The Case Against Valuation-Informed Indexing

The problem with the conventional indexing approach (developed by Vanguard Founder John Bogle) is that it does not call for adjustments in the investor’s stock allocation at times of extreme valuations. The historical stock-return data shows why conventional indexing works well during bull markets; stocks perform so well in bulls that it is not necessary for investors to take on the risks associated with trying to pick stocks effectively to obtain solid returns. It also shows why conventional indexing is not likely to prove effective in a prolonged bear market; indexers are hit hardest during a prolonged downturn (they cannot avoid the hit by picking companies doing better than the market as a whole) and the losses sustained in secular bear markets are so great as to make continued reliance on buy-and-hold strategies a practical impossibility for most middle-class investors.

Dangers of Valuation-Informed Indexing

The purpose of my Valuation-Informed Indexing approach is to provide a means by which middle-class investors can realistically expect not only to talk the buy-and-hold talk but also to walk the buy-and-hold walk. Valuation-informed indexers lower their stock allocations by about 25 percent at times of extremely high valuations (a P/E10 level above 20) and increase their stock allocations by about 25 percent at times of extremely low valuations (a P/E10 level below 12). Valuation-Informed Indexers appreciate the futility of short-term timing. Their expectation is that stocks will perform in the future somewhat as they always have in the past and that long-term timing (changing one’s stock allocation with no expectation of seeing a benefit for doing so for a time-period of up to 10 years) will continue to provide a substantial edge. Valuation-informed indexers are concerned with the value proposition represented by their index purchases and are not willing to commit the same percentage of their portfolios to stocks at times when the 10-year return is likely to be low as they are when the 10-year return is likely to be high.

This article summarizes 20 arguments that have been made against the Valuation-Informed Indexing concept, and offers my brief responses to those arguments.

Argument #1 Against Valuation-Informed Indexing — The Equity Premium Has Recently Been Greatly Diminished.

James Glassman put forward this argument in his book Dow 36,000. The idea here is that middle-class investors have only in recent decades discovered the long-term appeal of stocks, that this discovery will cause prices to go higher than most now believe is possible, and that the higher prices will permanently reduce the long-term return on stocks provided from that point forward.

Glassman is arguing that stocks are going to perform differently in the future than they ever have in the past. Valuation-Informed Indexing is rooted in an assumption that things will likely not turn out too different this time from how they have always turned out before. Glassman might be on to something. The reality is that the one constant in investing is surprise.

Still, I doubt that the future is going to be entirely different from anything we have seen in the past. I think that there are some reasonable arguments that can be made that stock prices will go higher than the historical data alone would lead us to believe. It’s a mistake to get too carried away with this kind of thinking, however. Some upward adjustment in the numbers obtained by looking at the historical data makes sense for those with an optimistic bent. That said, I think it would be fair to describe Herman Hupfeld as every bit as much of an investing expert as James Glassman. And Hupfeld, who wrote the famous song used in the film Casablanca, argues forcefully that “the fundamental things apply as time goes by.”

Argument #2 Against Valuation-Informed Indexing — Economic Growth May Be Greater in the Future Than It Has Been in the Past.

What Is Valuation-Informed Indexing?
This is another way in which the future could turn out different than the past. Those who believe that economic growth will be greater should make an upward adjustment in the numbers generated by The Stock-Return Predictor (see tab to the left).

Argument #3 Against Valuation-Informed Indexing — Economic Growth May Be Less in the Future Than It Has Been in the Past.

Those who believe that economic growth will be less in the future of course need instead to make a downward adjustment to the numbers generated by the Return Predictor.

Argument #4 Against Valuation-Informed Indexing — The One Thing We Can Count On Is That There Will Always Be Surprises.

We look to the historical stock-return data for guidance as to how stocks may perform in the future. I think it is a big mistake to ignore the lessons taught by history. The other side of the story is that, while future events often rhyme with accounts pulled from the history books, things almost never play out in precisely the same way twice. We should expect to be surprised, at least a little bit and perhaps a lot.

Argument #5 Against Valuation-Informed Indexing — Today’s Numbers Are Just Too Shocking To Be True.

Many react to the numbers reported by The Return Predictor with shock. Too much funny talk about efficient markets has led some to believe that stocks always offer the best long-term value proposition.

This I do not buy. I do not see how any asset class can always be the best choice. We bid stocks up to insane price levels in the late 1990s. Where did the money come from? It was borrowed from the investors of today.

Yes, it is “irrational” that stock owners are being paid less for owning a risky asset than investors in Treasury Inflation-Protected Securities (TIPS) are being paid for owning a risk-free one. But this irrationality is just the flip side of the irrationality that saw the P/E10 value rise to an unprecedented 44 in January 2000. We brought into effect the irrationality of today’s stock performance the old-fashioned way — we earned it.

Argument #6 Against Valuation-Informed Indexing — If You Are Willing to Wait 30 Years, the Arguments for Conventional Indexing Hold Up.

The Return Predictor puts the most likely 30-year real annualized return for S&P stocks purchased today (this article was posted in November 2007, when the P/E10 level stood at 29) at 5.2 percent. That beats the return available through any of the safe asset classes by a big margin. It makes some sense to invest in stocks that portion of your portfolio for which you can truly wait 30 years to see an appealing return. Only you know what percentage that is for you.

Argument #7 Against Valuation-Informed Indexing — Economic Change Is Coming So Rapidly That the Historical Data Cannot Tell Us Much.

The Case Against Valuation-Informed Indexing

I see this as a reasonably good argument. I use the historical data as a guide because I am not willing to put money on the table without making reference to some sort of objective guidance and I view the historical data as the best source of objective guidance available to me. But we are indeed living in a time of rapid change. That cuts against placing too much reliance on any historical-based guidance.

Argument #8 Against Valuation-Informed Indexing — Investors Lack the Emotional Maturity to Follow This Approach.

Some of the “experts” who argue for maintaining the same stock allocation at all valuation levels make this argument. It could be that there’s something to it. We won’t know how people implement the principles of Valuation-Informed Indexing until a large number give it a try.

I have more confidence in my fellow middle-class investors than the experts putting forward this argument evidence by doing so. The biggest problem faced by most middle-class investors is that their common sense is telling them one thing (that prices must matter) and most “experts” are telling them something different (that there is some efficient market pixie dust that causes stocks to perform differently than any other asset that is bought and sold). I don’t believe that most investors are today emotionally prepared to execute Valuation-Informed Indexing successfully. If the “experts” regularly put forward more realistic advice, I think that many investors would over time come to grow in confidence that a buy-and-hold approach really can work in the real world.

Argument #9 Against Valuation-Informed Indexing — Investors Lack the Intelligence to Follow This Approach.

Lots of investors are making a terrible mistake to maintain a high stock allocation at today’s prices. Are they dumb? I see no evidence of it in the Post Archives of The Great Safe Withdrawal Rate Debate. My take is that investors are being misled by poor advice from the “experts,” which is put forward as a means of appeasing the small group of investors that is emotionally invested in the rationalizations that became popular during the wild bull market.

Valuation-Informed Indexing is in an important sense easier to follow than the conventional indexing approach. In a surface sense, it is slightly more complex because those following it need to make decisions as to when to make adjustments in their stock allocations. The other side of the story is that conventional indexing puts investors at war with their common sense while the idea of buying more stocks when they offer a stronger long-term value proposition is in accord with how we make purchases of all other assets. The new approach causes less emotional turmoil and thus is actually easier to understand for investors who have come to see the holes in the Efficient Market Theory.

Argument #10 Against Valuation-Informed Indexing — Investors Will Be Tempted to Take Extreme Positions.

This is a legitimate concern, in my view. The historical data makes a case for investors going with a zero stock allocation at times of high valuations. I think that is too extreme a position; stock prices can continue to go up for a long time even after reaching very high levels. Advocates of Valuation-Informed Indexing need to stress the need for investors following it to take moderate and balanced positions. We know that stocks perform poorly in the long term when purchased at times of high valuations; we are not able to make good predictions of when prices will return to reasonable levels.

Argument #11 Against Valuation-Informed Indexing — Most Investors Lack the Patience to Wait 10 Years for Their Expectations to be Realized.

Again, this is a legitimate concern. We know that long-term strategies pay off. We also know that they are hard to pull off. We need to do more to encourage investors to tune out the media-generated noise reporting on the short-term performance of stocks and to focus on the long-term realities. The first step to getting to where we need to go is reporting the long-term realities (including those that make stocks look like a bad deal at extremely high prices) in clear and understandable and actionable terms. The more that investors know about how stocks work in the real world, the more able they will become to handle the emotional ups and downs of long-term investing.

Argument #12 Against Valuation-Informed Indexing — The Experts Do Not Endorse This Approach.

The Over-Confident Investor

Most middle-class investors have limited time to devote to learning about investing. Most rely on the advice of “experts.” Most of today’s experts have let us all down with their unwillingness to address the valuations question squarely. We need a new kind of expert, one possessing a richer and deeper understanding of the role played by emotions in the setting of stock prices.

For now, it is a reality that the big-name experts do not endorse this approach (although a good number do endorse the principles on which Valuation-Informed Indexing is based).

Argument #13 Against Valuation-Informed Indexing — This Approach Has Not Been Tested in the Real World.

This is a good point. A measure of caution is certainly appropriate when considering a new investing strategy.

Argument #14 Against Valuation-Informed Indexing — The Market Has Remained at High Valuations for Over 10 Years Now.

This blows people’s minds. It certainly is a legitimate point; stocks have been at very high valuation levels for over 10 years. The historical data shows that it sometimes takes 10 years or even a bit longer for prices to return to reasonable levels. Still, prices have stayed higher for longer this time around than ever before. That reality provides some legitimate grounds for holding doubts about the Valuation-Informed Indexing approach.

Argument #15 Against Valuation-Informed Indexing — What Sounds Too Good to Be True Probably Really Is Too Good to Be True.

It sounds wonderful to be able to form reasonable assessments of how stocks will perform 10 years out and 20 years out. My sense is that a good number of investors see our claim that it is possible to predict long-term returns with a reasonable degree of accuracy as a claim that is too good to be true.

