensiveness among advocates of the Old School SWR studies and among advocates of the Efficient Market Theory. They don’t like to be questioned and they try to suggest that questioning of their investing views constitutes a personal attack. No sale.

There are two things responsible for this defensiveness, in my view. One, the Efficient Market Theory is full of holes; it cries out for criticism. Two, lots of Efficient Market Theory advocates got rich during the wild bull; success breeds arrogance. Our unfortunate situation is that we have a lot of people whose financial success was due to a lucky turn of the cards trying to portray it as having been due to them having had the intelligence to buy into the Efficient Market Theory.

The great risk of stock investing is that short-term results often argue for strategies directly counter to those that make long-term sense. To see through the short-term noise, you need to possess a sure grasp of the fundamentals of how long-term stock investing really works. You cannot trust anything that came out during the wild bull to tell you the straight story — not books, not articles, not success stories.

What can you trust? I recommend studying the historical stock-return data. It goes back long enough to show how stocks work in both kinds of markets. It is the only way I know of to get outside of the echo chamber that argues during a wild bull that stocks are always best and during a wild bear that no middle-class person should ever invest in stocks. Both of these extremes are emotionally unhealthy. It is the job of the “expert” to become sufficiently informed of the message of the historical record to see beyond the popular enthusiasms of both wild bulls and wild bears.

The words quoted above are indicative of a healthy attitude toward investing issues. You should be skeptical of all claims you hear, including those put forward at this site. I’m one of those darn humans too. I make mistakes too.

Stock Panic Comment #16 — “Hocus is the only person I know (if only via message board) who has completely opted out of participation in the stock market bubble.” (Comment #45 in the earlier article)

I was the typical middle-class investor in the years before I began putting together my Retire Early plan. What put me on the road I am on today is that I was planning to hand in a resignation from a high-paying corporate job and I had a wife and kids depending on me not making big mistakes in doing so. I had to check things out for myself. I report on my findings in the articles posted to this site.

Behavioral Finance 2.0

Do I know more than most of the big-name experts? On some aspects of the investing question, I believe that I do (I possess a different skill set than they do, permitting me to see things that they do not see). On some aspects of the investing question, I am certain that I do not.

If there is anyone out there relying solely on what I say to put together their investing strategies, please stop! I don’t understand this stuff well enough to take on that sort of responsibility. That said, I believe that it would be a good thing if all middle-class investors heard my message. I believe that I have identified (with the help of hundreds of Retire Early Community members, especially John Walter Russell) big flaws in the conventional advice that those seeking early financial freedom need to take into consideration.

Dallas Morning News Columnist Scott Burns says that I go about making my case in “a manner that is catastrophically unproductive by adding missionary zeal that inflates your importance and demeans others.” He adds that: “The whole idea that there is a new school of Safe Withdrawal Rates reeks of personal aggrandizement.” I don’t see it. But I have a great deal of respect for Scott’s work and I think you should know that a well-regarded personal finance columnist says this of me.

Stock Panic Comment #17 — “That’s why I call it hateful…. It’s predatory. Whom does it benefit? Do you feel more powerful in your derision of hocus?” (Comment #47 in the earlier article)

I call this article “Stock Panic Up Close and Personal.” Some would say that’s not appropriate. Some would say that we have not yet seen a stock panic. I disagree.

I don’t think of a stock panic as something that happens all in a flash, on the day when prices plunge. I think of a stock panic as a long-term development, one that begins when people first realize at some deep level of consciousness that prices have gone up by too much for too long to be sustainable and one that ends when people reach a point of such despair over their effort to ignore that knowledge that they say out loud what they have long known to be so deep inside. The source of the panic is the battle between our two selves, our smart and loving selves and our ignorant and hateful selves. I define a wild bull as an unfortunate series of events that causes our ignorant and hateful selves to assume dominance over our investing views for a stretch of time.

The panic began in the mid-1990s. The panic caused the blow-off price jolts of the late 1990s. Few think of those price jolts as evidence of a ”panic.” I say they were. Those price jolts were reckless and irrational and self-destructive and hurtful of ourselves and others. They were part of a buying panic. People were afraid of “missing out.” Those sorts of fears become translated over time into other sorts of fears, fears of losing everything. All irrational investing decisions are bad news for the long-term stock investor, in my view.

I see panic in thousands of the posts that have been put forward during The Great Debate. The panic has not yet been resolved. We have not yet seen The Big Price Drop. The panic is ongoing. It is extremely high prices that cause a panic. It is the drop in those prices that resolves the panic.

Panic is an ugly emotion. It connects to all other sorts of ugly emotions. The “experts” are not writing about this. Why?

You would not see the sort of behavior that is discussed in the earlier article if stock investors were confident in the stock allocations they are holding today. You would not see the nastiness, the hate, the fury. Where does all this negative emotion come from? What is its source?

People should be writing about this. People should be talking about this. Ignoring it does not make it go away. Ignoring it makes it worse.

Most of the experts of today do not see it as being part of their job to address these sorts of issues. I see this as a failing on their part. I see the emotional side of the stock investing story as an important part of the story.

What have our discussions been about? Valuations, right? Yes and no. Our discussions have been about investor emotions. It’s a different way of saying the same thing. Changes in investor emotions are what cause changes in valuations.

When the Efficient Market Theory says that valuations do not matter, it is saying that emotions do not matter. That’s saying that humans do not matter. It is because all stocks are held by humans and because all humans are emotional creatures as well as reasoning creatures that emotions are such an important part of this story.

Bogleheads Forum

The Efficient Market Theory denies our humanity. What we see in the sorts of posts summarized in the earlier article is our humanity trying to reassert itself. What we see in the abusive posts is the Efficient Market Theory being employed to smack it back down again.

I want to make stock investing safe for humans again.

Stock Panic Comment #18 — “I am sure that everything will work out and the result will be much better than either of us can imagine.” (Comment #49 in the earlier article)

Our community has been put through a lot. Has it been worth it? It depends on what we make of it. My hope is that we will turn this into a great learning experience.

The problem has been the intensity factor. The Goons are 20 times more intense than the Normals. We need the Normals to speak up more. We need the Normals to get over their feeling that the “experts” must know so much more than they do.

Experts make mistakes. Most are well-intentioned. But all are human. All are capable of making mistakes.

When you ask questions about things that concern you, you help not only yourself, but also the expert to whom you direct the question and the entire community of investors that stands to benefit from the learning experience initiated. It is clear to me that many middle-class investors feel doubts about today’s conventional wisdom on stock investing. I encourage them to give voice to those fears.

Strong ideas can withstand questioning. Ideas that cannot withstand questioning do not deserve to remain standing.

Stock Panic Comment #19 — “When we lost a few posters because I reinstated hocus I learned quite a lot. I learned that it feels good to do the right thing. I learned who my friends truly were. And I learned a lot about running this web site.” (Comment #52 in the earlier article)

Do you see the emotion in this post? El Supremo does not share my investing views. But he felt better about himself when he did the right thing than he did when he did the wrong thing.

Multiply that by 10 million and you will begin to get some idea of why extreme bull markets are not a good thing for long-term stock investors. When prices reach the sorts of levels where they reside today, it becomes all but impossible for just about anyone to tell the truth about investing.

Say that you are close to retirement and that you have a stock portfolio valued at $1 million. Reduce that for the Big Price Drop that the historical data tells us to expect, and you have a portfolio valued at $600,000.

A columnist writes an article telling you that. Does this make you like him? Or does it make you want to boycott his column or his entire newspaper or the companies that advertise at his newspaper? Do you see the problem? Scott Burns said that the reason why we have not seen many articles about our New School SWR findings is that: “It is information most do not want to hear.”

Bull markets turn us all into liars.

We need to find our way back to a place where we can tell the truth about stock investing. We need to, like El Supremo, discover what it takes to feel good about ourselves once again.

Stock Panic Comment #20 — “Why not just let it go? Why not just put all this behind you and forget about hocus and this tool thing and all this other stuff? Why not go back to the way we were? ” (Comment #54 in the earlier article)

It must be difficult for someone who did not live through the Campaign of Terror to make sense of it. I’ve had a front-row seat since the first day and it is more than a little difficult for me to believe some of what has gone on.

Cognitive Dissonance of Investors

Again, multiply by 10 million to gain a sense of what it means for a nation of investors to work their way back down to reasonable prices after participating in the most out-of-control bull in our nation’s history. It ain’t easy.

I knew that valuations were an important factor back on the morning of May 13, 2002. I learned that from reading Bogle’s book back in the mid-1990s, when I was putting together my Retire Early plan. But I didn’t know all this other stuff. I was naive.

It makes sense in a strange sort of way, once you force yourself to make sense out of it. Stocks are an unusual asset class in that the buyers of the asset collectively determine the selling price. Think of beanie babies. Beanie babies were selling for crazy prices for a time, right? How come? Because people came to not care what they were worth but only about what they could get for them when they sold them to the next buyer. The market for beanie babies was highly inefficient. The price of beanie babies became disassociated from their fair value. The same thing happened with stocks.

This sort of situation encourages deception. People are scared about whether they are going to have enough to retire. They see prices shooting up and that provides some emotional relief. They wonder whether what goes up can also come down. They banish that discouraging thought from their heads. And then some idiot on a discussion board reminds them of the realities. Things go berserko.

Denial is not the answer. Learning how stocks really work is the answer. That’s how we develop the confidence in our long-term strategies needed for us not to feel so emotionally vulnerable. One thing that I have discovered is that, each time you acknowledge a truth, it opens the path to the learning of many more truths.

The realities of stock investing are not depressing. They are exciting. Our story is a positive one. We do need to let go of the discredited “theories” of the past. I think that a good number of people have an exaggerated idea of the pain that is involved in doing so. Doing one right thing leads to doing another right thing and then another and then another. It gets easier.

Stock Panic Comment #21 — “Anonymity on these boards allows small-minded cowards to take shots at their betters; and where else can that happen? ” (Comment #60 in the earlier article)

Envy has played a big role in our investing discussions. The crazy thing is that much of the envy has been evidenced by people who enjoyed huge gains during the wild bull.

There are studies that have been done that show that people can be happy with small amounts of money so long as they feel that they are doing well compared to the group to which they compare themselves. And people can be unhappy with large amounts if they feel that they do not measure up in the eyes of their peers.

Out-of-control bulls cause some people to feel that they are not keeping up and others to feel that they must find a way to convince themselves and others that their outsized gains are attributable to more than just dumb luck. We are not rational actors seeking to maximize our long-term investing returns. We are in part that. We are also humans with all of the positive and negative emotions that go with being such.

It is impossible to invest successfully without devoting some attention to these questions. They are tricky. It sometimes makes us feel yucky to go down deep, where things are tangled and dark. That stuff influences us, though. We need to look at it if we are to achieve our financial freedom goals.

Stock Panic Comment #22 — “Not to say Hocus (Rob) is a pearl, but maybe he does get some people to come up with pearls for their replies. ” (Comment #62 in the earlier article)

Scott Burns says that our safe withdrawal rate findings are no biggie, that they are sort of snoresville. Why then did our discussions generate hundreds of thousands of posts at 10 different boards in discussions that have now continued for over five years?

People post about what they care about. People care intensely about the effect of valuations on long-term returns. Most people don’t understand all the issues. But lots of people clearly see that there is something seriously wrong with the conventional take on this question. People are trying to put together the pieces of the puzzle.

Investor Emotions

In any other field, people would be pointing to the reaction we have seen to my SWR posts and saying “this is a huge story!” Because we are talking about investing and the failure of the Efficient Market Theory, the official reaction is that this is snoresville.

Still, people cannot help but post about it, can they? This topic is still generating dozens of posts on a daily basis in November 2007 (when this article was posted), more than five years after the posting of the first thread-starter.

SWRs matter.

Valuations matter.

Investor emotions matter.

Humans matter.

This isn’t like that time when I bought the Leo Sayer album. I’m sure about this one.

Stock Panic Comment #23 — “At this point it doesn’t even look like Hocus is running an underhanded smear campaign against Mel, Taylor and other so-called “big shots”, right? It looks like the debunkers are to blame for the ruckus and subsequent polarization of the board into two camps. Like I said, skillful.” (Comment #64 in the earlier article)

My great “crime” was that I was the first person to report accurately what the historical data says about safe withdrawal rates. At a later time, I expanded on the insights that we developed in the SWR area to show the effect of valuations on long-term stock returns in general.

Tons and tons and tons and tons of abusive posts were dropped on us to block the discussions that hundreds of us expressed an interest in holding. In response to that, I said that the published rules of the various boards should be enforced to bring the abusive posting to an end.

There are people who deny that investing is primarily an emotional endeavor.

Stock Panic Comment #24 — “The Diehard mentality has done more to discourage investing dialogue and an open exchange of ideas than any other philosophy I know of.” (Comment #67 in the earlier article)

John Bogle is fifth on my list of favorite investing analysts. I see the Indexing Revolution as a big step forward for middle-class investors. I recommend a form of indexing (Valuation-Informed Indexing) in the articles posted at this site.

All that said, I agree with the words quoted above. Bogle has done some great things. Bogle has messed up in some big ways. Both things are so.

If Bogle is as smart as I like to think he is, he will take note of the fact that so many have put forward comments along the lines of the one above. There is something seriously wrong with an investing approach that causes as much hostility and defensiveness and hate as is caused by the conventional indexing approach.

Crazy Investors

I come not to bury indexing but to save it. The conventional approach has failed us. Let’s get to work building something better!

Is anyone able to identify any possible downside?

Stock Panic Comment #25 — “A few years ago when Motley Fool boards were free, I followed those discussions. I actually was on the side of Greaney regarding the 4% safe withdrawal rate based on historical. I actually think I now lean towards Rob’s view, that you have to consider the starting point…. While intercst was busy making fun of Rob, he kept putting out information that may prove extremely painful for those who took his safe withdrawal rate as gospel.” (Comment #68 in the earlier article)

Lots of smart people have been taken in by the Old School studies. Most readers of the Old School studies do not spend hours reading all the fine print. The Old School findings appear at first impression to be plausible. This is what makes them so dangerous.

When the Motley Fool board was in its glory days, there were hundreds of threads posted in which aspiring early retirees made clear that they were making use of the Old School studies in their retirement planning. All of the people who are saying today that SWRs are of no consequence were saying then that they were of great consequence. What changed? The only thing that changed is that we learned that the Old School numbers are wildly off the mark.