Investors who see these claims as too good to be true need to study the data and and the research and the articles backing this new approach to investing. Those who do not understand the reasons why predicting long-term returns is possible will not possess enough confidence to stick with the strategy when it does not appear to be working.

Argument #16 Against Valuation-Informed Indexing — There is a Potential Opportunity Cost Associated with Being Out of Stocks for a Long Time.

If stock prices remain high enough for long enough a time, it is possible to imagine a scenario in which it would have been better to have maintained a high stock allocation despite high prices.

My sense from my study of the historical data is that the odds against these scenarios playing out in the real world are long indeed. John Walter Russell’s research has provided valuable insights re this point. But I would like to see a greater amount of informed discussion of this point than I have seen to date.

Argument #17 Against Valuation-Informed Indexing — It Is Suspicious That This Approach Relies on Use of a Rarely Used Valuation Metric (P/E10).

Worst-Case Scenario

We use the P/E10 valuation metric to determine when stocks offer a strong long-term value proposition and when they do not. Most people have never heard of P/E10. This naturally makes them reluctant to convert.

Those who study valuations have known of the defects of the P/E1 metric for a long time. I view it as a scandal that many “experts” regularly cite P/E1 to this day, despite its known flaws. P/E10 is no doubt an imperfect tool. But I have yet to hear an argument that I find compelling for why it should not replace P/E1 as the most commonly cited valuation assessment tool.

Other reasonable valuation metrics (Tobins’s “Q” and the Gordon Equation, for example) generally also show stocks to be dangerously overvalued today. That lends credibility to the P/E10 tool, in my view.

Argument #18 Against Valuation-Informed Indexing — The Leading Advocate of This Approach Has Been Banned from Several Internet Discussion Boards.

That’s me!

In ordinary circumstances, being banned should be viewed as a bad sign. The circumstances that apply here are extraordinary. While I have been banned from several boards, I have never put forward a post that is in any way, shape or form abusive. The fact that I have been banned for the “crime” of reporting accurately what the historical data says about the effect of valuations on long-term returns should be viewed as an argument in favor of Valuation-Informed Indexing rather than an argument against it. The fact that advocates of conventional indexing feel so unable to formulate an effective argument for their positions as to feel required to seek bans on honest and informed posting on this topic reveals them to be holding an extremely weak hand.

Argument #19 Against Valuation-Informed Indexing — Few Investors Invest Solely in the S&P Index.

The S&P index is often used as a proxy for U.S. stocks in general. It is certainly true that investors who are not invested solely in the S&P index will see results different from those that will apply for the S&P. There is more data available for the S&P index, so researchers often must focus on that index. Knowing how the S&P is likely to perform provides useful but highly imperfect guidance as to how other stock indexes are likely to perform.

Argument #20 Against Valuation-Informed Indexing — If This Worked, Surely We Would Have Heard About It A Long Time Ago.

What's Wrong with Indexing?

It truly does seem that someone other than me should have come forward with these ideas a long, long time ago. From one way of looking at things, a good number did so. For example, Benjamin Graham, author of Security Analysis, put forward similar ideas decades ago. So perhaps there really is nothing new under the sun. My take is that the popularity enjoyed by the Efficient Market Theory during the wild bull of the 1980s and 1990s caused most experts to “forget” the essentials of common-sense investing for the exceedingly strange stretch of stock-market history that we happen to be living through today.

My contribution was to apply ideas that long had been viewed as nothing more than common sense to Bogle’s indexing concept and thereby to transform it into strategy far more likely to pay off in the real world.

Treasury Inflation Protected Securities (TIPS) Are Today’s Most Underrated Asset Class

It takes a long time for InvestoWorld to wake up to new realities. Treasury Inflation Protected Securities are an amazing asset class. In most circumstances, they are better than bonds. In many circumstances, they are even better than stocks.


Reason #1 Why Treasury Inflation Protected Securities (TIPS) Are Today’s Most Underrated Asset Class — TIPS Are the Perfect Remedy for Overvaluation

I have been arguing the merits of TIPS for a long time. I took my money out of stocks in 1996 because of concerns re stock overvaluation and went looking for an asset class that promised to preserve capital while not failing to keep up with inflation (the big downside of certificates of deposit). I was thrilled when Treasury Inflation Protected Securities came along. Unfortunately, it was hard to persuade investors of their merit for so long as stock prices remained high. But I have seen more interest in alternatives to stocks since the price crash (this article was posted in March 2010).

I doubt there has ever in history been another time when an asset class that comes with a government guaranty offered as much of an edge over stocks as Treasury Inflation Protected Securities offered over stocks in January 2000. The Stock-Return Predictor tells us that the most likely annualized 10-year return for stocks purchased at the prices that prevailed at that time was a negative 1 percent real. TIPS were paying 4 percent real. That’s a differential of 5 full percentage points of return! Every year! For 10 years running!

Do the math and you learn that buying TIPS at a time when 90 percent of the “experts” were recommending a high-percentage stock portfolio put you ahead by 50 percent of your initial portfolio amount at the end of 10 years. Those with $100,000 saved were likely to be ahead by about $50,000 ten years later. Those with $500,000 were likely to be ahead by $250,000. Near-retirees who enjoyed $1,000.000 of accumulated wealth in January 2000 were able to put themselves ahead by $500,000 just by making a decision to buck the experts from The Stock-Selling Industry and invest in Treasury Inflation Protected Securities instead.

And then there’s compounding. Those who are ahead today by $50,000 or $250,000 or $500,000 will move even farther ahead over the years as the earnings differential for investing in the non-stock asset class grows and grows.

Stocks are not as overvalued today as they were then, to be sure. So the differential going forward is not likely to be as great. But the historical data shows that, every time stock prices have risen to twice fair value, they have fallen to one-half fair value in the huge bear market that inevitably followed. That’s a price drop of over 60 percent from where we are today. So a good case can still be made for the asset class that is my favorite at times of dangerous overvaluation.

Reason #2 Why Treasury Inflation Protected Securities (TIPS) Are Today’s Most Underrated Asset Class — They Are the Perfect Counter to Stocks

TIPS are a better alternative to stocks than are corporate bonds. The conventional investing wisdom is that the money you don’t put into stocks you should put into corporate bonds and the money you don’t put into corporate bonds you should put into stocks. But why? This wisdom was developed at a time when Treasury Inflation Protected Securities did not exist. We need to rethink it. When we do, I think we will see that TIPS do the better job of serving as the alternative to stocks.

Treasury Inflation-Protected Securities

Diversification offers the proverbial free lunch. Diversify effectively and you obtain higher returns without taking on added risk. Bonds and stocks have long been pushed as the perfect combo of investment classes for diversification purposes. But I don’t see it.

The downside of stocks is that prices are prone to crash at times of high valuation. What asset class performs in an opposite way and thereby provides great diversification? It’s not corporate bonds. Bonds sometimes do poorly at the same time as stocks are doing poorly; bad economic times can cause trouble both for those holding stocks and for those holding bonds. The magic of Treasury Inflation Protected Securities is that they are the precise opposite of stocks. Stocks offer high growth and high price volatility. TIPS offer limited growth and perfect stability; you know what your long-term, inflation-adjusted return will be on TIPS on the day you purchase them. That’s diversification!

When I am seeking growth in an investment class, I go with stocks. Bonds just are not as strong in the growth department. But when I am seeking stability of return, I go with Treasury Inflation Protected Securities. Bonds are not only not as growth-oriented as stocks, they are also not as stable as TIPS. My view is — Go with stocks when valuations are moderate or low and the long-term value proposition of stocks is strong and go with Treasury Inflation Protected Securities when buying a stable asset class makes more sense.

Reason #3 Why Treasury Inflation Protected Securities (TIPS) Are Today’s Most Underrated Asset Class — They Are the Easiest Asset Class to Understand

There is a crying need today for simple investment strategies. Middle-class workers must invest effectively if they are to build successful retirement plans. But millions of today’s investors do not have the interest or background or experience needed to become experts on scores of different investment topics. We need “good enough” investment options that can be fully comprehended with minimal effort (the biggest investment risks come from making choices that you don’t fully understand).

You want simple? Go with Treasury Inflation Protected Securities. Go to the Treasury Department site explaining what Treasury Inflation Protected Securities are about and all your questions can be answered in an hour or two of study. You put your money in. You get the return promised. It really is as simple as that. TIPS are the perfect investment class for today’s middle-class investor.

Reason #4 Why Treasury Inflation Protected Securities Are Today’s Most Underrated Investment Class — They Earn Higher Returns Than You Think

The Stock Selling Industry sells stocks. Hard. Surprise! Surprise!

We have all been subject to so much marketing (disguised as “expertise”) on behalf of stocks that we have come to believe that stocks always offer the highest returns. Um — not so. The proper way to identify the long-term return of an asset class is to look not at the return provided on paper but to look at the return provided to real live investors. In the case of Treasury Inflation Protected Securities, there can be big differences.

Safe Investing

If you are buying TIPS because you want a portion of your portfolio to be in a rock-solid safe investment class, you really will earn only the return stated. With TIPS, that can be a low number, perhaps 2 percent real or so. But another option with TIPS is to hold them at times when stock valuations are high and the long-term value proposition of stocks is poor and then to shift the money held in TIPS to stocks when stocks return to moderate or low valuation levels and the likely long-term return on stocks goes sky-high.

Again, The Stock-Return Predictor (see link above) tells the story. If stock valuations drop to one-half fair value in coming years (as they did on the three earlier occasions when we permitted valuations to go to insanely dangerous levels), the likely annualized long-term return for stocks will rise to 15 percent real. If you hold money in Treasury Inflation Protected Securities earning 2 percent real for five years and then shift it for five years to low-priced stocks likely to provide a long-term return of 15 percent real, is your 10-year return 2 percent or something a good bit higher than that? It seems to me that it is something a good bit higher than that.

Treasury Inflation Protected Securities are a wonderful asset class for the investor pursuing Valuation-Informed Indexing, the strategy advocated at this web site. TIPS came along just in time!

Technical Analysis for Non-Dummies

The Dismissive Attitude that Some Evidence Toward Technical Analysis Is a Turn-Off.

I know little about technical analysis. I don’t practice it. I don’t recommend it. But hey! Where would I be today if I let little things like that stop me from spouting off my opinions on an investing topic?

Technical Analysis for Non-Dummies
We all have too many books on our reading tables and an insufficient number of quiet hours to work our way through all of them. It’s not likely that a book on technical analysis is going to work its way to the top of my pile anytime soon. So technical analysis is probably going to remain a topic that I do not know much about.

It’s not the point of this article to tell you that. The point of this article is to tell you that, despite that, I make an effort not to be overly dismissive of technical analysis. It could be that I am wrong. It could be that my life experiences caused me to get all wrapped up in studying things other than technical analysis when it is technical analysis that would have opened all the doors a lot sooner.

I don’t think that’s right. But it could be right. I’ve run into a good number of people who follow investing strategies other than technical analysis and who feel a need to engage in all sorts of snide putdowns of those who follow it. That inspires in me doubts about the strategies being followed by the ones putting forward the snide putdowns. Why so defensive, Mr. Man?

My take is that technical analysis is probably not worth your time. But I would sure like to hear from you if you have strong feelings otherwise. My secondary take is that I hope that I never reach a point where I have so many chips riding on an investing strategy that I feel a need to direct significant amounts of my limited human energies feeling superior to people who follow an investing strategy other than the one I favor. I find the putdowns of technical analysis often put forward by those believing in the Efficient Market Theory a big-time turn-off.

Many Smart People Believe in Technical Analysis.

Those who ridicule technical analysis engage in an act of supreme arrogance, in my assessment. Can those of us who are not believers really be so certain that those who follow this approach have nothing whatsoever to teach us? If they have even a small something to teach us, we should be trying to learn from them. Every little thing we learn can bring us to financial freedom sooner. Is that not cause enough to open our minds just a wee bit? I sure think so.

There was a fellow who posted on a discussion board about technical analysis (his screen-name was “MannFM”) who was one of the smartest investing analysts I have encountered. He might have been wrong. He sure wasn’t dumb. I read a lot of the guy’s posts. I didn’t understand everything said because he discussed all sorts of technical matters. But I am able to tell whether someone is making an intelligent and well-structured argument even when I do not fully appreciate many of the points being made. You’ll have a hard time convincing me that technical analysis is for dummies after my experience seeing how strongly this very intelligent fellow believed.

This fellow lost a lot of money following technical analysis. He said so on the board. That didn’t make me dismiss what he said. If anything, it made me wonder whether he was onto something. I’ve seen lots of Big Shot investors come to discussion boards saying that they know it all and anyone who knows things other than what they know cannot possibly know much. This guy possessed the confidence it takes to acknowledge losing lots of money following his favored investing strategy (he said that he learned from his mistakes and now knew better how to employ technical analysis successfully). That impressed me.

It could be that he’s just too dumb to admit when he’s wrong. That’s the other possibility.

How do you know which it is? It’s not skills particular to investing that tell you that. It’s people-watching skills that tell you that. To the extent that I possess people-watching skills (I do not believe that I am entirely lacking in this regard), my read is that there were things that this guy could teach me if I could spend more time with him. I don’t always have that feeling when listening to some of the harsher critics of technical analysis.

The Significance of Technical Analysis Is That It Focuses on the Emotional Side of the Investing Project.

The Four Seasons of Stock Price Changes

The primary reason why technical analysis inspires dismissive reactions from the sorts of investors who buy into the Efficient Market Theory is that technical analysis focuses on the side of the investing project that the Efficient Market Theory ignores — the emotional side. The psychological reality is that the personality types who find appeal in the idea of dealing with the emotional questions by denying that they exist freak out over the idea that there are other investors getting a jump on them by exploring those very issues in depth. If there is anything at all to technical analysis, then there isn’t much to the Efficient Market Theory. These two schools of thought are naturally at odds.

Or are they?

I am no fan of the Efficient Market Theory. I often refer to it as the Efficient Market Disease. That’s because it ignores the emotional questions. I am not able to imagine any way that an investing approach that ignores at least 50 percent of what affects stock prices can work in the real world. So I should be a big believer in technical analysis, no?

I don’t know. I like the idea that technical analysis takes the emotional side of investing seriously. That’s the draw for me. However, I am not too comfortable with the idea that human emotions are sufficiently predictable that market turns can be identified through the examination of patterns and charts. The tendency of technical analysis to rationalize the irrational leaves me skeptical.

What I am saying here is that there are at least three types of investing personalities: (1) a type that is drawn to technical analysis; (2) a type that is drawn to the Efficient Market Theory; and (3) a type that sees strong and weak points in both. My general belief is that it is these personality matters that are responsible for most of our beliefs and that few of us are truly going with what is “proven by the studies,” as we so often pretend to be. I think that most of us are kidding ourselves about the level of proof there is backing up our investing ideas.

I don’t think that we can get around that. I think that the best we can do is to become sufficiently aware of it to cause us to open our minds a bit to ideas that do not come naturally to us. I think it is healthy for me to struggle at times to have some sympathy for ideas that arise from a belief in the Efficient Market Theory. I also believe that it is healthy for me to struggle at times to have some sympathy for ideas that arise from a belief in technical analysis.

I feel confident in saying that the issues examined by believers in technical analysis are important ones. I doubt whether they can pull off what they say they can pull off. But they are struggling with questions that matter and applying a good bit of intelligence to the task. I respect them for that.

Buffett Doesn’t Believe in Technical Analysis and I Don’t Know What That Means.

I have seen too many investing experts come to possess far too much unwarranted confidence in their understanding of the subject matter for me to allow expert opinion on any topic influence me too much. There are exceptions to that general rule, however. There are some who have been right about so many things that the fact that they say something is alone enough to give me pause in making an argument otherwise.

Stock Market News

Warren Buffett is in that group. Warren Buffet does not believe in technical analysis. He says that he studied it a great deal in his youth because he was anxious to learn about any strategies that could make him money. He came away an unbeliever.

That impresses me. Buffett is the real turtle soup and not the mock. Plus, he is not speaking out of arrogance if he went to the trouble to study technical analysis. Buffett has at least given technical analysis a fair try. His opinion should count for something, in my view.

I don’t think it is absolutely dispositive, however. Buffett has a personality, just like everybody else. Perhaps he just cannot get his head around technical analysis. Perhaps there’s just no click there, despite his intelligence. Buffett’s wife once said that, when he was asked to get a bowl for someone to throw up in, he came back with a collander. He’s plenty smart. But you know how it is with them darn humans.

Do I really believe that Buffett is wrong re this one? No. I don’t think it hurts for me to go to the trouble to construct the argument, however.

Technical Analysis Sounds Too Good to Be True.

One big problem with technical analysis is that it sounds too good to be true. If it worked, it would be possible for lots of people to make a living trading stocks. I believe that skepticism re this possibility is appropriate.

Still, I don’t know that the idea should be dismissed out of hand. There are people who make a living acting in movies. There are people who make a living catching fly balls. There are people who make a living writing novels. There aren’t many people who are good enough at these activities to be able to make big incomes engaging in them. But there are some. Perhaps that’s how it is with technical analysis. Perhaps it works for a rare sort of person, but not for the vast majority.

If that’s the case, the rest of us should not be following technical analysis. But perhaps we should be tapping into insights developed by people who do follow it. Perhaps we are hurting ourselves with our dismissive comments. I have seen so many cases in which people hurt themselves by being dismissive of the ideas of others that I cannot help but wonder if that might be what is going on here.

I am obviously not an advocate of technical analysis. It is certainly not my thing, at least not today. But it is even less my thing to make fun of technical analysis. My spidey sense tells me that the sort of investor who feels so superior as to laugh at others needs to take a hard look in the mirror before posting his (and it’s almost always a boy who is guilty of this, isn’t it?) next insincere smiley face.

Stock Valuation Made Easy — Bogle & Buffett Are Like Chocolate & Peanut Butter

Step One to obtaining the rewards of stock valuation without doing all the work — Appreciate its importance.

Stock Valuation Made Easy

I am mystified as to why many middle-class investors do not aim to invest in a valuation-informed way. There is nothing that you can learn about how to invest that will pay greater long-term rewards than learning about the benefits of stock valuation.

It’s simply not possible to invest intelligently without looking into valuation questions. To purchase stocks without engaging in some sort of valuation analysis is like purchasing a car or a house without first asking the price. It doesn’t make even a tiny bit of sense to do something like that.

If you purchase stocks without tackling stock valuation questions, you are shooting in the dark with your investment strategies. You have no way of knowing whether you are getting a good deal for the money you invest in stocks or not.

Step Two to obtaining the rewards of stock valuation without doing all the work — Accept that there is a price to be paid for not doing a lot of research.

The best way that I know of to become an expert at stock valuation is to study how Warren Buffett goes about determining whether a stock purchase makes sense or not. Buffett is the master.

The problem with the Buffett approach is that it is a difficult and time-consuming approach. Many middle-class investors are not cut out for it. This is why Buffett himself recommends index investing for the typical middle-class investor.

Many index investors argue that it is not possible for those following the Buffett approach to obtain gains better than those obtained by indexers. I don’t buy this argument. I believe that there are often rewards paid to those who take the time to research their stock picks carefully. Buffett’s long-term success is evidence of this.

I believe that, if you are not willing to engage in the years of research required to make you a top-notch stock picker, you are likely to pay a price for not doing so. I think it is a mistake for many indexers to argue so strongly that this is not so.

Step Three to obtaining the rewards of stock valuation without doing all the work — Understand that the price paid for not doing a lot of research need not be that large.

John Bogle revolutionized the world of middle-class investing by developing and popularizing the indexing approach to investing. When you buy an index, you lock in for yourself the return of the market as a whole. While I do not believe that this approach is likely to provide returns as good as the Buffett research-oriented approach, it can provide pretty darn good returns. I think of indexing as the “good enough” approach to investing.

Why settle for an approach that is merely good enough? Because the years of research work required to succeed using the Buffett approach are not needed to succeed at investing. With indexing, you don’t need to worry about whether you have picked good companies or not as your investment choices. You pick them all, the good and the bad, and, so long as the market as a whole earns good returns, so do you.