There are investors who very much want to know what the safe withdrawal rate is so long as the number is overstated by a percentage point or two but who very much do not want to know what it is if the number is reported accurately. And there are people who to this day maintain that stock investing is primarily a rational endeavor.

Imagine that we were talking about a trampoline manufacturer who used an invalid study to support a claim that its trampoline is safe for kids who weigh more than 50 pounds when in reality testing shows that kids of that weight who use the trampoline have only a 30 percent chance of escaping serious injury. Would there be people devoting years of their lives to seeing to it that none of the parents involved were able to hear the accurate information?

It’s an insane question. We all know that it is important to state safety claims accurately when we are talking about trampoline manufacturers. Why is it that so many follow a very different set of rules when we are talking about claims made about the safety of our retirement portfolios?

Real live people use these studies to plan real live retirements that take place in the real live world. Do we not owe it to these people to permit them to hear honest reports as to what the historical data says?

Again, it’s an insane question. Incredibly enough, however, the answer we have gotten back from the owners of the Motley Fool board, the Morningstar board and the Early Retirement Forum is “No, it is absolutely essential that we block honest posting, to permit honest posting on SWRs is too disruptive.” Perhaps some require some “disruption” to get their heads on straight.

I, Rob Bennett, have been charged with the high crime of reporting accurately what the historical data says about safe withdrawal rates. I hereby plead an enthusiastic “Guilty as Charged!”

Yowsa!

Stock Panic Comment #26 — “Nevermind that there are also experts that take contrary positions, and that point out ambiguities and complexities in the evidence.” (Comment #69 in the earlier article)

Pseudo-science rules in the investing field. It’s not what you don’t know that is likely to hurt you. It’s what you may be fooled into thinking that you know that you do not that is most likely to hurt you the most.

My most important piece of advice for middle-class investors is to develop a firm grasp of the fundamentals of how stocks work before putting even a dollar into this high-potential/high-risk asset class. It doesn’t take that long to learn the basics. Once you do, you won’t fall for all sorts of nonsense dressed up as science.

Morningstar Discussion Boards

There will still be lots of things that you will not know if you follow this advice. That’s okay. The important thing is that your spidey sense will alert you when someone is engaging in some funny business aimed at selling you something.

You don’t need to know everything. You need to know enough to be wary of the most obvious sorts of trickery. Many of the tricks used on us are not so terribly sophisticated. We fall for them because they are repeated so often by so many different people (many of whom do not know that they are putting forward trickery because they are merely repeating thoughtlessly junk ideas that they picked up from others) that we presume that there must be something to the claims being put forward.

Never assume that just because it is a Big Shot expert saying something that there must be something to it. I have learned to my dismay that this is too often not the case.

Stock Panic Comment #27 — “The very idea that Jack Bogle’s ‘safety’ (or anyone else’s) would be an issue puzzles me, and the notion that the invited speakers need to be ‘protected’ from disagreement really is astonishing.” (Comment #72 in the earlier article)

Discussion boards are an important communications medium of the future. They will not realize their potential until site owners take seriously their responsibilities to administer the published rules of the boards in reasonable ways.

When big-name “experts” participate at a board, they provide that board a measure of credibility that it would not otherwise possess. My rule is that I will not participate at any board community that bans honest posting on the topic of the board. That’s a pretty darn minimal standard, is it not? I find it shocking that there are “experts” with far bigger names than mine who appear to be unconcerned with the abusive posting practices being engaged in at boards at which they participate.

No expert is able to be aware of every post posted to a board. I do not advocate some severe standard that requires this. The abusive posting at the Vanguard Diehards board became so intense that the board imploded; that board today generates only a small fraction of the posting it obtained at an earlier time in its history. There are a number of big-name experts who posted at that board or participated in the community in other ways during the time that the abusive posting was going on and who took no public acts to stop it. I find this strange and dangerous and irresponsible.

If board leaders are not following the published rules of the site at which the board operates, that is shameful behavior. If a board has become a shameful enterprise, big-name experts should not be permitting their good reputations to be used to promote it.

Is there anything that in any way, shape, or form would in ordinary circumstances be controversial about what I am saying here? Is what I am saying here not something that would pass as simple common sense in any area of endeavor other than stock investing?

Stock Panic Comment #28 — “If you want to understand the dynamics of what happened here, you need a model for understanding. I suggest you use a ‘cult’ as a model.” (Comment #74 in the earlier article)

Yes and no.

Capitulation

The group that opposes discussion of the realities of long-term stock investing is indeed cult-like in its blind adherence to stale and mindless dogmas. They practice thought control of “newbies” by striking out at those who offer reasoned takes on the topics addressed.

I am a bit uneasy with the “cult” explanation, however. My concern is — how far do we take it? It is not at any one discussion board that we saw this behavior; we saw it at a good number of different places. And the phenomenon is not limited to discussion boards. We see word games in the writings of some of the leading authorities in the field, people like John Bogle and William Bernstein and Scott Burns and Jonathan Clements. Are these people part of a cult? It seems to me more than a little bit of a stretch to argue this.

I place the blame on the model we use to understand investing — the Efficient Market Theory. This theory is wrong, terribly wrong. That’s my opinion, of course — you are free to reject it or accept it. Presuming that I am right in saying that the theory is wrong, I think that tells us what we need to know to explain the strange behavior without needing to say that the majority of middle-class investors belongs to a cult.

Most middle-class investors do not know what the Efficient Market Theory is. What they know is what it teaches — timing does not work, no one is capable of picking individual stocks effectively, stocks are always best for the long run, these sorts of things. It is hard for them to see these things as wrong without going to the root and seeing what is wrong with the Efficient Market Theory. Most don’t have that great an interest, largely because they just don’t have the time to be sorting though the good and bad points of a theory. They assume that the experts know what they are talking about.

Is it cult-like to put your faith in experts? It is a bit, but not really. Investing is not a religion for most people; it is a small part of their lives and they don’t want to spend a great deal of time on it. It seems safe to trust the experts, so most Normals do.

The real problem in my mind is that the experts have let us down. The experts bought too heavily into a bad theory and things got out of control.

The conversations are indeed cult-like. I grant that. The real problem is that people do not have the background needed to think their way through the conflicts in the arguments put forward in support of the theory. We need to become educated on the fundamentals. Those who know where stock returns come from are informed enough to see the flaws in the Efficient Market Theory. Experts should know this, but the reality is that most don’t. The Efficient Market Theory determines how our experts think and they are not able to see how wrong the theory is until they develop a new way of thinking about what is involved in the investing project.

Stock Panic Comment #29 — “I began reading this Morningstar forum about 6-8 months ago and quickly learned that valuation matters…and yes from Rob…but I read others to validate my “new” thoughts on the matter.” (Comment #76 in the earlier article)

This is what it is about — learning and teaching. In heaven, all who post on investing discussion boards will be participating in either a learning experience or a teaching experience or both. It’s not that way here on Planet Earth.

The Efficient Market Theory assumes that it is. The Efficient Market Theory assumes that we are something that we are not. It assumes that we are robots who are aware of every information bit about stocks that exists and that we are Mr. Spocks who process those information bits without being influenced by any emotions we feel about the topics they address. This is not so. This is a falsehood. This is a lie.

People show emotion on investing discussion boards every hour of every day of every week. Every show of emotion illustrates why the Efficient Market Theory is a bad model for understanding how stocks work. Why do the “experts” not write about this?

There are ways of testing theories. A great way to test the Efficient Market Theory is to go to investing discussion boards and see how real live humans form their investing strategies in the real live world. I have been doing this for a long time. My report to you is that the way the Efficient Market Theory says people do it and the way people do it in the real world are very different things.

Reason does indeed play a role in the investment decision-making process, to be sure. The poster quoted in the words above behaved in a reasonable way. He heard some new ideas that seemed to make sense, he checked them out to make sure, he acted on what he learned. That’s good. But I doubt that that poster always acts in a purely rational or efficient way. And I know for certain that lots of others do not. So the market can never be entirely rational or entirely efficient. The dominant investing model of today is built on sand.

Stock Panic Comment #30 — “If Rob ignored them, they accused him of evading their questions. When Rob responded to their questions, they accused him of being long winded. When they attacked, Rob responded too gently, IMO. So, they accuse him of being ‘passive aggressive’. There was no way for Rob to come out even.” (Comment #77 in the earlier article)

Consumer Confidence

I cannot count how many times I have seen posts suggesting that I was “mean” to John Greaney by pointing out that he got an important number wrong in his study on safe withdrawal rates. I don’t see it that way. One of my biggest worries is that I will get a number wrong in an article that I write about personal finance and that I will cause someone great pain by doing so. When someone points out to me that I got a number wrong in one of my articles (John Walter Russell has done this on more than one occasion), I consider that person one of my best friends. I worked with John Greaney for a long time. I consider him a friend. I pointed out the analytical error he made in his study in a spirit of friendship.

I think it would be fair to say that he does not see it that way. I think it would be fair to say that he took my correction of his study personally. That’s highly unfortunate. It’s also highly human, right? We’re all humans. Each and every investor is first of all a human. We must never forget this critically important reality.

The Stock-Return Predictor tells us that the most likely real annualized return for the next 10 years is 0.7 percent (this article was posted in November 2007). How would purely rational investors respond to that information bit? If they were highly invested in stocks, they would lower their stock allocations. We have seen that in the real world many have not reacted that way. They have reacted instead with — denial.

Again, this is both unfortunate and human.

It’s also important.

There is no room in the Efficient Market Theory for recognition that humans go into denial when confronted with realties that do not please them. None of the thousands of pretty little studies with all of their pretty little tables of numbers that have been produced by advocates of this theory account for this reality in their research. Guess what that means? It means that their research is flawed. It means that they too got the numbers wrong.

Valuations matter. I say that all the time. Another way of saying it is to say that emotions matter. It is swings in emotion that cause swings in valuation. The reason why stocks are so absurdly overpriced today is that stocks provided such absurdly high returns in the late 1990s. That caused lots of people to come to believe things about stocks that cannot possibly be so. People have been learning over the course of the past eight years (a time-period in which super-safe asset classes have provided higher returns than stocks) that stocks are not what the “experts” have made them out to be. Many of us responded to this news in much the same manner as Greaney responded to his discovery that he got the number wrong in his study — with denial.

John Bogle is not a psychologist. He has no training in how to recognize or treat denial. William Bernstein is not a novelist. He isn’t able to recognize denial in all of the little ways in which it evidences itself in the daily playing out of the grand investing story. Scott Burns is not a detective. He doesn’t follow the clues provided by expressions of denial to solve the puzzles of investing.

The investing “experts” are not trained in much of what they need to be trained in to do their jobs. They know about numbers. They know about the theories cooked up in the ivory towers. They know about the way it is supposed to work. They don’t know about the way it which it actually does work in the real world.

Visit an investing discussion board for a few hours and you will have a front-row seat to a drama showing you how it actually does work. Report the realities, and you will prompt a reaction. It will not be an entirely rational reaction. You will hear the Efficient Market Theory cited many times. You will rarely see its core assumption of rational investor behavior evidence itself.

Waves of Emotions

Humans like to fool themselves. People who are experts in fields other than investing have known this for a long, long, time. We need to get about the business of spreading the word to the investing “experts” before more of the accumulated wealth of middle-class America goes down the drain.

Stock Panic Comment #31 — “If the only posters they want on that board are those that will be yes men, repeat the tired old mantras and bow down and kiss the feet of Bogle and the moderators, do you really want to waste your time with such close-mindedness? ” (Comment #79 in the earlier article)

You are looking to buy a new car. Do you look into only the good points of the model you have in mind, or do you look into both the good and bad points? You look into both.

You’ve bought the car. Now what? Now you focus on the good points and ignore the bad points. You’ve already made your decision. The idea now is not to learn which car is best. The idea now is to avoid buyer’s remorse.

Some people come to discussion boards seeking to learn how to invest effectively. Some people come to discussion boards seeking confirmation of decisions they have made. The two goals are opposites. One is a learning motive, which requires exposure to new ideas. The other is a reassurance-craving motive, which requires unconditional support.

When should we stop learning how to invest? Some would say “never.” But doesn’t that conflict with the buy-and-hold concept? Learning brings on change. Change does not fit well with a pure buy-and-hold strategy.

My view is that we need to combine a certain measure of close-mindedness with a certain measure of open-mindedness. If you revisit every investing question every day, you will not follow any one strategy long enough to find out if it works. But if you become dogmatic, you are doomed. No one knows everything. Buy into the idea that some investing guru knows everything and you place yourself on a path leading to dogmatism and doom.

It makes sense to be resistant to certain new ideas because acceptance of them would require a revisiting of your fundamental beliefs about what works. It does not make sense to close your mind entirely to any new idea. I don’t believe that short-term timing works. But I make an effort to avoid dogmatism on this point. I don’t know everything about how to invest and I never will.

How would you react if someone told you that your spouse was an alcoholic? Your reaction would probably be a strongly negative one; you wouldn’t want to hear it. That’s how many people react to hearing that their investing strategies are not likely to pay off. It’s a healthy reaction to a point. If six different people tell you that your spouse is an alcoholic, you need to get out of denial mode and do something to address the problem. When it’s been eight years since stocks have performed in the way they are supposed to (according to ideas you bought into long ago), it’s time to return to the basics and figure out what is really going on.

The Five Stages of Investing Grief

It’s important to understand that there’s a reason why we are resistant to new ideas. It’s not because we are stubborn or dumb or bad. It’s because it’s not always good to be open to new ideas. But it is a mistake to make resistance to new ideas your sole driver. There are exceptions to every rule. There are times when new ideas should be resisted and there are times when new ideas should be welcomed.

Stock Panic Comment #32 — “Vanguard monitors this forum on a regular basis at a very high level, so the “higher-ups” do, indeed, know exactly what’s going on here.” (Comment #80 in the earlier article)

I find this comment disturbing. If there are people in positions of responsibility who are aware of what is going on, they should be taking steps to help the members of the board community.

Some people see stock investing to be a “knowing” project. I see it as a “caring” project. Being strong in the knowing department can help you become effective in the caring department. Being strong in the caring department comes first and is most important. There are many investing “experts” around today who know too much and who care too little.

Stock Panic Comment #33 — “Wouldn’t that be a crackup if what Rob is doing actually worked? I think people would be really mad.” (Comment #81 in the earlier article)

People would be really mad to discover that an investing strategy that was shared with them and that they rejected worked. If that comment doesn’t persuade you that investing is primarily an emotional endeavor, I think you might as well stop reading articles posted to this site because I am not going to be able to do it for you here.