Investing Doesn't Have to Be So Complicated

Given the returns typically earned by the market as a whole (the U.S. market has generated a long-term annualized real return of 6.8 percent), that’s a pretty darn good deal. I think of it as an application of the wonderful 80/20 rule. There are some endeavors in life in which you can obtain 80 percent of the potential benefits by engaging in 20 percent of the effort that it would take to obtain 100 percent of the potential benefits. In life endeavors in which that rule applies, it makes sense to tap into the benefits of the 80/20 rule.

Step Four to obtaining the rewards of stock valuation without doing all the work — Don’t fall into the trap of becoming an Indexing Purist.

Indexing is a wonderful deal. Unfortunately, there is a group of investors that I refer to as Indexing Purists or True Believers who manage to turn what should be a wonderful deal into something a lot more dubious. I noted above that indexers often argue that it makes no sense ever to pick individual stocks. I disagree.

It may be that you don’t generally have the time to perform the research needed to succeed at the Buffett approach to investing, but that you are able to do research on particular companies at particular times. If that’s the case, why not go ahead and do it? I would not advise putting too large a portion of your portfolio in a small number of stocks because you give up the benefits of diversification by doing so. But there are benefits to be had by following more than a single approach to investing. One obvious benefit to doing some stock picking is that you learn about the companies you investigate and over time that makes you a better-informed investor.

An even bigger problem with the Indexing Purists is that they often argue that valuations do not matter. This claim does not make sense, in my view. Please do investigate the indexing option. It is a great option for most middle-class investors. Please try to avoid the dogmatism of the Indexing Purists. Please keep in mind the importance of always examining stock valuation questions before you invest.

Step Five to obtaining the rewards of stock valuation without doing all the work — Combine the insights of Warren Buffett and John Bogle.

Due to the unfortunate influence of the Indexing Purists, many investors have come to think of Warren Buffett and John Bogle, who are both giants in the investing field, as coming from entirely different schools of thought. The idea seems to be that, if Warren Buffett is right in the way that he goes about investing, John Bogle must be wrong in the way that he goes about it. And, if John Bogle is right in the way that he goes about investing, Warren Buffett must be wrong in the way that he goes about it.

That’s dumb.

Don't Make Me Work So Hard on Investing

I noted above that Buffett himself endorses use of the Bogle approach for the typical middle-class investor. So obviously Buffett does not believe that it has to be his way or the highway. I don’t know what Bogle thinks about the Buffett approach, but it’s hard for me to imagine that Bogle doesn’t have a good deal of respect for the many powerful insights that Buffett has put forward. So let’s dismiss as True Believer silliness the idea that you need to choose between the thinking of one of these two giants.

Why not combine the best of Warren Buffett with the best of John Bogle? It’s my view that these two investing philosophies go together like peanut butter and chocolate. A combined approach makes more sense for most middle-class investors than does either approach standing alone.

What does it mean to combine the Buffett approach with the Bogle approach? It means to never lose sight of Buffett’s focus on stock valuation while tapping into the investing-made-easy benefits of Bogle’s indexing revolution. Practice indexing, but do so in a valuation-informed way.

Step Six to obtaining the rewards of stock valuation without doing all the work — Think through William Bernstein’s explanation of why it is easier to predict the returns of entire markets than it is to predict the returns of individual companies.

Why is it that Warren Buffett and those who follow his investing approach spend so much time and effort in the pursuit of effective stock valuation? It is because they want to know that the stocks they are buying are worth the money they are paying for them. The purpose of stock investing research is to predict the return to be obtained from the stock purchased.

Most investors who pick individual stocks engage in stock valuation. They would feel irresponsible not to do so. Most indexers do not do this. I cannot tell you why. I find it an exceedingly strange reality. But it is a fact that most indexers do not do this. A good number are even hostile to the idea of engaging in stock valuation.

The incredible reality is that stock valuation is a far easier task when directed to the task of valuing an index than it is when directed to the task of valuing an individual company. William Bernstein explains why in his book The Four Pillars of Investing. Bernstein tells us: “Not infrequently, promising companies with large expected future dividends streams stumble and fall; nearly as often, companies given up for dead recover and provide shareholders with prodigious amounts of future income. On the other hand, when you examine an entire market, consisting of hundreds or thousands of companies, these unexpected events average out. For this reason, the income stream of the market as a whole is a much more reliable calculation.”

The incredible investing reality of June 2006 is that most investors following the Warren Buffett approach engage in stock valuation (even though it is hard work when investing in individual companies), but most investors following the John Bogle approach do not engage in stock valuation (even though it is not too hard to do when investing in a broad index). You make sense of that one, if you can. Please drop me an e-mail if you come up with anything good.

Step Seven to obtaining the rewards of stock valuation without doing all the work — Familiarize yourself with the P/E10 valuation tool.

John Bogle Is the King of Simple Investing

The intuitive way to practice stock valuation when investing in index funds is to check the price/earnings level that applies for the market in which you are planning to invest. You want to know how many dollars you are being asked to pay for each dollar of earnings you are purchasing. The P/E value purports to tell you that.

There’s a problem with looking at the plain P/E value of the market. The problem is that changes in earnings can jump wildly from year to year because of recessions and other temporary events. These wild swings can cause dramatic jumps upward or downward in the P/E value that do not reflect well the true value proposition of a purchase of the shares of that stock market. If you want to engage in effective stock valuation for an index-fund purchase, you need to do a little more than look at the plain P/E value.

Not much more, though. An good way of smoothing out artificial earnings jumps and falls is to instead look to the P/E10 value, the price of the index divided by the average of its earnings for the past 10 years. While the plain P/E does not always provide reliable stock valuation information, the P/E10 tool works reasonably well. This is the tool used by both Robert Shiller (author of the book Irrational Exuberance) and John Walter Russell, publisher of the web site.

If you plan to engage in stock valuation in the indexing context, you should familiarize yourself with the P/E10 tool.

Step Eight to obtaining the rewards of stock valuation without doing all the work — Don’t get too cute.

You have probably heard that short-term timing does not work when investing in stock index funds. There is a good bit of research indicating that that is indeed the case. If you make too many moves in and out of the market, you will probably hurt yourself. If you shift large amounts of your assets in response to small changes in valuations, you will probably hurt yourself. If you try to pick precise bottoms and tops in market prices, you will probably hurt yourself.

Forget the discredited short-term approach to market timing. Aim instead to engage in a more sensible approach to taking stock valuations into account in determining how high to go with your stock allocation. Clifford S. Asness stated the message of the historical stock-return data well in an article (“Rubble Logic: What Did We Learn from the Great Stock Market Bubble?”) recently published in the Financial Analysts Journal. Asness tells us: “Changing your exposure to the stock market based on current prices with a long horizon in mind, and perhaps only at extremes, seems like a form of market timing that would be beneficial.”

Step Nine to obtaining the rewards of stock valuation without doing all the work — Start slow.

Warren Buffett Is the King of Smart Investing

I think that Valuation-Informed Indexing is an approach to investing that makes a lot of sense. It is a new approach, however. Many find it strange to try to combine the best insights of Buffett with the best insights of Bogle. Many feel that investors need to choose one path or the other.

Why not ease your way into this new approach? When the P/E10 value for the S&P index is high (as it is in June 2006), lower your allocation to the S&P index. When the P/E10 value for the S&P drops to moderate levels, increase it a bit. When the P/E10 value for the S&P drops to low levels, increase it still more.

I believe that the more you think about the Valuation-Informed Indexing approach, the more you will come to see that it represents the best of the Buffett and Bogle worlds combined into one very exciting package. If you run into problems, please let me know. I hope to be able to develop this approach as fully as possible before stock prices fall, so that middle-class investors seeking an alternative to the Indexing Purist or True Believer approach when that approach fails them will have something available to them that permits them to put the long-term buy-and-hold concept to a more realistic and more practical and more effective use.

All You Need to Know About Stock Price Changes

The first thing you need to know about stock price changes is that the short-term stuff is generally unknowable.

This is the stuff that the newspapers and television programs and web sites focus on. Stocks went up. Stocks went down. Stocks slept in. Stocks wore a tie and shirt that didn’t match. Stocks got annoyed with the paparazzi. Stocks stayed up too late and suffered a meltdown. Stocks got bored and changed the channel.

Stock Price Changes

Stocks don’t do anything. Stocks just sit there. We do stuff. We tell stocks what to do and stocks jump. We have the power!

This is an important point. It is how we feel about stocks that determines how stocks do in the short term. Our feelings are unpredictable. You say yes, I say no, you say stop, and I say go, go, go. You don’t want to be putting money down on a guess as to how stuff like that is going to turn out.

Short-term price changes mean nothing. Don’t waste your time reading about that stuff. It eats up your brain cells. The more you know about the short-term stuff, the less you know about the stuff that matters, the long-term stuff. It is the economic realities that control the long-term stuff. Paying attention to the short-term stuff causes you to start thinking about stocks in a way that makes it difficult to understand the long-term stuff.

My friends at the Vanguard Diehards board have a phrase they use to sum this up: “I don’t know and I don’t care” about the short-term stuff. That’s it. That’s the attitude that you want to adopt.

The second thing you need to know about stock price changes is that it’s probably not worth your time to do what it would take to learn the little that is knowable about the short-term stuff.

There are a few exceptions to what I said above.

Some time back I used to visit a discussion board at the site. There was a fellow there named “MannFM” who was smart as the dickens and who would from time to time write long posts describing an approach he used to predict short-term price changes. He would usually identify more than one possibility and ascribe rough probabilities to each of the possibilities identified. That strikes me as being a sensible way of going about what he was trying to do.

I don’t know if it works or not. The guy was smart. What he said made some sense to me. My guess is that it doesn’t work. But if you are willing to put lots of time and effort into checking it out, it’s possible that you will obtain a financial reward for doing so. I cannot rule out the possibility.

Most of us don’t have available to us the time it would take to check out something like this in the way we would need to check it out to justify putting money down on it. And we don’t need to. Solid investing returns are available to those who make no effort whatsoever to understand what is going on with short-term stock price changes. So my take is that it’s not worth messing with.

There’s no quick and easy way to profit from following short-term stock price changes. If you are going to take this path to investing success, you need to make a serious commitment to the project. Otherwise, direct your energies elsewhere. Putting a halfhearted effort into understanding short-term stock price changes is far more likely to hurt you than to benefit you. Let it be.

The third thing you need to know about stock price changes is that there is great value in knowing the long-term stuff.

What Causes Stock Prices to Rise or Fall?

The long-term stuff is different. The time it takes to understand the long-term stuff is minimal. The payoff is big. This is where the action is.

In the long-term, stock prices are determined by the economic realities. The longer you go out, the more that is so.

Short-term stock price changes are determined by emotions and thus are unpredictable. Long-term stock price changes are determined by economic realities and thus are predictable. That’s the most important thing that I have learned about stock investing. It’s huge. Understanding the difference between how stocks work in the short term and how stocks work in the long term will help you solve dozens of investing riddles. Understanding this distinction, and the strategic implications that follow from it, is the key to becoming a confident and successful investor.

When you understand the long-term stuff, you will no longer be afraid of stocks. You will no longer be taken in by all the various cons. You will get it. You have limited time to devote to learning how to invest. Spend it learning about the long-term stuff.

The fourth thing you need to know about stock price changes is that most of the long-term stuff is to a large extent knowable.

It wouldn’t hurt to read the sentence in bold two or three times. I’ve been working as a reporter for 25 years and those words comprise the most important story I have ever reported. The long-term stuff is knowable. Most people don’t believe me when I say this. I’m not kidding. I mean what I am saying here.

People have the idea that stock returns are the product of some big Random Number Generator in the Sky. No! Stock returns are the product of economic growth. The U.S. economy is a strong and stable economy. It is possible to form pretty darn accurate assessments of how much economic growth we are likely to see over the next 10 years, or the next 20 years, or the next 30 years.

So it is also possible to form pretty darn accurate assessments of the sorts of stock returns we are likely to see over the next 10 years, or the next 20 years, or the next 30 years. No?


Stock returns are predictable. Please review the material at the “Return Predictor” section of the site for details. Stock returns are predictable. You don’t need to hand over your money with no idea as to whether you are ever going to see it again or not. Stock investing is less risky than most people think. Stock returns are predictable.

Most investing “experts” don’t talk about this much. A good number don’t even know it. It’s important. It’s worth taking some time coming to understand why long-term price changes can be anticipated in advance and developing investing strategies aimed at taking advantage of this reality.

The fifth thing you need to know about stock price changes is that almost all actionable information is communicated in the P/E10 value.

My web site is the new kid on the block. The good people at Google World tend not to give lots of points to the new kid on the block. They employ all sorts of nefarious schemes to keep mention of the articles at this site buried in the results handed back to searchers looking for information on saving or investing or career growth. Drats! Curses! Life is so unfair!

There are some exceptions to the usual rule, however. Enter a search for the term “P/E10” and you will find articles from my site sitting there right at the top of the pile. It shouldn’t be that way!

I’m happy to be sitting at the top of the pile. I’m not going to be writing a letter of complaint to the good people at Google World. But I should not rank that high for that term. There should be thousands of sites competing for that term, and the ones who are more established should be knocking young upstarts like me down on our fat bottoms each time we dare make an effort to climb that hill. But it’s not like that. I rank high for the term “P/E10.” It’s a big old goofy world, just like John Prine argues.

Wall Street Today

The P/E10 valuation tool is a tool of great importance. P/E10 is the price tag of the S&P stock index. You wouldn’t think of buying a car or a house or even a banana without first looking at the price tag, right? Well, you shouldn’t think of buying shares in the S&P index without first checking out the P/E10 value that applies at the time you are planning to make the purchase. If you don’t check out the P/E10 value first, you are investing blind. You are uniformed. You do not know what you are doing.

There are lots of “experts” who don’t tell you to check out the P/E10 value before purchasing a stock index. What I say above goes for them too. They are advising blind. They are uninformed. They do not know what they are doing. That’s my sincere take on this one. If you prefer to go by what those other guys and gals say, please feel free to do so. I understand. If you come here for your investing advice, what you are going to hear is that P/E10 is the price tag of stocks. I think it is as important as important can be, and I’ve got to say it the way I’ve got to say it.

When the S&P index is at a P/E10 value of 14, stocks are priced well, and you can realistically expect to see very strong returns 10 years out. When the S&P index is at a P/E10 of 8, stocks are scary but priced to return absolutely mouth-watering returns presuming that the entire U.S. government does not go bust (an outcome that strikes a good number as a real possibility when we are at a P/E10 of 8). When the S&P index is at a P/E10 value of 29 (that’s where we stand in October 2007, when this article was posted), look out below!

Not in the short-term. I don’t know and I don’t care what is going to happen in the short-term. P/E10 is an extremely valuable tool for those investors smart enough to understand that it is by focusing on what drives long-term price changes that they get from where they are to where they want to go.

The sixth thing you need to know about stock price changes is that it is perfectly sensible to consider other information.

When I talk about the power of P/E10, people often enter moderate freak-out mode (Believe it or not, I’ve known one or two or two-hundred to enter Full and Complete Freak-Out Mode, but discussion of that sort of thing is for a different section of the site). They say: “But isn’t it possible that the U.S. economy will perform differently in the future than it ever has in the past?” Or they say: “But isn’t it possible that people will someday come up with a valuation tool even better than P/E10?” Or they say: “But don’t lots of people ignore this P/E10 jizz-jazz despite all that you say about it?”

The future could be different. There might someday be an even better tool. Lots of people ignore what I say. Lots.

Please feel free to look at things other than P/E10 in assessing for yourself the value proposition offered by stocks at any particular time. You pays your money and you takes your chances. That’s how the wonderful game is played.

I think that it’s the long-term that matters and I am convinced that P/E10 is the tool that provides the sharpest insights into what is likely to happen in the long term. But perhaps some others will put some good work into the project of finding new ways to skin the cat. Perhaps you and me and everyone else will learn from their efforts. That would obviously be a very good thing for all of us. Let’s all root for the possibility.

The seventh thing you need to know about stock price changes is that the hard part is acting on what you know.

Investing Probabilities

You look into this P/E10 gizmo. You find out that the number today is 29. That’s bad. Real bad. What do you do?

If you’re like most people, you do nothing.

Man is a social animal. We like to do what others around us are doing. We don’t feel comfortable straying too far from the rest of the flock.

That’s reality. I can tell you what works (or at least what I believe works). I cannot change human nature and make you feel comfortable taking action based on what works.

That’s why stocks pay such a strong return. That’s why stocks are risky. Many people say that stocks are risky because of the volatile price changes characteristic of this asset class. I don’t buy it. Those who understand the long-term stuff can develop strategies that take care of the volatility problem. The killer is developing the emotional fortitude that permits you to stray from the flock when straying from the flock is what’s needed to get the job done.

When just about everybody thinks that stocks are really, really, really risky, stocks are as safe as they will ever be (because prices are so low that stocks are a can’t miss bet). When just about everybody thinks stocks are really, really, really safe, stocks are as risky as all get-out (because prices are so high that it takes huge economic growth just to get buyers back to zero). Stock investing plays with your mind. There’s no getting around it.

It’s one thing to use the historical stock-return data to learn how best to invest for the long term. It’s something different to act effectively in response to what you learn. Taking action in accord with what the data tells you is the hard part. That’s the step in the process at which most investors lose their way.

The eighth thing you need to know about stock price changes is that we all need to know more than we do.

We know a lot more about what we need to know than we think we do.

We don’t know everything we would like to know.

Both things are so.

The ninth thing you need to know about stock price changes is that you need to resist the urge to believe that good economic developments are goods news for stock investors.

Stock Return Predictions

There is a poster at the Vanguard Diehards board named “Oildog” who once made a point that I found compelling but not ultimately persuasive. Oildog pointed out that the last time valuations dropped to extremely low levels (the early 1980s), the long-term economic growth picture really did look terribly poor. He cited an analysis by Warren Buffett showing that profits were so low that it really was reasonable to believe that corporate profits from that point forward might be permanently lower than they had ever been before in U.S. history.

It’s true that short-term price changes are never entirely driven by emotion. What usually happens is that investor emotions cause the effect of real economic developments on stock prices to be exaggerated.

Say that economic growth drops so low for a year that a P/E10 value of 8 seems perfectly appropriate. Does that mean that stocks are not as much of a steal as the P/E10 number indicates? It does not. When a long-term investor buys stocks, he is not buying them for a single year. Thus, the economic picture for the year of purchase is of only limited relevance to the analysis he needs to be performing. Implicit in a P/E10 value of 8 is a widespread investor belief that economic growth will remain poor for long into the future. That is the fallacy that creates an opportunity for investors using the historical stock-return data to “see though” emotion-driven pricing errors.

Things are never as bad as they seem when things seem really bad. And things are never as good as they seem when things seem really good. Our human emotions cause us to exaggerate the long-term effect of both good and bad economic developments. Buy stocks objectively (by using the historical data as your point of reference) rather than emotionally (by following the lead of other investors, as reflected in the “expert” advice broadcast in the conventional media) and stock price changes will work to your benefit instead of to your detriment.

The tenth thing you need to know about stock price changes is that taking your focus away from actionable information will hurt you rather than help you.

The internet is a sea of information bits. Google phrases like “how to invest,” “buying stocks,” and “buy-and-hold” and you will have so much information delivered to you that it may be days before you are able to come up for air. Unfortunately, having easy access to all these information bits hasn’t made us better investors. If anything, it has made us worse investors.

The problem is that junk information gives you the illusion of knowing what you are doing without providing the reality. The trick is distinguishing junk information from the real thing. Good information is actionable. You need actionable information. You need to learn what matters. You need to develop a strong grasp of the essentials, and, if doing that leaves you with no time even to take notice of the less-than-essential stuff, then so be it.

Disappearance of the Middle Class

Robert Shiller says in his book Irrational Exuberance that: “The ability to focus attention on important things is a defining characteristic of intelligence.” I agree. What Shiller says becomes more and more important as more and more information bits become easily available to us.