Envy is an emotion. There is no room for envy in the Efficient Market Theory. The Efficient Market Theory does not tell the complete story.

Stock Panic Comment #34 — “I have seen many rip Rob, but truthfully I don’t understand what the counter argument is. Is there a counter-argument?” (Comment #82 in the earlier article)

This guy speaks for many. Abusive posters dominate discussions of how valuations affect long-term returns. The majority of posters possesses a desire to learn. But the majority is intimidated by the knowledge that the abusive posters pretend to possess.

The abusive posters do not know nearly what they pretend to know. But the “experts” have not educated the rest of us to the extent we need to be educated to point out the holes in their arguments. I’ve been there. I was a typical investor who presumed that the experts were shooting straight with me in the days before I began putting together my plan for early retirement in the mid-1990s. I’ve been shocked by what I’ve learned in the time since.

You need to know the basics. Stocks are an asset. Price matters when purchasing an asset. That must be so. There can never be a counter to that claim because that claim must be so.

Goon posters will aim to intimidate you into backing down on what you know must be so by citing “experts” and “studies” and “theories” that seem to suggest that price does not matter when buying stocks. No! You must hold fast to common sense. Common sense trumps all in my book. A theory or a study or an expert that defies common sense should always be suspect.

Common sense will take you a long, long way in investing. It’s a good idea to fortify your common sense with some reading and with some knowledge of what the historical stock-return data says. But you can’t go too far wrong returning to common sense often. Go over the basics in your mind again and again. You need to possess confidence in your understanding of the basics. That’s what will get you through challenges to your buy-and-hold convictions.

Stock Panic Comment #35 — “Go back 100 years in finance and many other disciplines, and examine the academic studies of that era. You will see that they are often riddled with assumptions, theories, and analysis that are now considered to be wrong or even ridiculous. And 100 years from now people will likely view the studies upon which we rely in the same light. Moreover, even today, for every academic study that argues for one proposition, there will typically be another study that argues the opposite. The primary way people on this forum can maintain that academic studies support their views, to the exclusion of others, is by simply ignoring contrary studies and/or the ambiguities and limitations of current studies.” (Comment #83 in the earlier article)

Emotional Depression Leads to Economic Depression

Dogmatism is evidenced in its strongest form when the support for the idea being advanced dogmatically is weakest. Dogmatism arises from a lack of confidence. It betrays a weak hand.

Why is there so much dogmatism in discussions of investing? It’s a highly uncertain business of great import. It scares people to acknowledge how little confidence they feel in their investing strategies. By shouting, people try to persuade themselves that they feel sure of what they are saying.

The risks are especially great for those planning retirements. That’s why there is virtually zero tolerance for accurate reports of what the historical stock-return data says about the safety of retirements planned pursuant to the Old School safe withdrawal rate studies.

Every time you see an abusive post on an investing discussion board, there should be a voice in your head saying “deduct points, this speaker lacks confidence in the case he is putting forward.”

The Efficient Market Theory is the quintessence of dogmatism. It is a theory that defies common sense and that defies the historical data. It is properly described not as a theory, but as an assumption. How do we know that the market price is right? We assume it. How do we know that long-term timing does not work? We assume it. How do we know that stocks are always best? We assume it. How do we know that taking risk is always rewarded? We assume it.

There are studies put forward that purport to prove these things. But those studies are generally not set up in the ways in which they would be set up if the driving force behind them were a quest for truth. The authors of these studies are often guilty of doing what the author of the words quoted above finds discussion-board posters guilty of; they ignore the positions of those who question their findings. The analytical errors are probably not intentional in most cases. That doesn’t change the reality that the studies do not prove what they claim to prove.

I believe what I believe. I often state my views strongly. I pray that you never take anything I say on faith. I am a human and I make mistakes. I probably am wrong about some of the things I say about investing.

Those words are hard to write. I know from what I have seen that I need to learn how to write them frequently if I am to offer something different and better than what most of today’s “experts” offer. I hope that others will learn to write these sorts of words and to mean what they write and to keep these sorts of words in mind when offering investing advice.

It’s not what we don’t know that most hurts us. It’s what we think we know for certain that just isn’t so.

Stock Panic Comment #36 — “I’ll venture a regular guy opinion. I will say that Rob’s explanation does make sense. However, no one can predict the future. Just when someone uses history to try to backtest, create a model, and then predict the future, the factors change or new factors emerge, thus making the model useless for predicting the future. (Comment #84 in the earlier article)

Waiting for Economic Recovery

This guy is expressing a healthy open-mindedness combined with a healthy skepticism.

Stock Panic Comment #37 — “What Rob said sounds reasonable enough, so I wouldn’t be able to judge his advice without additional input. I must rely on the fact that I don’t hear the authors I trust saying the same thing. The authors I trust seem to agree that returns may be lower in the years to come, but none of them suggest that we should drastically reduce our stock allocations in light of this information…. I don’t have time to join the search for ‘the Grail of Investing.’ Besides, I have other priorities in life. So, I have to rely on the judgment of people who make the most sense.” (Comment #85 in the earlier article)

This is a good expression of the viewpoint held by many Normals.

Stock Panic Comment #38 — “If all he thought was that the market is a bit overvalued and we are probably in for a period of below average returns there would be no controversy. His views go way beyond that. He claims that the entire industry is wrong and he, as founder of the New School [of safe-withdrawal-rate analysis], has the “correct” answers.” (Comment #86 in the earlier article)

The history is that I started out with an exceedingly modest tone. The famous post put up on the morning of May 13, 2002, asked a question. I wasn’t brave enough to say that I thought that the Old School SWR studies get the number wrong (although I did believe this to be so). I put it in the form of a question so as to come across as nonassertive and non-offensive and non-threatening.

I have become more bold over time. That is because of what I have seen. What I have seen amazes me. The Old School studies give people demonstrably false retirement advice. We discovered this over five years ago. A good number of people who claim some level of investing expertise (including several big names) do not seem to care enough to do much to get the word out to people before they suffer one of the most painful life setbacks imaginable. The system is broken, friends and neighbors. That’s what I have learned.

I don’t claim to know all there is to know about investing. There are all sorts of things I do not know. I know with 100 percent certainty that it is wrong to give people demonstrably false information on what the historical data says about safe withdrawal rates, knowing that they are going to use this information to put together retirement plans. How much of a genius do you need to be to grasp that much?

I became radicalized. The word “radical” means “to the root.” The investing advice field is intellectually corrupt to the root. Most of the people in it are good people. But they are trying to adhere to a model for understanding how stock investing works that just does not make sense. We need to pull up the Efficient Market Theory by the roots and start over with something else. I couldn’t have told you what the Efficient Market Theory was on the morning of May 13, 2002. Today I say that we need to pull it up by the roots. That’s because of what I have seen and what I have learned during The Great Debate.

The sorts of things that I have seen take place could not have taken place unless the entire field was corrupt. Again, I am not saying that the people are corrupt. I am saying that the investing field today is intellectually corrupt. It is impossible to give realistic advice that fits with the Efficient Market Theory. I’ve seen a number of big-name experts try to do it and end up twisting themselves up in nonsense gibberish logic pretzels. I’ve been making my living by stringing words together for a long. long time and the goal of a writer is to say things as plain and clear and simple and true as possible. Most of today’s investing guides are polluted with convoluted word games. This is not because the people writing them are lacking in intelligence. It is because there is no way to combine what the Efficient Market Theory mandates and what observation of the real world mandates in a single narrative possessing a reasonably strong logic chain.

There's No Such Thing As an Unemotional Investor

We need to get the word out about the errors in the Old School safe withdrawal rate studies. I’ll tell you why I believe we have not yet been successful in this pursuit. It’s because fixing the Old School studies raises questions that experts in this field do not know how to answer. The obvious question is — How did so many smart people get taken in by what these la-la land studies say? They were taken in because they placed some measure of confidence in the la-la land Efficient Market Theory and buying into the premises of that theory makes it impossible to think clearly about how long-term investing really works.

Please take a look at the Stock-Return Predictor (see the tab at left). The Predictor tells us that, if stocks perform in the future as they always have in the past, the most likely annualized real return for the next 10 years is 0.7 percent. Did you know that? Are you shocked to learn that?

You shouldn’t be shocked by learning something of such basic importance. In a system that worked, this would be widely shared information. Everyone with any money in stocks would know this. Why doesn’t everyone know it?

It’s because the Efficient Market Theory says that this situation is impossible. The theory says that all available information is incorporated into the market price. The fact that returns for the next 10 years are likely to be less than what can be obtained by investing in far safer asset classes is an important piece of information. That should be factored into the market price, according to the theory. But if that were factored in, the price could not be as high as it is today. Knowledge that the long-term return is likely to be low should cause the price to drop (bringing the likely return up to more reasonable levels).

Some advocates of the Efficient Market Theory deny this, but what the theory really says is that investors are rational; prices cannot be efficient if investors are not rational. Investors are not rational. I know this. I’ve spoken with thousands of them. They’ve called me names. They’ve banned me from their discussion boards. They’ve made fun of some of my favorite song lyrics. They made fun of the Frank Sinatra song All the Way. How crazy can you get? I mean, come on!

Here’s a snippet:

When somebody loves you, it’s no good unless she love you
All the way.
Through the good and lean years and through all the in-between years,
Come what may.
Who knows where the road may lead us?
Only a fool would say

Please take note of the part where he observes that “only a fool would say” where the road will lead us. I think it is fair to describe this as a none-too-veiled criticism of the Old School studies. Listen to Frankie Boy! He knows whereof he speaks. And what he is saying about long-term asset allocation strategies is entirely consistent with what many of the other big-name “experts” (people like Marshall Crenshaw and Miles Davis and The Who — but not Leo Sayer!) say on the topic. Is it really possible that all of the best-respected names in the field got it wrong?

We need to face facts, people. We humans are more than a little bit bonkericious. We buy Barry Manilow records — don’t deny it, somebody has to be buying them or they wouldn’t offer them for sale in record stores everywhere. We need a model for understanding how investing works that takes into account this obvious reality. The Efficient Market Theory has to go.

Investors in Pain

What was the question again?

Stock Panic Comment #39 — “What truly impresses me is the consistency that hocus points us to something of value. “ (Comment #87 in the earlier article)

These words were put forward by John Walter Russell. Please note the way in which he phrases what he says. He doesn’t say that I am especially smart or especially knowledgeable. He says that I am able to point discussions in directions which often end up being fruitful.

That’s what I see as my talent. There are some who believe that to be an investing “expert” you need to know it all. I do not know it all, so, if that’s your standard, I fail the test. However, I have seen my pointing lead us to some pretty darn wonderful stuff over the years, so my intent is just to continue doing what I do to the best of my ability.

My biggest worry today is that we do not have enough people contributing on the constructive side in our investing discussions. I know that the stuff that we have been coming up with is of great value. But we need checks on it. We need people looking for flaws (with good intent, of course) and we need people adding different perspectives. That’s the advantage of developing our ideas in a community. One of the reasons why I founded the Retire Early Community in the first place was to make this sort of healthy interaction possible.

Get to work!

In all seriousness, please do understand that we need the help that you can provide and that we all are grateful for any contributions you are able to make.

As for me, I’ll just keep pointing.

Stock Panic Comment #40 — “Jim Rogers stated that new ideas tend to be first ignored, then people grow actively hostile, and only later does acceptance come.” (Comment #90 in the earlier article)

I probably laughed once when I was young at something Lyndon Johnson said in a speech and now God is paying me back for it. Do you remember how he used to always be seeing “light at the end of the tunnel” re the Vietnam quagmire? I’m always seeing the beginning of the acceptance stage re this SWR matter.

Stock Panic Comment #41 — “Maybe this can be summed up by one question: Why would anyone subject themselves to this much abuse? They’d either have to be a troll or the most saintly person on earth trying to save all of our souls. ” (Comment #93 in the earlier article)

The Science of Investing

Or maybe they really like exploring early retirement junk.

Stock Panic Comment #42 — “I have never seen hocus show incivility. No matter what. Truly amazing. Either he is really the output of an artificial intelligence program, or the man’s on the way to becoming a saint! ” (Comment #95 in the earlier article)

Here’s Dylan:

I got the pork chop.
She got the pie.
She ain’t no angel
And neither am I.

I am grateful for the kind words all the same.

Stock Panic Comment #43 — “Rob and Cleo are the most trustworthy. These posters always get to the heart of a matter and offer sound, intuitive, original, creative and helpful advice. The good Lord should clone them for the benefit of mankind. Engineers, on the other hand, and here I include “engineer types” (we all know who they are) are typically quantitative and not qualitative. Whatever brain transmitters gave them their high level of mathematical, measuring and similar skills apparently resulted in a lowering of emotional, feeling and human relations skills. ” (Comment #96 in the earlier article)

We need engineer types in the investing advice biz. We also need non-engineer types.

Stock Panic Comment #44 — “Post on, Hocus! ” (Comment #101 in the earlier article)

Will do!

I’ll pick up my guitar and play,
Just like yesterday.
Then I’ll get down on my knees and pray
We won’t get fooled again.

— The Who, “Won’t Get Fooled Again

This Too Shall Pass

Fear and Greed: Investor Emotions Correlated With Stock Valuations

We need to know more about investor emotions.

The Stock-Return Predictor provides us the information we need to assess the risk and reward associated with a stock investment made at any of the various stock-valuation levels. That’s good stuff (thanks, John Walter Russell!). But it does us limited good unless we develop a means to implement the insights we mine with it. To implement what we have learned about how stocks work, we must learn more about how we work.

Investor Emotions

Yes, that’s right. It’s always humans who own stocks. To learn how stocks work, you must learn how humans — the sometimes funny-looking but generally goodhearted entities who buy and sell stocks — work.

It’s not a small part of the story. Investing is primarily an emotional endeavor and only secondarily a rational endeavor. Learning how humans work when they come into close contact with stocks is at least 50 percent of the job of learning what it takes to become a successful long-term stock investor.

This article is my first attempt to correlate investor emotions with the stock-valuation levels that give rise to them. The ideas reported on below are tentative ideas. I expect to revise them as we move to the next stages of The Great Safe Withdrawal Rate Debate.

Please understand that not all stock investors experience the sorts of emotions described below. I am attempting to describe the emotions that become dominant at a given valuation level. The dominant investor emotion today is anger. That doesn’t mean that you are angry, or that your friends and loved ones are angry, dear kind reader. It’s all of the other investors of today who are struggling with anger issues, okay?