Some stock price changes are meaningful. Some are not. Do you know the difference? If not, what aspect of the stock investing project is it that you are directing the time to that you instead need to be directing to learning how to distinguish the meaningful stock price changes from the insignificant ones? Answer that one, and you are on your way to being as intelligent in your investing life as you already are in all other areas of life endeavor.

Stock Picking for Indexers

Benefit #1 of Stock Picking for Indexers — It can increase your returns.

John Bogle’s argument for indexing is that half of all investors must obtain a return worse than the market return. Transaction costs are less for indexers. So, after consideration of transaction costs, indexers must do better than stock pickers on an overall basis.

Stock Picking for Indexers

It doesn’t follow that those who see appeal in the idea of investing in a broad index shouldn’t also see appeal in the idea of aiming for the higher returns possible through stock picking. You have to watch expenses, of course. Those who are careful not to trade often can overcome that hurdle. You need to be sure that you possess better-than-average stock-picking skills. Most investors seeking financial freedom early in life are in that category. And you need to provide for enough diversification in your portfolio so that a number of bad picks will not ruin you.

There are lots of people who invest in ill-informed ways. Each investor who invests in an ill-informed way opens up an opportunity for those of us who aim to invest in an informed way. Investors who put their money in hot tips or story stocks earn lower-than-market returns. If it is possible by being dumb to earn lower returns, it must also be possible by being smart to earn higher returns.

There’s no good reason why indexers should not tap into the rewards of stock picking.

Benefit #2 of Stock Picking for Indexers — Stock-picking strategies complement indexing strategies.

Indexing is a safe approach to investing. You cut out the best possibilities and you cut out the worst possibilities and you assure yourself of obtaining the “good enough” market return.

Stock picking is both more exciting and more dangerous. Choose well, and you can make money faster with stock picking than you can with indexing. Choose poorly, and you can get wrecked.

It sounds like these two approaches should be mixed, does it not? The best marriages are those between The Practical One and The Dreamer. We all know people who took too many risks and died young. We all also know people who took too few risks and died too young in a different way. The sensible middle path is to take on some risk and to counter it with some safe moves.

Indexers who engage in stock picking win for themselves the best of both worlds. Indexing provides a strong measure of diversification for a portion of their portfolios. Stock picking provides some added tiger in the tank to the extent desired.

There is no requirement that indexers engage in stock picking or that stock pickers engage in indexing. I don’t understand, though, why indexers often come across as being hostile to stock pickers and why stock pickers often come across as being hostile to indexers. It’s not an either-or, is it?

Stock picking possesses an obvious appeal. Indexing possesses an obvious appeal. Is there any reason why we should not feel free to mix the two approaches to come up with portfolios that best serve the purpose of advancing investors with our own particular financial circumstances and pursuing our own particular Life Goals? I am not aware of one.

Benefit #3 of Stock Picking for Indexers — It makes it more likely that you will stick with your strategy.

Stock pickers do well when one or more of their picks does well. Stock pickers do poorly when one or more of their picks do poorly. Indexers do well when the market does well. Indexers do poorly when the market does poorly.

Get Rich of Die Trying

Stock pickers are tempted to abandon their strategy when they experience a long run of poor returns. So are indexers.

Those who engage in a combination of indexing and stock picking are less likely to experience a long run of poor returns. When their stock picks are doing poorly, the market may be doing well. When the market is doing poorly, their stock picks may be doing well.

A portfolio that contains both individual stocks and shares in an index benefits from a diversification of strategies. The stocks held by the owner of this portfolio are not as well diversified as the stocks held by a pure indexer. In a larger sense, however, this portfolio may achieve greater diversification as the investor’s fortunes are not tied to the success of a single investing strategy.

Benefit #4 of Stock Picking for Indexers — It helps you avoid dogmatism.

Dogmatism is the long-term investor’s worst enemy. We all fear putting our money at risk. None of us possesses perfect information as to how our investments are going to perform. So we all seek assurances that we have made good investing decisions.

Often it is that quest for reassurance that ruins us.

The fearful investor’s quest for reassurance often leads to dogmatism, a rigid refusal to acknowledge the weaknesses of his own choices or the appeal of the alternatives for which he elected to take a pass. I’ve seen investors transformed into boys in the schoolyard taunting each other with cries of “My asset allocation is more rational than yours!”

You can’t have every investing approach represented in your portfolio. That would render it an illogical mishmash. But in cases in which two investing styles work well together and in which it makes sense for someone in your circumstances to combine them, diversification of styles can help head off dogmatism. You can hardly find fault with stock pickers when you are one yourself, can you? You can hardly find fault with indexers when you are one yourself, can you?

Do you remember that great commercial that argued that —

Sometimes you feel like a nut.
And sometimes you don’t!

Here’s my financial freedom lover’s version —

Sometimes you feel like an indexer.
And sometimes you feel like a stock picker!

No, it doesn’t sing. But I bet you will never again hear that commercial without for a moment considering the merits of combining stock picker strategies with indexing strategies!

Benefit #5 of Stock Picking for Indexers — It provides an easy means to begin a transition to a new index.

Indexing purists would have you believe that they have discovered the Holy Grail of investing strategies. No one knew anything about how to invest rationally before Saint Jack arrived on his horse. Then the skies opened and we all got taught the true religion. Now we know, or at least we darn well should. If there is anyone today not indexing with 100 percent of his or her portfolio, names will be recorded and steps will be taken.

They Used Our Natural Risk Aversion Against Us

Please don’t let anyone know that I was the one who happened to mention this to you, but some of the purist indexers are a wee bit touched. Saint Jack is a fine fellow with a fine kettle of ideas. He’s not actually a saint, though. Not yet anyway. That’s just some people talking. Bogle continues to walk the Valley of Tears as of February 2007 (that’s when this article was posted).

Anyway, a lot of people have taken a liking to Jack’s idea of investing in an index. The only trouble is — What index?

Should it be the S&P? Should it be the total stock market? Should it be a fundamental index? Should it be an index with a value tilt? Should it be a global index?

No one knows!

What if we persuade everyone in the world to index but we can’t agree on what that means?

If you are a stock picker, and begin thinking that you need to move into value a bit, you could pick a few value stocks. If you are a stock picker, and begin thinking that you need to move into global a bit, you could pick a few global stocks.

Purist indexers have no flexibility, especially if they buy into a severe vision of buy-and-hold. Stock-picking indexers have the option of trying some things out and then deciding whether to move on to a second date or not.

Benefit #6 of Stock Picking for Indexers — It’s fun.

Even purist indexers acknowledge that indexing is boring. Many indexers “permit” themselves to pick one or two stocks just to keep the blood running through their veins.

Life is short. Live it up! Make stock picking part of your “official” strategy and you no longer will feel that you are “cheating” when you engage in it.

Do you want to know what I think? I think that a whole big bunch of indexers are already mixing stock picking and indexing. They play it down in public because they worry that the purists might toss drinks in their faces if they found them out.

My guess is that there are lots of poor souls who pick one or two stocks thinking that it can’t do all that much harm. Then one day they wake up to realize that they are addicted! Oh, yes, stock picking can be hard to stop, especially if you spend most of your life confined to the drab and gray prison cell of an indexing purist.

There is a house in New Orleans
They call “The Rising Sun.”
It’s been the ruin of many a poor indexing purist.
And, Lord, I know — I’m one.

It’s a sad and disturbing song, but it’s one that they’ve been singing since the day that Saint Jack arrived on his big white stallion. I’m saying: “Let’s legalize stock picking and maybe we will be better able to control it. Maybe people will no longer feel a need to turn to a life of crime to support their stock-picking habit.”

Risk Tolerance in the Real World

It’s a progressive idea. But, hey, that sort of thing is “in” today, no?

Benefit #7 of Stock Picking for Indexers — It allows you to tilt your portfolio in desired directions.

Some investors think that indexing works, but that the broad indexes do not contain enough value stocks. Some investors think that indexing works but that the broad indexes do not contain enough small-cap stocks. Some investors think that indexing works but that the broad indexes do not contain enough high-dividend stocks.

These people do not have to buy value indexes or small-cap indexes or high-dividend indexes to go along with their broad indexes. They can buy individual stocks that possess the traits they are seeking.

Indexes do a lot. There is no rule of the universe that says that indexes need do it all.

Benefit #8 of Stock Picking for Indexers — It helps you learn.

Stock pickers can never forget how it is that stocks generate returns for those who invest in them. Since they are always on the lookout for better stocks, they are learning all the time more and more about what comprises a good stock.

This is not so of indexers. Stock pickers are one step removed from the profit-generation machine (they don’t work for the companies they invest in). Indexers are two steps removed. Indexing is an artificial way to invest. Taken too far, this artificiality can become dangerous.

Indexing works best for those who keep both feet on the ground at all times. Stock picking forces you to keep both feet on the ground. Stock picking helps you avoid the worst pitfalls of the indexing approach.

Don’t turn out like that poor girl whose face you saw looking down at you from the window of that house that isn’t any home. Be an indexer, sure. But be an indexer with both a heart and a brain. Be one of them new fangled stock-picking indexers!

Oh! There’s one more benefit, one for which I didn’t think I should create a separate listing. Knowing that there are indexers out there who engage in stock picking drives the indexing purists positively bonkersville!

When to Sell Stocks: The Case for Selling in a Stock Market Downturn

When to Sell Stocks: Argument #1 for Selling in a Stock Market Downturn — Panic is Sometimes Appropriate.

The conventional investing advice is that you should not give in to feelings of panic in a stock market downturn. You should stick with your strategy, you should Stay the Course. Keep the chin up! Show some fortitude! Be a man!

Stock Market Downturn

Or don’t.

Look. The Cowardly Lion was shivering and quivering and shaking and quaking when the Wicked Witch of the West sent those flying monkeys after him. For good reason! The Cowardly Lion had cause to be afraid of those monkeys. They were creepy as all get-out. He wasn’t wrong to panic. The poor fellow had common sense, that’s all. His common sense told him to run.

There are times to stick it out and there are times to panic. What I don’t like about the conventional investing advice is that it makes out like there is never a good time to panic. The conventional claim is that it is always a good idea to stick it out. That cannot be.