You know the sort of person who shifts suddenly into your lane at 60 miles per hour and almost causes you to come face to face with your Maker before you have had time to prepare yourself properly for the meeting? That’s the sort of individual to whom I am making reference when I identify anger as the typical investor emotion of today.

In all seriousness, my sense is that most of today’s investors are more confused than angry. Many people who appear to me to possess a fine emotional balance have thanked me for the investing insights developed in our community over the past 53 months. These people are obviously not angry. They are questing.

Still, I identify the typical investor emotion of today as anger. The many investors who are unsure about how stocks work and who would like to learn more tend to be docile in the face of the intense pro-stock positions of the smaller group possessing a strong desire not to learn and not to see others learn either.

There are more in the group seeking to learn than there are in the group that fears learning (Praise the Lord!). However, because of the unwillingness of the larger group to challenge the intimidation tactics of the smaller group, it is the anger of the smaller group that dominates investing discussions of today. When 10 or 20 percent of all investors fall victim to feelings of anger, that is enough to undermine the learning efforts of all investors.

Investor Emotions (Fear and Greed) at a P/E10 Level of 6 — Indifference.

My first thought was that investors would feel a contempt for stocks when they were at a P/E10 level of 6. This is the price level at which stocks are a screaming buy, the price level at which those who in earlier days had proclaimed themselves buy-and-hold investors are filled with so much hatred of stocks that they not only have sold most of their shares but also have taken vows never again to buy into this dangerous asset class.

After thinking about it a bit, exploring some of the literature describing earlier investing eras, and playing a bit with The Stock-Return Predictor and two other investing calculators now in the development stage, I decided that that first thought was a wee bit off.

What’s the worst feeling that you can have about a former lover? Hate? No. There’s something worse than that.

Indifference is worse.

Hate is a strong feeling. Hate can be transformed into love. That doesn’t only happen in movies. Almost never do we see indifference changed into love, however. Indifference is hate turned cold.

When stocks are a screaming buy, the typical investor doesn’t pointedly reject the opportunity to buy — he ignores it. He’s been through enough. He just doesn’t care. You could tell him that the P/E10 level had dropped to 1, and you wouldn’t win his interest.

When the P/E10 level is 6, the typical investor isn’t saying that his love affair with stocks is over. He doesn’t feel a need to say it anymore. At this P/E10 level, it really is over. The romance between the investor and his once-beloved stocks is so dead that there is not even a spark of hate offering the promise of perhaps bringing it back to life.

Investor Emotions (Fear and Greed) at a P/E10 Level of 12 — Desperation, Skepticism.

When we are at a P/E10 level of 12 and are on the way down from much higher stock-valuation levels, the typical investor emotion is one of desperation. Many investors who purchased at far higher prices have already sold, so the investors who have high stock allocations at this price level are the one-time True Believers. They have a lot riding on a bet that stocks are going to come back, but they also understand at some level of consciousness that their old understanding of how stocks work is gravely flawed. This is a time for Hail Mary passes.

Investor Defensiveness Stock prices don’t move in a straight line from absurdly high prices to absurdly low prices. My guess is that when we again touch a P/E10 level of 12, prices will have dropped enough that it will be possible for stocks to stage a significant rally. There is no non-emotional reason why stock prices should not be able to go up again to stay once we are down to a P/E10 of 12 (a price level a bit below the fair-value P/E10 level of 14). The economic realities cannot support a strong and long-lasting rally from today’s prices (this article was written in October 2006), but they could support a strong and long-lasting rally beginning from a P/E10 level of 12.

Why is it, then, that in earlier secular bear markets, stock valuations have always dropped much lower? My guess is that it is that desperation quality that is to blame. The True Believers are hurting emotionally when we are at a P/E10 level of 12. They have seen most of their friends get out of stocks at better price levels, and feel envy towards them for having had the sense to do so. When valuation levels rise to 14 or 16, they see an opportunity to “get whole” (in comparison to where they were at a P/E10 level of 12, but not to where they were at a P/E10 level of 26, of course). The desperation of the True Believers causes them to sell and the sales of the True Believers rob the market of the rocket fuel it needs to go higher.

Because the dominant investor emotion at this time is desperation, the drop down again doesn’t stop at the 12 mark. The prevailing investor emotions of the day cause the downfall to gain momentum that the upswing was not able to accumulate for itself.

As prices drop below a P/E10 of 12, we start to see investor emotions turn into hate, before being transformed into the indifference that applies at even lower price levels.

When the P/E10 level of 12 is touched on the way up from lower levels (rather than on the way down from higher levels) the investor emotions that dominate are emotions of skepticism. Investors are hopeful when we reach a P/E10 level of 12. Things are looking good. But they have heard so many I-Hate-Stocks-And-I-Always-Will-Hate-Stocks stories from True Believers who were burned in the fires of the last bear market that they are not quite able to feel confidence that things are as good as they look.

That helps prices advance further. So long as the dominant investor emotions are emotions of skepticism, there is little possibility of crushed hopes. So long as we do not see crushed hopes, and the stock sales that are a consequence of them, there is nowhere for stock prices to go but up. Skepticism is the most bullish of investor emotions. It’s like when you think she loves you but you are not entirely sure. You feel intensely then, don’t you? You want it to happen and you are beginning to feel some confidence that it just might.

Investor Emotions (Fear and Greed) at a P/E10 Level of 18 — Confidence, Anguish.

A P/E10 value of 18 is the happiest of P/E10 levels on the way up and the most alarming of P/E10 levels on the way down.

On the way up, investors are reassured by seeing a P/E10 level a good bit above the fair-value P/E10 level of 14. The skepticism dissipates. You move in together. But at this point we have not yet reached a stock valuation level at which further upward moves are too problematic. It is the best of all worlds for the stock investor. He is sure that stocks are a good place to put his money. And he is still to a considerable extent right to think that.

On the way down, investors are crushed to see a P/E10 value of 18. It is an ominous sign. It’s the feeling that you have at the top of a hill on a giant roller coaster. Things are chugging along so slow that for the moment it feels as if nothing is happening. You have a sick feeling in your stomach, however, about what you strongly suspect is going to begin happening soon. You haven’t experienced much of a drop yet (unless this is one of those cases where things went stark raving bonkers, as they did in the late 1990s). But you can no longer fool yourself into believing that there isn’t a big drop in your short-term future.

If investing were a rational endeavor, people would not feel anguish about being at a P/E10 level of 18. That’s a number a good bit above the fair-value number of 14, after all. But look at it from the standpoint of the investor who bought in at 44 (that’s the P/E10 level that applied in January 2000 — the highest valuation on record for the U.S. market). To that investor, a P/E10 level of 18 is an illusion-buster. Ideas that he has employed to comfort himself that valuations might not matter as much this time as they did in the past can no longer be seriously entertained once we have dropped to a P/E10 level of 18.

How It Feels to Lose Money

At this P/E10 level, the lies don’t work anymore. The honeymoon is over and it’s time to go back to working for a living again. That’s not a source of anguish for those of us who have become accustomed to the realities of life in this Valley of Tears. But the investor who has seen a P/E10 level of 44, and who let in the thought that perhaps his stock shares really were worth what the newspapers of the time were saying they were worth, is brought back down to earth with an uncompromising punch to the gut when we get to a P/E10 of 18. Seeing a P/E10 level of 18 on the way down hurts.

Investor Emotions (Fear and Greed) at a P/E10 Level of 24 — Giddiness, Anger

On the way up, a P/E10 level of 24 inspires giddiness. For obvious reasons.

This is the P/E10 level at which people come to believe that stock investing is a perpetual motion machine and an incantation that turns coal into gold and a fountain of youth all rolled into one. Buy-and-hold makes emotional sense at this valuation level. What’s not to buy? What’s not to hold?

It is the investor emotions experienced at this valuation level that cause most middle-class investors to give back on the way down a good portion of the gains they earned on the way up. If investing were a rational pursuit, people would lock in some of their gains when prices got this high. But the investor emotions experienced at this sky-high valuation level are so dreamy that the idea of selling stocks is anathema to the typical investor.

A P/E10 level of 24 is not just profitable. It is downright fun. It confirms for us our sneaky suspicion that we really are smarter than most of our peers and handsomer too. It makes us feel like we are a lot richer than we really are. These are the sorts of investor emotions that we never want to see go away.

In short, the investor emotions experienced at a P/E10 level of 24 are the most dangerous investor emotions of all.

On the downside, the investor emotions experienced at a P/E10 level of 24 are the most dark and negative of investor emotions. Hate. Anger. Fear. Injured pride. That sort of thing.

Prices are too high when we are at this price level for even the least-informed investor to convince himself that there are not dark clouds on the horizon. But the giddy feelings experienced when stocks are being sold at the highest prices at which they ever are sold are so strong that it is just too painful for the typical investor to disentangle himself from his loved one.

“Would you really do anything me for me, dear?”

What the Price Earnings Ratio Tells Us

“Oh, yes, I would do absolutely anything you ask of me.”

“Then do this — hold all of your shares long enough through the ride down so that you experience the feeling of losing most of what you gained during the bull market.”

“Of course, my darling. I know that you are just gifting me with another display of your warm and wonderful sense of humor. I know that nothing bad can ever happen to me now that I’ve met you. But you look so scrumptious when you talk that way that of course it would be impossible for me to say “no” to your tantalizing request. Of course I would do that for you, my jelly crumpet, and more, and with a song in my heart.”

Why do we feel passion? Because we know how hard it is to gain access to good feelings and because we know how easily we can lose access to them.

Why do investors possess the least willingness to hear about the realities of stock investing at just the time when it would do them the greatest financial good to take them into consideration? They already know the realities at some level of consciousness. And they feel an intense anger about them. There’s nothing so aggravating as knowing perfectly well something that you very much do not want to know.

You don’t want to be the one to tell people how stocks really work when stocks are being sold at absurdly high prices. When the P/E10 level is 24, the typical stock investor would rather lose a lot of dollar bills than lose the fine, fine feeling brought on by the continued enjoyment of his illusions.

And the longer we stay at a P/E10 value of 24 or thereabouts, the greater is the pain experienced at the thought of leaving those illusions behind. This is “I Heard It Through the Grapevine” time, and the typical stock investor is just about to lose his mind. The dominant investor emotion at the sky-high valuation levels is anger at anyone or anything that reminds him that love always fades (unless it is rooted in something real) and that loneliness always returns.

Today’s P/E10 level is 27.

A Behavioral Finance Approach to Picking Stocks

It used to be that the most important tool that you needed for picking stocks was a subscription to Value Line. It was by studying the numbers that you gained an edge.

Many question whether it is possible to gain an edge anymore just by studying the numbers, given the widespread access of fund managers to databases that slice and dice the publicly available data in dozens of ways. Does the individual investor need to give up picking stocks?

Picking Stocks Successfully

Not necessarily. Investing is primarily an emotional endeavor and only secondarily a rational one. It remains possible today to gain an edge by developing insights into the behavioral aspects of investing. The fund managers generally have no particular edge on that score.

This article lists eight ways in which an understanding of behavioral finance might help in picking stocks today.

Edge #1 for those picking stocks today — Investors overreact to bad news.

The stock prices of companies that are stigmatized because of lawsuits or public relations fiascos can drop to very low levels. In cases in which the companies involved are not strong enough to overcome the challenge, you don’t want to get involved. In cases in which they are, buying your piece of the stigma can provide a long-term payoff.

Edge #2 for those picking stocks today — Boring companies generate non-boring returns.

Two companies have the same profit-generating potential. One is involved in a sexy business. The other isn’t. Which one has the higher stock price?

Most investors love story stocks. That opens up an edge for those willing to seek out non-story stocks. Boring can be good.

Edge #3 for those picking stocks today — Starting the wild ride at the right spot.

Check out Apple’s price history. It’s a story of wild ups followed by wild downs. Either investors believe that Apple is about to take over the world or they believe it’s about to go under.

It makes no sense at all to invest in a company like this when its price is high. But how about when its price is low? When the price is low, there will be reports that the company may be about to go out of business. And those reports might be right. If they are not, though, the company might be able again to take advantage of the resources that permitted it to rise from the dead before. Buying low gives you a high-risk shot at an attractive return.

Edge #4 for those picking stocks today — Buy up companies that will be buying up companies when prices drop.

Stocks are highly overvalued today (this article was posted in February 2007). That’s not always going to be so. When prices fall, the economy will likely stall and many companies will be desperate for capital. Companies that are heavily in debt will be vulnerable to buyouts.

Berkshire-Hathaway has lots of cash available to take advantage of such opportunities when they open up. So does Microsoft. These are the sorts of companies that might benefit from developments that will cause trouble for lots of others.

Edge #5 for those picking stocks today — Dividend-payers are straight shooters.

How to Pick Good Stocks

Investors who disdain dividends often argue that it is better for the company to be using the funds to fuel quicker growth than to be distributing them to shareholders. In theory, dividend-payers should grow more slowly than non-dividend-payers. In reality, it often works out just the opposite. Dividend-payers often grow faster.

How come? For the same reason that those who give to charity often live full lives themselves too. Giving is a sign of strength. Many companies that pay good dividends do so because they can afford to pay good dividends; they are strong companies.

The dividend that a company pays is not just a number. It is a behavioral sign of the strength of the corporate enterprise.

Edge #6 for those picking stocks today — Integrity matters.

Warren Buffett would never put his money down on a stock without knowing all the numbers inside and out. But he argues that the numbers are not the most important thing you need to know about a company. The most important thing you need to know about is the management. The most important thing you need to know about the management is its reputation for integrity.

It’s sometimes hard with large companies to gain a sense of what sort of people it is who are driving the business. When you can, it’s the sort of information that can provide a profit-generating edge. You need to be capable of patience. It’s not an edge that always pays off immediately. But integrity usually makes a big difference in the long run.

Edge #7 for those picking stocks today — Companies need to practice buy-and-hold too.

They tell us individual investors that we need to “buy and hold.” Why is that so important? It’s because it takes time for investing strategies to pay off. If you jump from this to that and then to the other thing, you never get anyplace good.

Companies too should stick to their strategies. Before looking at what the company is saying about itself today, check what it was saying about itself five years ago. If the message has changed in a way that is not part of a natural growth process, I would step away. If the company seems to be advancing in pursuit of a long-term vision, it might be that you have an opportunity to tap into the benefits of that vision just before it begins paying off.

Practical Side of Behavioral Finance

Anyone can say that they are pursuing a vision. You need to see a demonstrated commitment over a significant amount of time before putting money down behind an idea. If a company has shown that it cannot stick to a vision through a number of struggles, you as an investor should not want to be involved. It’s often worth taking a chance on those who have demonstrated the courage of their convictions.

Edge #8 for those picking stocks today — You’ve got to stand for something.

When I was hiring, I didn’t look only at the skills possessed by candidates I was considering. I looked for a story in their resumes. What was it they were trying to accomplish in their careers? How did they bounce back from frustrations? How creative were they in overcoming obstacles? Was there a logic to their career paths, or were they jumping from one ill-considered notion of how to move ahead to another?

Some companies are a mishmash of ideas that made sense once upon a time. I like a company with a strong identity. I like a company that stands for something. Companies (and employees) that stand for something don’t always succeed. Even when they don’t, you usually learn something from being involved with them.

Why Is Today’s Stock Investing Advice So Poor?

Much of today’s stock investing advice can fairly be described as less than top-rate stuff. Stocks are good, we are told. After “buy” comes “hold,” they say. Don’t worry about losses, things are sure to work out in the long run, according to the conventional wisdom. As Neil Young once observed in song: “Everybody knows this is nowhere.”

What’s gone wrong?

Explanation #1 for why today’s stock investing advice is so poor is that it’s a logical impossibility that most investing recommendations could be top-rate at a time when valuations are what they are today.

Censorship of Investing Views

We live in highly unusual times. There have been only three times in the history of the U.S. stock market in which stock prices have reached the level of overvaluation that applies today (this article was written in October 2006, with the P/E10 level at 27). My guess is that most investing advice was poor in those earlier trips to la-la land as well. If you think it over a bit, I think you will see that it hardly could have been otherwise.

If most of the investing advice put forward at a time of extremely high valuations was solid, it would recommend that investors lower their stock allocations to protect at least a portion of their life savings from the price drops to come. If most investors followed that advice, it would bring prices down to more reasonable levels. Good advice about overvaluation, if it becomes popular enough, solves the overvaluation problem!

Times at which we hit a P/E10 level of 28 are times when investors’ emotions overrule investors’ ability to follow reasonable strategies. What sort of investing advice becomes popular at such times? Unreasonable investing advice. The kind that flatters investors into thinking that their experience with overvaluation might prove to be the exception that proves the rule. The kind that dominates most newspapers and television programs and web sites today.

To some extent, we get the investing advice we deserve. When we are responsive to good investing advice, we get more of it. When we insist on investing advice that allows us to remain in the fantasy worlds we have created for ourselves, we get more of that sort of thing.

The poor investing advice of today is to a large extent just a product of the runaway Bull Market (the Bull may be on his way to leaving the scene of the crime, but he does not appear to be in too great of a hurry to do so). My guess is that we will see a marked improvement in the quality of much of the investing advice available to us when prices enter an extended downturn.

Explanation #2 for why today’s stock investing advice is so poor is that most of the popular strategies were not developed with the needs of the middle-class worker primarily in mind.

It’s a rare middle-class worker who can afford to ignore investing issues for his or her entire life. For most of us, corporate pensions and Social Security are not going to provide what we need for retirement. So we all need to save and we all need to invest. There’s a pressing need for good investing advice today.

My guess is that good investing advice will in time be put forward to meet that need. The reality that we need to keep in mind when trying to understand the poor quality of much of today’s investing advice is that the need for all middle-class investors to learn about investing is a reality that came into play only in recent decades.

For most of humankind’s history, the majority of workers had to work until they were too weak or sick not to do so. Retirement has been a viable option for the majority for only 60 to 70 years.

For part of that time, corporate pensions provided much of the funding needed for those employees in circumstances fortunate enough to permit retirement. Social Security was in better shape in earlier years too. It is only in recent decades that the pressure has been put on the middle-class worker to invest his or her money effectively to finance his or her retirement.

Good investment advice will come along to meet that pressing need. It should not surprise us too much if it takes a little bit of time for this to happen, however.

I don’t believe that most of today’s investing advice was developed with the needs of the middle-class worker primarily in mind. Many of the ideas that drive today’s advice are holdovers from an era where the needs of higher-income workers were paramount.

Today's Investing Advice

The good news is that there are already signs that things are beginning to change for the better.

Explanation #3 for why today’s stock investing advice is so poor is that reporters need sources.

I used to work as a reporter under daily deadline pressure. Do you know what your primary concern is on waking up each morning when you know that you need to produce at least one news article by the end of the day? It’s getting your calls returned. A lot of the words that you use to fill up your articles are brought in through the telephone line. If your calls are not returned quickly, your editor is required by law to take out a gun and shoot you (that’s why it’s called a “deadline,” you know).

There are lots of people who make a living selling stocks. Those people know that helping out reporters on deadline pressure helps sell stocks. These people are motivated to paint stocks in a positive way and so naturally they do so. Those with different perspectives on how to invest generally are not able to devote as much time and energy to getting their message heard.

Explanation #4 for why today’s stock investing advice is so poor is that many of the sources of investing insights are compromised by their connections to the stock-selling industry.

Even people who are not directly involved in the business of selling stocks often do better for themselves by saying things that slant things in favor of stocks.

I have a lot of my money in IBonds paying 3.5 percent real. I bless the day that I made that investment.

It wasn’t the easiest investment in the world to acquire. When I went to a bank to purchase the IBonds, there were no pretty brochures on the table pointing out the benefits of IBonds. When I said that I had come to buy IBonds, no one rushed forward to shake my hand like they were my long-lost cousin. It was a different experience than the experience you are likely to have if you show up somewhere where stocks are sold and say that you want to buy stocks.

I don’t know any of the details, but my guess is that there is not much of a commission earned by the people who sell IBonds. IBonds are bought, not sold.

That affects people’s thinking on them. Advertising works. The good points of stocks are repeated to the point at which we are exhausted from hearing the message and are inclined to buy some stocks just to make the broken record stop repeating itself. You only hear about the good points of IBonds from developing a desire to learn about the good points of IBonds. IBonds are the naturally shy investment class.

When I use the word “compromised” above, I don’t mean that the people providing today’s investing advice are unethical. I mean that, like most humans, they generally do what it is easiest to do. It takes a lot more effort to buy IBonds than it does to buy stocks, and it takes a lot more effort to sell IBonds than it does to sell stocks. People tend to put forward advice on things they are comfortable talking about, and most people are more comfortable talking about stocks than they are talking about IBonds.

It’s in that sense that much of the investing advice you hear today is slanted in favor of stocks. There’s a huge industry set up to make the selling of stocks proceed smoothly. There is no such industry in place for the selling of IBonds or TIPS (Treasury Inflation-Protected Securities). It’s harder to sell or to buy these alternative asset classes. What is hard to do is not done so often as what is easy to do.

Explanation #5 for why today’s stock investing advice is so poor is that the investing field is perfectly designed for the proliferation of spin.

Investing Experts Suffer from Cognitive Dissonance

A “spin” statement is a statement that lives halfway between the world of the truth and the world of the lie. Spin is not false. Spin is usually plausible and in many cases even partly true. Spin is not the complete truth.

Spin thrives in discussions of investing. There are two reasons: (1) investing discussions usually involve lots of numbers; and (2) few possess a strong understanding of where the numbers are coming from. Numbers are often included in investing advice to make the advice sound more convincing than it would sound if the focus were on the logic of the statement being made. The reality is that our understanding of the numbers relating to investing is generally so weak that the numbers can be used to “prove” just about any point imaginable.

What 10-year annualized return are you likely to obtain on your purchase of shares of the S&P index? A numbers-oriented case can be made for just about any number you care to pull out of the air.

A case can be made for 12 percent. That’s the real return stock investors received during the recent bull market. Those returns are freshest in people’s minds. To many, those are the returns that count most.

A case can be made for 10 percent. That’s the nominal return that applies over the history of the U.S. stock market.

A case can be made for 7 percent. That’s the real return that applies over the history of the U.S. stock market.

A case can be made for 4 percent. That’s the real-return number you get if you adjust for valuations to determine the number that applies on a going-forward basis (long-term returns always drop dramatically in the wake of a wild bull market) and assume that valuations will remain at today’s levels indefinitely.

A case can be made for 1 percent. That’s the real-return number you get if you adjust for valuations and assume that valuations will drop in the manner in which they have dropped in the wake of prior big bull markets.

A case can be made for a negative 5 percent. That’s the number you get if you assume a worst-case scenario (it’s the 10-year annualized real return for the S&P that has only a 5 percent chance of turning up but which cannot be entirely ruled out).

Tell me what return you want to believe you will see from making a stock investment, and I can make a spin-driven case for the number you want to hear. Not all of these numbers are equally likely. But most of us don’t know what we need to know to predict long-term stock returns effectively. Until we get up to speed, spin will continue to dominate the investing advice we hear.

Explanation #6 for why today’s stock investing advice is so poor is that 80 percent of the advice is aimed at serving 20 percent of the need.

Much investing advice is provided free, but with the hope that some sort of transaction will take place that will generate a financial benefit for someone. That’s one of the reasons why much more effort is put into developing advice on advanced investing questions than is put into developing advice on the fundamentals.

Failed Invesing Theories

What most of us need is a sure understanding of the basics. There aren’t too many people who profit from developing clear and effective advice on the basics. Much of the advice you hear on the basics of investing is stuff that the people offering the advice just pulled from some other source without giving much thought to it.

Explanation #7 for why today’s stock investing advice is so poor is that many investing experts don’t relate well to their readership.

Here are some words from the preface to The Four Pillars of Investing, by William Bernstein, in a description of the flaws of his first book, The Intelligent Asset Allocator: “My aim had been to explain Modern Portfolio Theory, a powerful way of understanding investing, to the general public. What I instead produced was a work comprehensible only to those with a considerable level of mathematical training and skill.”

Bill is one of the good guys. The words above show that he is trying. The reality, though, is that most of us don’t need another explanation of Modern Portfolio Theory. I don’t say that there is no place for that sort of thing. There is. But there is too much of that stuff being put forward today. What those of us in the investing-advice field need to do is to avoid the temptation to offer yet still more descriptions of Modern Portfolio Theory.

I’ve reached a point in my own understanding of these issues at which it irritates me just to write or speak the phrase “Modern Portfolio Theory.” I don’t applaud it as “a powerful way to see investing” (there are ways in which Bernstein’s claim is correct, to be sure). I see it as a dead end. I see it as something worse than that. I see Modern Portfolio Theory as something that has caused middle-class investors to become alienated from their own common-sense understanding of how stock investing works.

This isn’t the place to go into the theoretical failings of Modern Portfolio Theory. The point for purposes of this article is that using Modern Portfolio Theory as the root theory in the development of investing advice turns people off.

If people get turned off by your investing advice, they don’t listen to it. They often do something even worse. They ignore the boring reasoning process and take away just the bottom-line recommendations. That means that people end up doing things without understanding why they are doing them. Not good.

Bernstein is bummed because his readers don’t want to look at his fancy equations. Maybe it’s his readers who have more sense. Maybe his readers get it that learning how to invest shouldn’t be so darn complicated. Maybe his readers think that that sort of thing is okay for people in the business but that the ordinary middle-class investor shouldn’t have to be struggling to come to terms with too many equations to figure out how to finance his or her retirement. I mean, for heaven’s sake!

Investing Recommendations

There’s a place for equations. I call the www.Early-Retirement-Planning-Insights.com site the most valuable site on Planet Internet, and that place has equations that walk up to you when you enter the room and ask you if they can have the next dance. The point is — there comes a time when you need to formulate the investing advice that follows from use of the equations into something that the average middle-class investor can understand. John Walter Russell does that at a number of articles at his site.

William Bernstein does it too at times. I’m not saying different. I see a difference between Russell’s work and Bernstein’s work, though. Russell’s work is rooted in common sense; the equations are used to identify the specifics that cannot be grasped through the use of common sense alone. Much of Bernstein’s work starts from the equations. Much of it is equation-centric.

That’s why he struggles to communicate his stock investing advice in a way that the average middle-class investor can understand. When you are dealing with Modern Portfolio Theory Brand investing advice, this cannot be done. With Modern Portfolio Theory, equations are often employed as a means to hide from reality, not as a means to learn about reality. Much of today’s investing advice has its roots in an artificial and excessively academic theoretical construct, and it shows when those trying to use it to supply investing advice aim to communicate their message to real live humans.

Since I’m banging on Bill Bernstein a wee bit here, I think it’s only fair that I send you over to his site (after you finish the article here, if you please!) for a little of that Modern Portfolio Theory Brand of stock investing advice.

Explanation #8 for why today’s stock investing advice is so poor is that there is a pronounced unwillingness in this field to integrate new information into the dominant theoretical framework.

It’s not just that the Modern Portfolio Theory jizz-jazz is in many ways wrong-headed. It’s also that the Modern Portfolio Theory is a jealous mistress. So long as this flawed theory remains the dominant theory, alternate theories that better explain how investing works in the real world are not able to gain a footing.

Robert Shiller wrote an important book a few years back. It’s entitled Irrational Exuberance. The book put forward startling claims. It advanced a fresh and more realistic way of looking at the question of how to invest successfully for the long run. The book obtained good reviews. Lots of them. It was a best-seller. All of this is good. The thing that is most striking about the reception given that book, though, is the thing that didn’t happen as a consequence of its publication.

Very few investing advisors changed their investing advice as a result of what Shiller said in his book.

Shiller showed that the now-dominant paradigm (I call it “The Stocks-for-the-Long-Run Investing Paradigm”) is dangerously flawed. He made a compelling case. He provided footnotes and all that sort of thing. He gave speeches where he responded effectively to questioning. He showed that the likely effect of failure to heed his message is going to be a crushing wipeout of middle-class wealth in days to come.

And pretty much everybody in the investing-advice field carried on with business as usual. Outside of a few berzerkos like yours truly, it was as if Shiller had never bothered to make his case.

That’s a bad sign.

The Future of Investing Advice

A healthy investing paradigm deals with a challenge like the one put forward by Shiller by integrating the new information into a revised version of the core theory. That’s how theories grow and develop and come to bear new fruit. The Modern Portfolio Theory monster deals with challenges by looking the other way. It ignores challenges.

That’s not a sign of a strong paradigm. That’s a sign of a paradigm about to be sent to The Great Beyond. A paradigm that has lost its ability to adapt to the ever-changing world is a paradigm that is about to go the way of the dinosaur.