God created all the emotions with a good purpose in mind. He created fortitude so that we could stick things out when sticking things out is the right thing to do and he created panic so that we could panic when panicking is the right thing to do. Advice that argues that there are no possible circumstances in which panicking is a good idea is flawed advice. There are times when panic is appropriate.

In a long stock market downturn, those who panic first panic least.

When to Sell Stocks: Argument #2 for Selling in a Stock Market Downturn — Those Who Panic First Panic Least.

Say for purposes of discussion that you agree with Argument #1, that you agree that there are times when panic is appropriate. If that is so, when is the best time to panic, early in the stock market downturn or late in the stock market downturn?

Early is far better.

Those who panic early in a long downturn (the only kind in which panic would be appropriate) lose much less than those who panic late. If you sell early in a downturn, you will be worse off than if you had sold before the downturn began. But you will be a whole big bunch better off than those who wait until the end of the long downturn to give in to their feelings of panic. If you sell enough to bring your stock allocation down to a level at which you feel comfortable holding through price drops, your worries go away.

In a long stock market downturn, those who panic first panic least.

When to Sell Stocks: Argument #3 for Selling in a Stock Market Downturn — The Strident Rejections of Selling as a Reasonable Choice Are Rooted in a Different Kind of Panic.

Those who argue that it is never a good idea to sell in a stock market downturn are evidencing feelings of panic of their own. Why do they suggest that those who sell are dumb? Why do they suggest that those who sell lack courage or balance or patience or whatever? Why are they so intense in their rejection of the idea that feelings of panic are appropriate?

That’s fear talking.

They’re afraid that they should be selling too.

They want you not to sell and millions of others like you not to sell because it gives them comfort to see that lots of others are doing what they are doing and holding onto their stocks during a stock market downturn. Their advice is aimed at benefiting them more than it is aimed at benefiting you.

They are not going to cover your losses if you follow their advice and suffer serious financial pain as a result of doing so. You need to do what’s right for you. You need to examine why it is that you are feeling desires to sell and whether those are feelings that you should pay heed to or not.

When to Sell Stocks: Argument #4 for Selling in a Stock Market Downturn — Feelings of Anxiety Early in a Stock Market Downturn Are a Warning Sign.

Assume that you buck up like a good soldier and ignore those voices you are hearing telling you to take something off the table. What’s going to happen if prices continue downward? You’re going to freak, aren’t you? If you’re barely able to take a small hit, a big hit is going to wreck you. The very fact that you are even thinking of selling today tells you that you probably are not going to make it through a prolonged downturn.

Investor Panic

Your feelings of panic are telling you something. They are telling you that you are over-invested in stocks. Whether you sell or not, you should not be ignoring those feelings. You should be figuring out why you are experiencing them and taking action to be sure that you do not come to feel them all the stronger in a deeper stock market downturn.

Buy-and-hold is a wildly popular investing strategy today. It is a sound strategy. But guess what? Most of us know next to nothing today about how to pull off buy-and-hold in a secular bear market.

Buy-and-hold became popular during the wild bull of the 1980s and 1990s. Lots of people say that they are going to stay the course through the secular bear that we appear to have entered early in this decade. But that’s just people talking. Those who purport to be buy-and-hold investors will find out if they really have what it takes only when we experience the rough part of a secular bear. Most of those purporting to follow buy-and-hold today have never yet been personally tested in any meaningful way.

We’re all shooting in the dark. That’s what it comes to. Those who say that they will hold no matter what are shooting in the dark. And those who say that they are wondering if perhaps they should take a bit off the table are shooting in the dark.

Who’s evidencing more emotional honesty and more emotional maturity, though?

My take is that it is those who are acknowledging their fears early in the stock market downturn who are evidencing more emotional honesty and more emotional maturity. Those who say that they will never sell in any circumstances either have not informed themselves as to what sorts of circumstances a secular bear can dish out or are in denial about their own likely responses to those circumstances.

You can’t trust what these people say. They are humans like all the rest of us. Their emotions influence their investing decisions. For now, their emotions dictate that they be dismissive of any concerns about what is going to happen in a prolonged stock market downturn. But who knows if they are telling it straight even to themselves, much less to us? Where did these people come from that they can claim to be above the normal human emotions, emotions that have caused investors to suffer oceans of pain in earlier stock market downturns? Were they born free of original sin?

Do you know what would give me confidence in the claims of those who say that they will never sell, no matter what? I would have more confidence in those claims if they were delivered with a more dispassionate tone. The words that I hear from them say “I’m not worried.” The tone that I hear from them says “I can’t stand even to think about this sort of thing!”

I don’t place too much confidence in the words that I am hearing from those who are dismissive of the idea of selling early in a stock market downturn. I don’t think you should either. If you’re worried, the odds are that you are worried for a good reason. You’re not a dope, right? You’re not by nature a worry wart, right? So why are you concerned?

You’re concerned for a good reason. Don’t let people too fearful to acknowledge that they too are experiencing fear talk you out of taking action on your legitimate concerns.

When to Sell Stocks: Argument #5 for Selling in a Stock Market Downturn — This Might Be the Big One, Elizabeth!

There’s a reason for your concern. It doesn’t follow that you should sell. If you sell every time you feel little feelings of panic, you are not going to prove to be a successful long-term investor. The reality is that the advice not to give in to feelings of panic is generally good advice. Armies don’t win wars by retreating every time they hear enemy fire. Sometimes the thing to do is just to march forward and let the battle be engaged.

Explain Stock Market

Sometimes the thing to do is to turn around and find a safe place to hide until conditions are more favorable to your chances of winning the battle. The trick is figuring out which sort of circumstances you face with the particular stock market downturn at issue.

No one can say with certainty, of course.

We can inform ourselves of the probabilities, however. This is where I break ranks with the conventional investing advisers. Most take the attitude that because we can never be certain that this next stock market downturn is the big stock market downturn that we should treat it the same as all the others, that we should always stick it out because it is usually a good idea to stick it out.


The odds change depending on the valuation level that appliesfor stocks at the beginning of the stock market downturn at issue. We have seen stock market downturns that begin at times of low and moderate prices. You know what? They pass. They don’t do too much harm to those able to stick with stocks for a reasonable amount of time. We have seen stock market downturns that begin at times of high valuations too. Those are different. Some of those pass. A good number of them wreck everyone going with a high stock allocation.

There are two different kinds of stock market downturns. Staying the course is not a good means of dealing with The Big Ones. With those, you want to cross over to the other side of the street as soon as you see one coming in your direction. Bruce Springstein once observed how there are times when we find ourselves “in the part of town where, when you hit a red light, you don’t stop.” Today’s P/E10 level is in the mid-20s. We are now taking a little trip through the part of town where, when you hit a red light, you don’t stop.

We are today at the sorts of valuation levels (this article was posted in March 2007) that sometimes bring on The Big One. It might be a good idea to cross over to the other side of the street in the early stages of the next stock market downturn.

When to Sell Stocks: Argument #6 for Selling in a Stock Market Downturn — We Don’t Know If This Is the Big One or Not.

It might be a good idea to cross over to the other side of the street. It might not. This might be The Big One. It might not.

Those telling you that you should not lower your stock allocation use that as an argument that you should not sell. If you cannot be sure that this is The Big One, you should hold to your current stock allocation, right?


That makes no sense. If you think that there is even a small chance that this is going to be The Big One, you should lower your stock allocation at least a bit. We don’t know when The Big One is coming, but we know that it is coming. Even if we don’t see a dramatic price crash, we know that times are going to be hard for stock investors until prices return to more reasonable levels. So why do we even need to determine whether this is The Big One or not? We know that we need to lower our stock allocations before The Big One comes, and we know that it is coming someday in the not-too-distant future. So what the jeepers are we waiting for?

Let’s speak plainly. If you are going with the same stock allocation today that you were going with the last time stocks were selling at reasonable price levels, you should be selling until you bring your stock allocation down to a level that presents the same level of risk as the risk level you signed up for back when stocks were selling at lower prices and were a lot less risky to own as a result. Make sense?

Confused About Stock Market

The downturn that you are concerned about today may well be a passing thing. If you sell, you might from a short-term perspective come to wish that you hadn’t. We just don’t know how stocks are going to perform in the short-term and I don’t see that there is much constructive purpose served in trying to guess. So let’s acknowledge that those arguing that you should not sell from a short-term perspective have a good point. How about from a long-term perspective?

That’s what matters, isn’t it? Successful investors are investors who focus on the long-term. When stock prices get out of control on the high side, they have to find their way back to more reasonable price levels in the long term, do they not? So what is the argument for sticking with the same stock allocation when prices have gone zoom-zoom for too long? There is no reasonable argument.

When to Sell Stocks: Argument #7 for Selling in a Stock Market Downturn — It’s Only By People Like You Selling That We Can Work Our Way Out of This Mess.

I am not a fan o wild bear markets. There are people who like them. Those who enjoy wild bulls evidence a short-term investing perspective by doing so. The best market is a market in which stock prices increase by the amount of the economic gains of the underlying companies, no more and no less. When things go stark raving bonkers, like they did in the 1990s, returns are reduced for many years to come. This is something that I am supposed to be happy about?

The thing that makes wild bulls so darn frustrating is that they are self-perpetuating. Once prices get out of control, there are many investors who want them to stay out of control because they don’t enjoy the idea of taking a ride back to more reasonable levels. That’s why it becomes so common at times like today for “experts” to advise us not to sell in stock market downturns. They are trying to ingratiate themselves with investors blinded by fear and greed into ignoring the fundamental realities of long-term investing.

Who needs it? This sort of thing gives me the creeps. If I am going to put my hard-won savings on the line, I want it to be on the line in an investment, not in a gamble. When we need to bully people into ignoring their natural concerns that prices are going soon to return to more reasonable levels, we’ve turned stock investing into a form of gambling. I’m not interested. I’ll play the game again when it again becomes less of a game.

It’s you, the investor thinking of selling in a stock market downturn, who is the key to turning this thing around. Do you know the real reason why many investors want you not to sell? Because they don’t want to have to sell themselves. They know that, if people like you sell, that brings prices down, and, after prices come down enough, they will have to sell too.

Let’s call the whole thing off. Let’s stop playing mind games with each other, admit that we got more than a little carried away back there in the 1990s, and do what we need to do to bring prices back to where the economic realities say they should be. Let’s act in our own best interest and thereby act in the best interest of all other genuine long-term investors at the same time.