We are living in the twilight years of the Modern Portfolio Theory, in this boy’s opinion. Good riddance too, by the way. I’m sick of all those equations that circle around and around and around and never get anyplace truly interesting. I’d like to see people like William Bernstein applying their intelligence and energies to the explication of paradigms with greater long-term potential to inform and reward us.

Explanation #9 for why today’s stock investing advice is so poor is that humans have a natural inclination to focus on the short-term.

God created us in such a way that we focus on the short-term when making money decisions. The big problem with the conventional saving model is that it ignores this reality; telling a 25-year-old to save to prepare for his age-65 retirement is a cruel joke. The same problem applies in the investing context. We hear all this stuff about buy-and-hold and the reality is that most investors who purport to be buy-and-hold investors are focused on what has happened in the past five years and what they believe is going to happen in the next five.

I see this on discussion boards all the time. Someone will point to the historical stock-return data to argue that going with a high stock allocation when valuations are where they are today is risky business and the answer will come back: “I had a return of 9 percent over the past four years, buddy, how have you been doing lately with all of those sissy non-stock investment classes you like to tout here?”

People are focused on the short-term. It’s a reality that investing advisors ignore at the peril of those who place confidence in their advice. The buy-and-hold advice you hear so often is good advice in a general sense. It is also extremely unrealistic as a result of its failure to address implementation questions in an effective way. There is little effort made by today’s investing advisors to prepare middle-class investors for what they are going to need to be able to live through if they maintain high stock allocations at times of extremely high valuations. Many of today’s investors don’t even appreciate that today’s valuations are extremely high!

Buy-and-hold will survive, I believe. But to survive it must change. I am looking for a Realistic Buy-and-Hold Investing Paradigm to replace the now-discredited Stocks-for-the-Long-Run Investing Paradigm. The new paradigm will focus on providing investing advice that permits middle-class investors to carry out buy-and-hold strategies in the real world. Tomorrow’s investors will aim not only to talk the buy-and-hold talk, but also to walk the buy-and-hold walk.

Explanation #10 for why today’s stock investing advice is so poor is that humans are inclined to place more confidence in success stories than in analyses of the historical stock-return data.

Where Are Stocks Headed?

People are drawn to success stories. They eat them up.

That’s probably a good thing in many circumstances. There’s a lot to be learned from hearing success stories.

Success stories carry dangerous messages to those seeking to learn how to invest successfully, however.

Who is the most successful in a wild bull market? The least prudent of all investors, the investor who throws caution to the winds.

Who is going to get burned the worst in the wild bear market that follows the wild bull market? The guy at the center of the success story of the earlier day.

One of the reasons why today’s investing advice is so poor is that we are drawn to believe in strategies that work for a time for all the wrong reasons. We are served poor investing advice for the same reason we are served fattening foods in fast-food restaurants. Offered a choice, that’s the stuff we grab for first.

Explanation #11 for why today’s stock investing advice is so poor is that those using common sense are often intimidated by those who have a wrong-headed understanding of what the numbers say.

I was at a party and I got to talking about a woman there about investing. I told her about what the historical stock-return data says about going with a high stock allocation at times like this and her mouth was hanging open. It was clear to me when we parted that she planned to have a talk with her husband about their investing plan.

Later, I saw the husband. He made a joke. He was perfectly nice. My sense, though, is that he was a bit annoyed about the thoughts that I had put into his wife’s head. My guess is that he defended their current strategy to her by pointing to the sorts of numbers arguments you see in the book Stocks for the Long Run. Those arguments often come across as strong ones to those who have not examined the numbers in an in-depth way.

I see this phenomenon play out over and over again on discussion boards. There are many people who have doubts about today’s investing advice. When I bring up the flaws, these people express interest and ask questions. But once some big shot know-it-all put up a series of abusive posts insulting anyone who asks questions about the conventional bull-market wisdom, the ones with an interest in exploring new ideas get quiet.

There are many middle-class investors out there today who sense that there is a lot wrong with today’s investing advice but who don’t understand the flaws well enough to challenge loudmouths who are highly defensive about the strategies they follow. The 10 percent or 20 percent who are loudmouth know-it-alls are able to intimidate into silence the 80 percent or 90 percent who possess a sincere desire to learn about investing. I think that phenomenon plays out outside of Discussion-Board World all the time.

We don’t get the stock investing advice we should because we don’t insist on it. We are sufficiently intimidated by the short-term successes of the conventional strategies to feel uncomfortable asking hard questions about them, especially if others react defensively when questions are put forward (and they often do, both in Discussion-Board World and in that giant-sized discussion board community we call “The Real World” too).

Explanation #12 for why today’s stock investing advice is so poor is that humans find comfort in going with the crowd.

We all possess a strong need to be liked and to be popular.

Stock Bias

That hurts us when it comes to investing. When stocks are unpopular, they are an amazing buy. When stocks are extremely popular, they are a dubious buy.

When stocks are a dubious buy, most people own more stocks than they should and are defensive about it. Point out the flaws in their strategies and you are likely not going to rise to first place on their Christmas card lists.

I have come to believe that one of the most important qualifications for an investing advisor is a good sense of humor. Why? Because an investing advisor who aspires to tell it straight has to often tell us things we don’t want to hear. The best way that humans have come up with for doing that effectively is through humor.

Most of today’s investing advisors aren’t up for a guest appearance on Seinfeld. That’s another reason why today’s investing advice is so poor.

Explanation #13 for why today’s stock investing advice is so poor is that we put too much trust in experts.

One of the most illuminating discussion-board posts that I have ever read was written by a woman named “Janey” and posted to the Vanguard Diehards board. Janey said that she thought that the things I was saying sounded reasonable enough. She also said that she didn’t have available to her the time it would take to check out my ideas. So she felt obligated to go with the ideas of the experts she trusted the most, experts who put forward viewpoints very different than mine.

That’s the real story. That’s the way humans really make decisions.

People generally do not analyze the arguments put forward by experts. What they do is look for signs as to whether they can trust the expert or not. If he says three things that strike them as being particularly sensible, they come to trust him. Then they go by his say-so on all sorts of issues.

It’s generally a reasonable way to proceed. We don’t understand what the electrician is doing when he fixes the wires in our house. We check to make sure he is competent and we check to make sure that he is ethical, and then we leave the rest to him. That’s what most people do when listening to investing advice too.

It’s not a procedure that works well in the investing context. When stock prices fall, you will experience the panic that follows in a personal way. The only way that you can come to possess the level of confidence you need to have to maintain a buy-and-hold strategy in such circumstances is to understand the whys of each of your investing strategies.

If we demanded that our stock investing advisors explain their recommendations until we fully understood them, we would get better investing advice. We often don’t for reasons that make sense in other areas of life endeavor but not in the investing context.

Explanation #14 for why today’s stock investing advice is so poor is that dumbing it down is often seen to be the only alternative to the Bernstein approach of putting forward too many boring equations.

“Investing for Dummies” is all the rage.

It’s a reaction to the sort of investing advice that is offered by someone like William Bernstein, investing advice with lots of equations weighing it down.

Mumbo Jumbo Investing Advice

The problem with most dumbing-it-down approaches is that they take the juice out of the topic. It is good for investing advice to be simple and clear and understandable and rooted in common sense. It is not good for investing advice to be simplistic. Some complexities are necessary to tell the story true. Some complexities are what give the story its color and depth and mystery and drama.

Our beef with complex investing advice is that it is boring. Simple investing advice can be boring too. We should seek exciting investing advice. Investing advice should challenge us enough to hold our interest. What is boring about the Modern Portfolio Theory Brand of investing advice is that it is artificially complex. Complications that are rooted in something real pull us in rather than repel us.

Explanation #15 for why today’s stock investing advice is so poor is that bottom-line thinking has become too popular.

The most frequent complaint that I get about my posts and articles is that they are too long. I don’t make a special effort to make them long. I do try to explain things in a step-by-step fashion. That sometimes causes my explanations to be longer than explanations that skip steps.

Many middle-class investors of today just want to hear bottom-line recommendations. They don’t want to know how the investing advisor reached his conclusions, just what conclusions he reached.

The problem with this is that each investing circumstance is so different that there is a danger in putting bottom-line statements of strategic advice to work in circumstances in which they don’t make sense. It is only by understanding the rationale behind a strategy that you can know whether there is a need to modify it in a particular circumstance.

There is no one who knows everything about how to invest. Those who try to make it appear that they do are dangerous people. I believe that the best way to learn about investing is to engage in back-and-forth discussions about it. Investing is more an art than a science. You don’t want to learn what is written on the answer page. You want to develop a feel for how to deal with situations that were not fully anticipated at the time the advice was put forward.

My hope is that this site will serve as a Learning Together resource rather than as a place for Rob to stand up on a box and shout his opinions at unfortunate passers-by. I hope to in time be able to incorporate features that permit more back and forth. Even today, many of the ideas discussed in articles at this site are the product of discussion-board interaction. You get my take on things at this site. But my take is a take informed by a good bit of interaction with a good number of other aspiring early retirees.

From time to time I will write articles summing up our bottom-line findings. But I view it as important that our community members understand the process by which we reached those findings as well as the findings themselves. Those seeking early financial freedom need to be willing to work it a bit harder than those content with financing an age-65 retirement.

Explanation #16 for why today’s stock investing advice is so poor is that we really don’t know all that much about the subject.

Bad Investing Advice

People have been investing for a long time. You would think we would know all about the subject. The reality is that it is shocking how little we know.

Behavioral finance is a growing field. Those studying behavioral finance aim to discover how humans interact with their investments to yield either good or bad results. That’s important and elementary stuff. You would think that people would have been studying it all along. The reality is that many ignore the behavioral aspects of the investing project even to this day.

I like indexing. i like it because it’s simple. I don’t take the purist stand that some indexers take, that indexing is superior to all other approaches. I think that it is dumb to become so dogmatic about an investing approach.

What kills me is that people can be dogmatic about an investing approach that has only been around for about 30 years. Indexing has never even been tested in a secular bear market! People make claims for indexing that are absurd given how new an investing approach it is.

What’s true of indexing is true of all sorts of approaches. We know some things for sure. We think we know some other things. And then there are a whole big bunch of things for which all that we have are clues pointing in one direction or another.

Today’s stock investing advice is not so hot because the state of humankind’s knowledge re the subject is just not yet all that well-developed. The dogmatics (I often call them “True Believers”) need to take a pill.

Explanation #17 for why today’s stock investing advice is so poor is that people lack a sure understanding of the fundamentals.

This is the most important thing of all. If you possess a clear understanding of the fundamentals, you will end up okay even if there are holes in your understanding of a lot of the detailed stuff. It doesn’t work the other way around.

If you understand the fundamentals, you will be able to quickly see the errors in most of today’s investing advice when they are pointed out to you. If you don’t, you can be taken in by dangerous claims that may sound good for a time but that will not stand the test of time.

About 20 percent of today’s investing advice focuses on the fundamentals and about 80 percent focuses on the more advanced coursework. I look forward to the day when it is the other way around.

Review the fundamentals and then review the fundamentals some more and then review the fundamentals some more and then review the fundamentals some more. That’s how you become a successful long-term investor. That’s how you attain financial freedom early in life. That’s how you break free of the need for a paycheck to cover your costs of living and become able to spend the hours of your remaining days engaged in work you truly love.

Whew! I did it again. I started out with good intentions. I said to myself: “I’m going to keep this one short, no matter what.” It never turns out that way, does it?

I’m bad right down to the bone. That’s the thing.

The Future of Behavioral Finance

The madman has lost everything except his reason.

–C.K. Chesterton

Behavioral Finance

The Efficient Market Theory is a lie (that humans do not possess emotions) that generated many other lies (the claim that the safe withdrawal rate is a constant number is only the most dangerous of a large number of such little stinkies that have come to our attention during the discussions of the past six years) during its years of influence. We have called out The Big Lie and few have been willing to put forward much of an effort to defend it in reasoned debate; I think it would be fair to say that those few who have been willing to give it a shot have been less than successful. It’s all over but for the shouting. A model for understanding how stock investing works that cannot be defended by those who follow it is a model of how stock investing works that is headed to the trashbin of history. The future belongs to the Behavioral Finance School.

But not the Behavioral Finance School as it now exists. As Behavioral Finance becomes the dominant model for understanding how stock investing works, the outlaw will become the sheriff. Proponents of the Behavioral Finance School will become more confident, more expansive, more assertive.

Proponents of the Behavioral Finance Model Have Been Insufficiently Aggressive in Challenging the Efficient Market Model.

It is not politeness for proponents of the Behavioral Finance School to pretend that the Efficient Market Theory is sorta kinda okay until something better comes along. It is cowardice. The Efficient Market Theory is a failed model. Failed investing models hurt people by encouraging people to invest in ineffective ways. The failed model needs to be taken out to the garbage dump before it stinks up the place even worse than it has already.

I have seen tens of thousands of abuse posts put forward by investors who are trying to maintain their confidence in the Efficient Market Theory. I do not recall seeing the first one by any investor who belongs to the Behavioral Finance School. That contrast is amazing and revealing and ominous. It’s indicative of the problems that realistic investors face today (this article was posted in December 2007). There is no intellectual case that can be made for the Efficient Market Theory. However, it has been poisoning the atmosphere for so long now that it is hard to convince people that it is not really a necessary part of our oxygen supply. There are many investors who long for discussion of more realistic investing strategies but who lack the courage to hope for a day when people can talk about how stocks work reasonably and honestly and plainly and frankly. It can be done. The first step is taking out the trash. Get rid of the poisonous fumes and new ideas will rush in to fill the void. I have seen this happen on numerous occasions at our boards.

Behavioral Finance proponents need to stop pussyfooting around. Our model and the Efficient Market Theory model cannot coexist. This is an us-or-them situation. For us to gain influence with large numbers of investors, those peddling the nonsense gibberish that became popular during the longest and strongest bull market in U.S. history need to be shown the door.

It sounds harsh. I mean for it to sound harsh. When a doctor tells you that he is going to need to cut, that sounds harsh too, does it not? He’s cutting not to hurt you but to heal you. It is by cutting out the cancer that we give the healthy tissue more years of life. The idea of an efficient market is a disease. It is not just that it generates poor investing strategies. It is that it makes the formulation of sound investing strategies impossible, unimaginable even. The Efficient Market Theory tells us that applying thought to the development of investing strategies does not pay, and thereby turns humans into monsters. Man is a thinking being; when we turn off our brains, we transform ourselves into something less than what we were meant to be; we cannot not think and yet remain recognizably human.

 

Behavioral Finance Research

The Efficient Market Theory is not a theory suitable for humans. It is not enough for us to find fault with it or to warn people about it or to engage in negotiated compromises with those who place their trust in it. I’ve seen many try half steps and I have never seen such efforts bear fruit. The discredited model is flawed at its core. We need to dig a big hole, drop it in, and shovel the dirt back on top. Then, like Father Mackenzie, we need to brush the dirt off our hands and walk away. We need to cut out the cancer. We need to make this Frankenstein of an investing theory a part of our history and make regaining what makes us human the top priority for our future.

The future of behavioral finance is to become the top dog. We need to stop apologizing for what we believe. We need to be less tentative, less compromising. Not because we are arrogant. Not because we are mean-spirited. Not because we possess a thirst for power. Because we want to help investors understand how stock investing really works. So long as the Efficient Market Theory walks and talks and struts and frets, it sucks all the oxygen out of the room; a theory that posits that intelligence serves no purpose is a theory that cannot be reasoned with — it is theory that can only be followed (with disastrous consequences once the bull market that gave birth to it comes to an end) or stabbed to death and buried deep in the ground.

We need volunteers to arrange for the printing of bumper stickers –“The Efficient Market Theory Is No Friend of the Middle-Class Investor!”

Behavioral Finance Proponents Do Not Place Sufficient Focus on Instructing Regular People How to Invest.

There is no book on the shelves today that tells us more about how stock investing works in the real world than Robert Shiller’s Irrational Exuberance. The book has one big flaw, however. The book provides little in the way of practical investing pointers. Just about everything that Shiller says is so. But middle-class investors need to know more. They need to know what to do with the insights he imparts.

This hesitancy to address the practical is one manifestation of the general lack of assertiveness of those in the Behavioral Finance School discussed above. Many behavioral finance proponents seem to feel that it is sufficiently bold to point out flaws in the Efficient Market Theory model and that it would be going too far to actually instruct investors as to what to do with their money. After 20 years of wild bull-market thinking, it seems a daring thing to discuss realistic strategies for long-term stock investing.

I know the feeling. It took me a long time to work up the courage to post the headlines for the lead articles at the Risk Evaluator (“Retirement Calculator Smashes Safe Withdrawal Rate Myths”) and Scenario Surfer (“Portfolio Allocation Shocker — Timing Beats Rebalancing!”) sections of the site. But you know what? Giving effective investing advice is the point of the game. If the insights generated by the Behavioral Finance School do not translate into better investing practices, they serve no constructive purpose.

The problem is that it is human nature to focus on the short term. The Efficient Market Theory does not make sense; it is not at all likely to generate good long-term results. Until such time as we see a Big Price Drop, however, we have a hard time accepting that the investing advice that follows from use of this model is as bad as a reasoned analysis tell us it is. It doesn’t make sense, but….but….but — it works, doesn’t it? Yes, for the length of a wild bull market, it works. That doesn’t make it good advice. That’s makes it advice that possesses a capacity to become popular for a time. There’s a difference.

 

Shiller Economics

Those of us in the Behavioral Finance School need to place more courage at the service of our convictions. If we believe that it is important to take human emotions into account, we need to reject out of hand the model that argues that this is not necessary. And we need to say in clear and simple and understandable and blunt terms how we believe people should change their investing strategies as a result of our teachings. We can’t be intimidated by the fact that the Efficient Market Theory approach seemed to work just swell for a certain length of time. People need to know how to invest now and in the future. The Summer of 1999 is over and it’s not coming back anytime real soon.

One of the reasons why many middle-class investors do not today have confidence in the Behavioral Finance School is that those of us in this school too often do not speak with the voice of authority. We speak tentatively, as if we are not yet really sure ourselves that the Efficient Market Theory has been proven a washout. We speak like teenagers asking if we can borrow the car on Saturday night. Are we not men (and women)? Do we not pay our own room and board and buy our own cigarettes and coffee? Are we not old enough to vote and drink and die in foreign wars? If we cannot work up the courage to serve Behavioral Finance straight up and with no chaser, how can we expect our readers to stake their retirement savings on it?

Behavioral Finance Proponents Have Incorporated Elements of Excessive Rationalism Into Their Own Model.

The core flaw of the Efficient Market Theory is its excessive rationalism. By pretending that investors are entirely rational, it has caused a good number of them to become mad-people. The great irony of our experiment with this doomed model is that, by positing that investors are able to avoid the effects of emotion when making investing decisions, the model has created a generation of investors more intensely emotional than any that has come before it. Today’s investor has more tools available to help him make rational decisions. But he disdains the findings of these tools in favor of a dogmatic belief that intelligence provides no help in the investing area because the price of stocks, no matter how nutso, is always in some strange and indefinable sense “just right.”

The Behavioral Finance model is generally viewed as the leading alternative to the Efficient Market Theory model. The reality, though, is that the new school has not kept itself entirely free of the influence of the failed model. There are pockets of excessive rationalism in the Behavioral Finance School too.

Behavioral Finance proponents often use surveys and statistics and scientific experiments to make their points. This is a fine thing to do to a point. I believe that there are times when it is overdone. Investing is an art, not a science. The Efficient Market Theory has shown us what we get when we try too hard to turn it into a science. By letting in the discussion of human emotions, the new school makes a great leap forward. I worry, though, that we still feel this need to dress up our insights in the clothes of science. The temptation is always there to pretend that we are putting forward science when what we really are putting forward is science fiction.

I am not saying that we should not make use of surveys and statistics and scientific experiments. Those things have value. I am saying that we should not force it. There are some points that can be made best through the use of science and there are some points that are just not scientific in nature; it is when we try to force the issue and to prove nonscientific points with the use of scientific trappings that we get into trouble.

The scientific method is a tool. Proponents of the Efficient Market Theory model have misused this tool terribly. Let’s not repeat their mistake. Let’s use science when appropriate and avoid trying to trick people with the use of the trappings of science when we are making points that are simply not properly expressed through use of the scientific method. Nonscientific findings are different from scientific findings; scientific findings are not better or more important or more trustworthy or more powerful, just different.

 

Investor Bias

The madman holds onto his power to reason, Chesterton tells us. Why? Because it’s all he has left as he nears the end of his descent into insanity. When you reach the point of madness, you have lost everything but your reason; that’s why your reason has gone out of control and become twisted. Humans should cherish their ability to reason. They should cherish all the other things that make them human as well. We need to give up the excessively strong preference for the trappings of science that transforms reason into rationalization, the scientific process into dogmatic madness, humans into slogan-quoting monsters.

It’s not enough for us to become humans again. We need to become humans who are proud of our humanity, humans who make no apologies for being such and who do not aspire to someday becoming more-predictably-behaved robots.

Behavioral Finance Needs to Avoid Abstractions and Stress Stories.

I tell stories. I quote song lyrics. I make jokes. In articles on investing!

Have I gone loony? I don’t think so. From my way of seeing things, it is all those who try to give sound investing advice without telling stories or quoting song lyrics or making jokes who are a bit touched. It cannot be done. Investing is an activity engaged in by humans. It scares us. It excites us. It inspires us. It intimidates us. It fools us. It comforts us. God gave us jokes and songs and stories to help us make sense of our troubles and our woes and out excitements and our discoveries. If we don’t make use of the tools God gave us to do the job, we cannot make proper sense of the investing project.

I once wrote a blog entry with the title “The Community Toilet Is Overflowing!” How else to make the point that the shit has piled up so high that we simply must make a commitment to dealing with it or pay a big price in terms of lost self-respect? I once wrote a blog entry with the title “John Bogle Started Out as a Little Boy.” How else to make the point that this august Expert of Experts really does at times get things wrong in a big way and that it’s not fair to him for some to pretend otherwise? I once wrote an article with the title “What’s Faith Got to Do, Got to Do with It?” How else to make the point that buy-and-hold is not the product of a mathematical calculation but of a terrifying leap into the unknown?

The fall of the Efficient Market Theory is not the fall of a single investing strategy. It is the fall of a way of thinking about stocks. It is the fall of a language. It is the fall of a process. We are now free to create a new way of thinking, a new language, a new process. I foresee us turning to a more natural way of thinking, a warmer language, a more fluid process.

What is wrong with the Efficient Market Theory is that it is a pompous and arrogant and rigid and eggheaded and stuck-up way of approaching the investing project. Humans know more appealing ways of being. We have to go outside the bounds of what is considered “normal” in the investing game to find appealing (and effective) ways of thinking, speaking, and proceeding. The tools needed already exist. We just need to let go of any preconceptions that bind us to the tools that have come to fail us so utterly and completely and obviously in recent years.

As Behavioral Finance Comes Into Its Own, It Will Make Use of a Wide Diversity of Disciplines to Formulate Its Insights.

Reason vs. Emotion

Biologists have things to teach us. Engineers have things to teach us. Historians have things to teach us. Astronomers have things to teach us. Journalists have things to teach us. Comedians have things to teach us. Mothers have things to teach us. Nurses have things to teach us. Business executives have things to teach us. Baseball managers have things to teach us. Card sharks have things to teach us.

Let’s look up their phone numbers. Let’s give them a call. Let’s invite them to the party.

We have permitted the demanding nature of one form of learning to block out the ability of many other forms of learning to teach us things we need to know for far too long now.

Behavioral Finance Proponents Should Feel No Shame about Their Fallibility.

The most amazing thing that happened in The Great Safe Withdrawal Rate Debate was the failure of the Big-Name Experts to help us spread the word about our findings that the Old School studies got the numbers wildly wrong and are thus likely to cause millions of busted retirements in days to come. What’s up with that?

My sense is that the “experts” like the certainty that the Efficient Market Theory permits. Writing about investing is a dangerous business. Get something wrong and you can cause your readers a great deal of pain. Cause your readers a great deal of pain, and you could be held financially liable for doing so in this litigious society of ours.

The reality is that there is no way to avoid the uncertainty inherent in advocacy of any investing strategy. I believe that what the “experts” who endorse the Efficient Market Theory are looking for is an approach that permits them plausible certainty. The Old School safe withdrawal rate studies get the number wildly wrong, and will likely cause millions of busted retirements in days to come. Those studies do possess a certain appeal for the people giving the advice, however. Cite the Old School studies as your retirement guidance, and you never need to worry about providing up-to-date information (the Old School studies are rooted in a false assumption that the safe withdrawal rate is a stable number, that the same withdrawal rate is safe at all possible valuation levels). The Efficient Market Theory greatly simplifies things. It does so at the cost of accuracy, and the wild inaccuracies that result cause great harm to investors. To those giving the advice, however, I can see how this false simplicity could be seen as a bit of a plus.

The idea with the Efficient Market Theory is not to state things correctly; it is to state things simply but incorrectly. It is viewed as more important to be clear and simple than it is to be accurate and perhaps a wee bit complex. We see this not only in the retirement advice given under this model. It is so with the advice given on timing the market. We are told that all timing is bad even though the historical stock-return data shows us that long-term timing does indeed work. We are told that rebalancing is a good idea even though making valuation-informed allocation shifts has always provided better long-term results; it would be a more complex task for experts to have to explain which price changes require allocation shifts and which do not. We are told that risk is always rewarded.; in reality, it is rewarded in some circumstances and not in others. We repeatedly see that the reality is just a bit more complex than the make-believe, almost-true story told by Efficient Market Theory proponents.

What drives this obsessive concern with simplicity, a concern so great that many investing experts have been willing to see their readers suffer big financial losses rather than make them aware of the huge flaws in the old investing model? I think it is a fear of being perceived to be wrong that drives this widespread reluctance to talk straight. The negative trait that I see over and over again among today’s investing “experts” is an unwillingness to acknowledge mistakes. They just cannot bring themselves to do it. It’’s been nearly six years since the Retire Early Community identified the analytical errors in the Old School safe withdrawal rate studies and these studies are still cited in articles on retirement to this day!

If we make our investing advisors feel too concerned about what will happen if they get things wrong, we hurt ourselves. They will stop talking straight with us, they will concoct nonsense gibberish simple-but-wildly-inaccurate methodologies like the Old School safe withdrawal rate methodology and we will be stuck holding the bill. We will complain when millions of our retirements go bust, but do you know what the “experts” will say then? Expert A will say “I wasn’t the only one giving wrong numbers, Expert B was too,” and Expert B will point to Expert C and so on and so on.

Effect of Personality Type on Investing Behavior

We need a new class of experts. We need experts who have a little bit of gumption. Most of all, we need experts who care too much about their readers to mislead them in serious ways. The first step to attracting those sorts of people to the field is making clear that there is no longer a cultural imperative that investing “experts” be all-knowing. We should encourage our “experts” to acknowledge mistakes when they learn of them and to benefit from the learning experiences that often follow from admitting having gotten things wrong.

Behavioral Finance Should Make Use of Discussion-Board Conversations to Show the Failings of the Discredited Model and to Look for Clues As to What Works Better.

There was a recent article in Money magazine that insulted middle-class investors in two big ways. The article provided a list of resources and for discussions of investing it recommended the Lindauerheads board. It insulted us by suggesting that nothing said on a discussion board could be trusted. My experience has been very much counter to that suggestion. I have seen insights of great value posted on all sorts of boards; there are many Retire Early community members who possess more investing expertise than the sorts of people frequently cited in Money, in my assessment. The other insult, of course, was the recommendation of the Lindauerheads board. There was no mention that this board was founded and is administered by the group of highly abusive posters who destroyed the Vanguard Diehards board, a board that was once one of the best on Planet Internet.

Discussion boards are an important communications medium of the future. Behavioral Finance proponents need to pay special attention because discussion boards are particularly well-suited to helping us learn about the emotional dimension of the investing project. Discussion boards permit us to see how investors are making use of the strategies explicated in other, more formal, media. The cliché comment that “you can’t trust anything you hear on a discussion board” needs to go. This is an important medium, and we need to begin treating it as such. We need to begin taking discussion boards seriously.

That’s not to say that discussion boards are perfect today, of course. The big problem today is the lack of integrity in the discussions. For the discussions to have integrity, site owners need to enforce the site rules in a reasonable manner. We have seen Motley Fool fail at this. We have seen the Early Retirement Forum fail at this. We have seen Morningstar fail at this. Site owners that open boards incur a responsibility by doing so. Middle-class investors need to begin insisting that they honor those responsibilities.

Boards of integrity will provide us a powerful tool for learning things about how to invest effectively for the long term that was not available to us before.

Behavioral Finance Should Encourage New Ways of Reporting on Financial Developments.

Behavioral Economics

I am appalled when I see a big-name “expert” use P/E1 as his valuation assessment tool. I mean, come on. People who are serious in their study of the effects of valuations have known about the flaws of P/E1 for a long time now. Big-name experts have access to the internet, where explanations of the flaws are easily accessible. Is there some reason why we continue to see the same nonsense put before us over and over and over again?

There is a reason, of course. The reason is that a good number of us like seeing nonsense put before us. As Scott Burns once put it, we are not told the truth about stock investing because the truth “is information most people don’t want to hear.”

Guess what? The experts need to begin telling us the truth whether we want to hear it or not. That’s the job. Investors are humans. That means that we are weak, that we are generally not well-informed, that we are emotional. It is the job of the investing expert to rise above the common human weaknesses and to present things as they are, not as some of his or her readers would like them to be.

It is the straight-talkers who are the true experts, in my view. Behavioral Finance proponents should applaud the straight-talkers and point out the games being played by the double-talkers. The future of behavioral finance lies in reforming a culture in which investing experts know too much and care too little in preference for one in which we combine reason and emotion in a mix that generates investing advice suitable for use by humans and other smart, fun-loving mammals.

 

How Did Common-Sense Investing Become Controversial?

I’ve got troubles so hard, I cannot stand the strain.
I’ve got troubles so hard, I just cannot stand the strain.
Some young lazy slut has charmed away my brains.


–Dylan, “Rollin’ and Tumblin’

Explanation #1 of how common-sense investing became controversial — Experts offering questionable advice won our confidence.

Common-Sense InvestingMiddle-class workers are not naturally inclined to turn over their money without asking questions. We all respect experts. We are all skeptical of expert claims too. Most of us come to place our confidence in experts only after they have proven themselves.

How does an investing “expert” prove himself? By producing good results. In the wild bull of the 80s and 90s, it was the experts who took wildly pro-stock positions that came off looking best. The more irresponsible the advice from a long-term perspective, the better the results it produced for the length of the wild bull. We have come to place our confidence in many of the worst of the available “experts” while coming to doubt the claims of those who are offering advice that stands the best chance of producing good long-term results.

Explanation #2 of how common-sense investing became controversial — Our desire for security backfired because of our lack of numbers skills.

We all desire financial stability. Once we save money, we don’t like the idea of losing it. So we favor investing advice that is backed by scientific-sounding claims.

Investing claims backed by objective evidence really are better than the stuff that is just the product of a bunch of bored guys sitting around in a room shooting the breeze. Unfortunately, most of us don’t possess the numbers skills needed to distinguish real science from pseudo-science. Much of today’s investing advice is backed by pseudo-science, not the real thing.

We demanded science and we got it. What we got is not what we bargained for. Weak claims backed by pseudo-science are more dangerous than weak claims that don’t purport to be anything more than the product of a bunch of bored guys sitting around in a room shooting the breeze. The pseudo-science claims have a greater power to entice us because they sound as though they come from someplace real.

Explanation #3 of how common-sense investing became controversial — Academics took the easy way out.

Making Sense of Investing

Most investors don’t know much about the Efficient Market Theory and don’t care to know more than they do. It even sounds boring, right?

Unfortunately, even boring theories can cost us a lot of money. Just about everything we read about how to invest is influenced by widespread acceptance of the Efficient Market Theory. Common-sense tells us that this theory is wrong. The historical stock-return data confirms what our common sense tells us. The best-informed investing analysts acknowledge that the Efficient Market Theory is a theory that appears to be on the wagon to whatever graveyard it is in which dead academic investing theories are buried. As of today (this article was posted in March 2007), though, this theory still exerts a lot of influence.

When the dust settles, this one will likely have cost middle-class investors more money than any flawed theory ever cooked up by any ivory-tower egghead of the past. There should have been more serious questioning of this one back when it was just gaining steam.

It’s a theory that made it a lot easier to do investing research. Of the factors that affect investing, the emotional factors are the hardest to quantify. This theory does away with them with the flick of an assumption. Nice!

Once the Efficient Market Theory got rolling, there was no stopping it. It just made being an academic doing investing research too darn soft not to have to deal with all that hard-to-figure emotional stuff. Once the theory became fuel for the longest and strongest bull market in U.S. history, it would have taken the power of a locomotive to slow down the rush to do “research” rooted in this theory. It’s mostly Clark Kents who seek tenure-track positions. Robert “Man of Steel” Shiller is very much the exception.

Explanation #4 of how common-sense investing became controversial — Once the bull market illusions became conventional wisdom, the sin of pride caused a lock-in effect.

You’re a self-styled investing “expert.” You create a web site to share your wisdom with the world. Your expertise in the field consists of some ideas you read about in popular investing magazines that you kinda sorta think you understand, which themselves were based on academic studies that the authors of the magazine articles think that they kinda sorta understand, which were in turn based on investing theories that the academics writing the studies think that they kinda sorta understand. You write that stuff up. It works! The people following your fourth-generation musings on how stocks work get rich quick as prices climb and climb and climb.

At Peace with Money

Then stocks stop acting as they are “supposed” to. For seven years, things just sort of drift. You begin to see articles appearing in those investing magazines that you still read from time to time (but not so often anymore — what investing genius has much time available for such distractions from his core goal of spreading the reach of his insights even farther?) suggesting that perhaps there were some flaws to the ideas in which your advice is rooted. Do you own up to the realities? Or do you cover up the realities?

Explanation #5 of how common-sense investing became controversial — Sally Field Syndrome.

You hate me. You really hate me!

I’ve been looking for an opportunity to use that one. It’s a take-off of the Sally Field acceptance speech at the Oscars where she cried out: “You like me. You really like me!”

We all want to be liked. Things reached a point where I had heard so many deceptions about how stocks perform over the long term that I just had to tell it the way it is, popularity be danged. Boy, was it ever danged! I’ve been getting regular doses of “The Treatment” ever since. No charge!

It hurts.

That’s my problem, not yours. Your problem is that lots of folks other than me know that it hurts. So lots of folks other than me have elected to tell the stock investing story not precisely the way they would tell it if their sole concern were helping you to find the best place to invest your money.

I’m not the only one telling it straight, by any stretch. There are lots of others. But guess what? Those guys and gals get little doses of “The Treatment” too. They don’t get invited to the best parties. Schoolyard bullies bounce basketballs off their heads. They don’t get to see their smiling faces on the cover of the Rolling Stone. There’s a certain appeal to telling it like it is. There’s a certain appeal to resisting the urge too.

Taking Charge of Your Money Life

It’s a lonely job being the Cassandra of the Retire Early boards. I suppose that someone’s gotta see that the job gets done right and proper, though, eh?

The point here is — we don’t reward straight-shooters. So we don’t get straight talk.

I don’t mean just in Retire Early World. I mean in that gigantic discussion-board called “Reality World” too.

I only hope that The Little Stinkers don’t figure out a way to ban me from that one!

Explanation #6 of how common-sense investing became controversial — We allowed big shots to intimidate us.

My wife can never ban me. It doesn’t matter how much I mess up. We’re Catholic. So that’s that.

Given that she can’t turn the page or hit the “Back” button, I sometimes run my investing stuff past her, just to see. She doesn’t have a problem with the bottom line. She worked as hard as I did to accumulate the financial freedom stash we have and she doesn’t like the idea of seeing large chunks of it go “bye-bye” anymore than I do. I don’t get the sense that this topic puts her on the edge of her seat, however. I don’t get the feeling that she would mind terribly much if I wrote about something else every now and again.

I’ve received e-mails from readers that give me the same sort of feeling. There was one not too long ago, for example, that said something to the effect of: “Listen up, lunkhead! Everybody loves your saving stuff and everybody wants to kill you for writing the investing stuff you do. If you want your site to succeed, you’ll be writing more on saving and less on investing. Hello? Hello? Is anybody home?”

With the Goons, it’s personal. They do not like the idea of acknowledging the possibility that there ever was a time in their lives when they were wrong about something. With the Normals, it’s obviously not personal. Even with the Normals, however, there is not a great deal of excitement about the idea of coming to a better understanding of how to invest for the long term. The Normals are okay with it, they even see it as a good thing in small doses. There aren’t too many who are intense about it. There aren’t too many who are willing to knock down walls to learn about investing (as the Goons are willing to knock down walls to block others from learning about investing).

The Normals think investing is boring. It really isn’t. It’s like so many other things. It seems boring until you learn enough about it to see that it really is exciting. Playing the guitar is boring until you learn how to play a few chords.

Talking Over Economic CrisisGoons (and, remember, it’s not only on discussion boards that goonishness evidences itself — there are lots of big-name experts who have engaged in word games and other forms of petty goonishness from time to time) make investing look boring. They use big words because they haven’t thought things through carefully enough to be able to tell the story in a clear and direct way. They turn to equations to protect themselves from having to deal with the more complicated realities that cannot be reduced to numbers and plus signs and minus signs. They take a topic full of human drama and reduce it to a string of nonsense gibberish catch phrases. Stay the Course! Remain Flexible! Stocks Always Go Up in the Long Run! No One Can Predict the Future! The Historical Data Shows That Short-Term Timing Doesn’t Work! What the Historical Data Shows About Long-Term Timing Doesn’t Matter!

Simple is good. Simpleminded is not good. Much of today’s investing advice is not the good kind of simple that means that it is easy to understand. Much of today’s investing advice is simpleminded.

The primary blame goes to the “experts.” But we play a part in this drama. We don’t insist on better. Our willingness to settle for second-rate efforts from investing experts hurts us financially.

Explanation #7 of how common-sense investing became controversial — We have short memories.

I reread Robert Shiller’s Irrational Exuberance not too long ago. It blew me away when he talked about how there was a version of the Efficient Market Disease — I mean, Theory! — going around in the late 1920s, just before The Great Crash. It’s like a bad guy in a bad horror movie. The good guys keeps killing him and yet he keeps coming back.

We’re falling for the same tricks this time that we fell for in the late 1920s and in the mid-1960s. Most of us weren’t around in those days, of course, so the song sounds new to our ears.

If we’re going to become long-term investors, we need to adopt a long-term perspective. If we’re going to become long-term investors, we need to stop citing results from the last five years as “proof” of the merit of whatever strategy it is that we are infatuated with at the moment. If we are going to become long-term investors, we need to stop getting caught up in the emotions of the bull or the emotions of the bear.

Bulls don’t live forever. Bears don’t live forever. It’s only Dolphins that live forever.

We do live forever, don’t we?

Middle-class investors need to grow up. I don’t mean that to sound harsh for the sake of sounding harsh. I mean to make a serious point.

Explanation #8 of how common-sense investing became controversial — We’re greedy.

You’re greedy.
Hope for the FutureYou’re my reader. I love you dearly. I have zero desire to insult you.

Still, if you want to win financial freedom early in life, you need to learn to take the realities straight up, with no chaser. You’re human, right? Then you’re greedy. That’s the way it is.

You don’t have to give in to your greed. You don’t need to let it ruin you.

You must deal with it. If you don’t deal with it, it will ruin you.

Lots of investing advisors don’t want to mention that you are greedy because they are afraid that you will turn the page or hit the “Back” button or whatever. You can do that. It won’t change things.

I’ve had people hitting the “Back” button on me for close to five years now. I’m still talking about the realities. The realities matter.

Those who possess a sincere desire to win financial freedom early in life enjoy working through the realities. They enjoy it for the fun they experience doing it. And they enjoy it for the financial rewards that follow from it. All of us show up here to work through this stuff together. It’s what we’re all about.

We are greedy. We are warm. We make mistakes. We achieve breakthroughs. We love money. We don’t love only money.

An expert who lacks the courage to tell you that you are greedy lacks one of the most important “credentials” needed to help you learn what it takes to invest successfully for the long term. There are too many out there today who are choosing to downplay this important reality.

Explanation #9 of how common-sense investing became controversial — We process information emotionally.

There’s a reason why I don’t like to be characterized as a “bear.” There are all sorts of negative associations that come to the mind of a middle-class investor when he or she hears the word “bear.” Bears are pessimistic. Bears are weird. Bears are grumpy. Bears dress funny. Bears leave a smell behind in the rooms they happen to pass through on their way to someplace else.

The root problem in a wild bull is that people come to think of stocks as good and of alternative investment classes as bad. Cut that out! Stocks are a tool. You use them to attain higher levels of financial freedom. Stocks are good when buying them helps you achieve your financial freedom goals and stocks are bad when buying them makes it harder for you to achieve your financial freedom goals. It’s financial freedom that is good.

Sensible Investing

When you form negative impressions of bears, you start walking down a path of emotionalism. That’s a dark path.

I don’t ask you to deny your emotions. Emotions are are not to be denied. You need to manage them.

You can’t just give in to them. When you give in to your emotions too freely, you give up the ability to think clearly. It’s when too many people choose that path that we end up in the sort of fix that we are in today.

Explanation #10 of how common-sense investing became controversial — We underestimated the possibility of ever getting to the price levels where we reside today.

I’ve spent some time trying to understand what the heck John Bogle was thinking when he advised indexers to stick with a single stock allocation even when stock prices change dramatically. Everyone is at risk when prices get high, but indexers are at the greatest risk of all (since they own the market as a whole and there is thus for them no chance of escaping the effects of a big price drop).

I have a hunch that part of it might be something simple — Bogle probably never thought that prices would get this high! Stock prices rarely get to the levels where they reside today. When indexing was being developed, prices were low. The risks associated with high prices might well have been the last thing on Bogle’s mind when he was trying to get people interested in his odd (at the time) approach to investing.

Indexing became more popular and prices went up. Prices going up caused indexing to become even more popular. At some point, all of the reasons cited above came to apply. There came a time when Bogle would have had to sacrifice popularity to tell people the realities of how changes in valuations affect long-term returns. There came a time when talking entirely straight would have required him to have admitted that he had been wrong in earlier times. There came a time when Bogle’s own emotions probably blew a fuse when he considered the idea of saying in clear and direct terms how much more risky it had become to be invested in stocks than it had been at times when prices were so much lower.

We’re all going to be reminded in days to come of how important it is to ensure that common-sense investing not become controversial. This time we need to make a special effort not to “forget” that prices that are low in time find their way to becoming high and prices that are high in time find they way to becoming low.

To everything — Turn! Turn! Turn!
There is a season — Turn! Turn! Turn!
And a time to every purpose under heaven.


–The Byrds  (I read in a magazine that they got the idea for this song from some book called “the Bible.” Judging from the song, which has a nice breezy and upbeat quality to it, it sounds like this might be a book worth checking out if time ever permits.)