Investing is a community endeavor. The worst rise to the top in a wild bull because there is no price to be paid for irresponsibility during a wild bull. Secular bears are the time when the Normals again assert control. You are thinking of selling because you are a Normal. Go with that good and positive and natural and perfectly reasonable feeling.

When to Sell Stocks

Don’t sell too much. Don’t get into the habit of selling in each stock market downturn and then buying again when prices recover. That way lies madness.

Sell to the point at which you feel comfortable with your stock allocation in a long-term sense. Get your allocation back to where it needs to be for you to be taking on the same level of risk as you were taking on back when prices were last at reasonable levels.

Do that, and you will naturally possess the fortitude needed to stick with your plan through scary times. It’s the difference between the bravado being shown by those telling you not to sell today and the genuine confidence rooted in an understanding of how valuations affect long-term returns possessed by the investor who knows not only how to talk the buy-and-hold talk but also how to walk the buy-and-hold walk.

The Wizard of Oz pinned a medal to the chest of the Cowardly Lion in the end, did he not? Dorothy gave him a big fat smooch on the cheek, did she not? Sometimes the truly brave thing to do is the thing that those of weaker character are dismissing as “cowardly.”

There’s a voice inside you telling you to lower your stock allocation a bit. That’s the voice of a friend. Give that voice a fair hearing. Sell until your stock allocation is one that inspires in you not a phony and false and loud and tiresome bravado, but a lasting confidence that your investing choices make sense and thereby advance a genuine stay-the-course approach.


Simple Investing — The Promise and the Risk

Simple Investing, Promise #1 — You can get good returns without spending a lot of time and effort on investing.

Many middle-class workers have jobs and family responsibilities that take up most of their time. They don’t want to be spending their weekends doing investing research. They are looking for a simple way to invest that provides a reasonable return with a reasonable amount of safety.

ABCs of Investing
Conventional indexing possesses a good bit of appeal to such investors. Indexers don’t need to research individual companies. Indexing generally provides good returns. Indexing provides a high amount of diversification, which helps reduce risks.

Simple Investing, Risk #1 — When prices get out of hand, conventional indexing becomes dangerous.

Stocks are far more risky at times of high valuations than they are at times of moderate valuations. This is true for all investors, but it is especially true for indexers.

Indexers are buying the market. So, when the market is risky, indexers hold risky assets. It is possible for those buying individual stocks to mitigate valuation risks through effective stock selection. No such possibility exists for indexers. It is imperative that indexers be made aware of valuation-oriented risks and take steps to mitigate those risks at time of high valuation by lowering their stock allocations.

Simple Investing, Promise #2 — You can leave your investments on autopilot and do well.

Indexing advocates often argue that it is better not to mess about with your investments too much. Investors often are tempted to do the wrong thing, to buy a hot investment just when it is beginning to grow cold or to sell a cold investment just when it is warming up. Indexers often argue that you should put things on autopilot not just because that simplifies investing but also because it enhances your long-term returns.

There’s a lot to this argument. Investments often offer the least long-term value when they are the most popular. Put things on autopilot and you won’t be tempted to do dumb stuff. Also, you’ll never learn whether your investing ideas are good ones or not unless you give them time to demonstrate their merit. Putting things on autopilot is not entirely a bad idea.

Simple Investing, Risk #2 — It’s a mistake to think that there’s no value in learning.

It’s generally smart not to believe that you can outsmart all of your fellow investors. Humility goes a long way in investing. Some investors run far too far with this thought, however. It’s a terrible mistake not to respect expertise.

I have heard indexers question whether Warren Buffett really possesses an edge in picking stocks. This is madness! Those who spend large amounts of time studying investing of course possess an edge. You don’t need to feel bad that you have chosen a “good enough” approach to investing because you don’t have the time to pursue more sophisticated strategies. But please don’t start thinking that there is no value to learning. That cuts you off from the benefits of learning for the rest of your life!

Investing 101

You don’t need to choose between adopting an overhaul of your investment plan every six months and putting things entirely on autopilot. The sensible middle-ground is to be reluctant to make big changes in your plan. But do be open to learning experiences. When you learn something new, of course you should make whatever changes in your plan are needed to reflect your new understanding of what works.

Simple Investing, Promise #3 — Understanding theory is not important.

Indexing advocates often describe their approach as the most “rational” way to invest. There’s something to that. Indexing is backed by a good bit of compelling research.

Many indexers possess only a foggy understanding of what the research really says. But there are many circumstances in which that does not matter. You do not need personally to be familiar with the research to benefit from use of the investing strategies developed as its fruit.

Simple Investing, Risk #3 — Following an approach that you do not fully understand may cause you to ignore warning bells.

The conventional approach to indexing is rooted in Efficient Market Theory. There are many smart people who hold serious doubts today about the merits of Efficient Market Theory. You need to understand the reasons for these doubts to protect yourself from the pitfalls of indexing.

You don’t need to read every academic paper published in the field. You need to know enough about the theory to understand both its strengths and weaknesses and to make an informed call as to whether adjustments to the conventional indexing strategies are needed in your case.

Indexers sometimes refer to themselves as “Know-Nothing Investors.” That makes me uneasy. You don’t need to be a “Know-Everything” Investor” and you certainly do not want to fall into the trap of coming to think of yourself as a “Know-It-All Investor.” Again, it is the sensible middle ground between the two extremes that holds the greatest long-term appeal. How about aiming to qualify as a “Know-a-Little-Something Investor?

Simple Investing, Promise #4 — It will work out in the long run.

Simple Investing

Indexers are told not to worry about price drops because indexing is intended as an investing approach for the long run and in the long run stocks can be counted on to do well. There’s a good bit of truth in that claim. The historical stock-return data indicates that stocks are likely to provide a good return in 30 years.

Simple Investing, Risk #4 — Tomorrow is a long time.

Many investors think that the long-term arrives in 5 years or 10 years or 15 years. The historical data shows that, for those heavily invested in stocks today (this article was posted in January 2007), the long-term may be more than 20 years away. If you are not prepared for poor results that remain in place that long, you should consider lowering your stock allocation until valuations return to more reasonable levels.

Simple Investing, Promise #5 — Indexing permits you to enjoy a share of the productivity generated by U.S. businesses.

On first impression, indexing might seem suspect. How could so simple an investing approach generate such handsome returns? Shouldn’t handsome returns go only to those taking on significant risks?

The reality is that, while indexers don’t like to think of themselves as gamblers, they are taking on a bet. They are betting that the U.S. economy will remain a strong economy for many years. If that doesn’t happen, indexers will be in trouble.

The beauty of indexing is that indexers only need to take on that one bet to obtain a solid return. If you are not confident that the U.S. economy will remain strong, you should not become a conventional indexer. If you are confident that it will, indexing offers you a one-bet way to tap into a strong long-term income stream. Indexing is simple investing because it eliminates the need to take bets on multiple questions and thereby eliminates the need to do research on multiple questions.

Simple Investing, Risk #5 — We are in a time of rapidly changing economic realities.

The U.S. stock market has been generating strong returns for over 100 years. That sounds impressive. It is that long track record that serves as the case for indexing.

Still, things change. Things change faster than ever today. We live in a global era. It might be that indexers should shift to thinking of a global index rather than a U.S. index as their core or even sole holding.

Stress-Free Investing

Indexers claim diversification as one of the benefits of their approach. But how diversified are you if almost all of your assets are tied up in a single type of investment, U.S. stocks?

Why not put some of your money into a U.S. index fund and some into a global index fund? Why not put some of your money into Treasury Inflation-Protected Securities (TIPS), which are a great counter to stocks? Why not put some of your money into individual stocks to provide the benefits of diversification at times when indexing is not generating good returns? Why not look into dividend-paying stocks, or real estate, or commodities?

Indexing is an investing option of considerable appeal. There is something in the mindset of many investors that makes them want to think that they have discovered the One True Way to invest. Indexers seem to be particularly drawn to dogmatism. Resist the urge to become fanatical about indexing and indexing will be more likely to provide you with an approach to simple investing that will stand the test of time.

If today was not a crooked highway,
If tonight was not a crooked trail,
If tomorrow wasn’t such a long time,
Then lonesome would mean nothing to you at all.



Stock Market Timing Strategies — What Works and What Doesn’t

Stock Market-Timing Strategy #1 — Short-Term Timing.

There are some smart people who engage in short-term timing of their stock purchases. I don’t feel that I can reject the methods they use out of hand as I have not studied them in sufficient detail to do so.

My personal view, however, based on my own study of the historical stock-return data, is that short-term timing does not work.

Market Timing

Stocks reached extremely high valuation levels in the mid-1990s. The data was telling us that stocks were dangerous and that we should lower our allocations. The reality is that stock prices boomed in the last three years of the decade. Those who sold their stocks in the mid-1990s did not see a short-term payoff for doing so.

That’s only one case, of course. My tentative conclusion, however, is that it is not so unusual a case. One of the most important lessons of the historical stock-return data is that stocks perform in surprising ways over and over and over again.

My recommendation is that you abstain from short-term timing.

Stock Market Timing Strategy #2 — Long-Term Timing.

Long-term timing is a different matter. The historical stock-return data indicates that long-term timing works.

Why is it that long-term timing works when short-term timing does not?

It’s because successful timing must be based on a well-informed prediction of how stocks are going to perform in the future. The best timing strategies are rooted in an understanding of how stocks have always performed in the past. Successful timers can’t see into the future any better than anyone else. They are taking an educated guess that stocks will continue to perform in the future at least somewhat as they always have in the past.

What is the basis for the educated guesses of successful market timers? It’s an understanding of the economic realities of stock investing combined with an analysis of the historical stock-return data. The economic realities tell us that stock prices can only go so high or so low because stock prices ultimately must reflect the earnings of the underlying companies. The historical stock-return data reveals to us the return patterns through which the economic realities influence stock prices in the real world.

In the short-term, the economic realities have little influence over stock prices. Stock investors can push prices up to absurd levels at times when earnings are nothing out of the ordinary, and stock investors can pull prices down to absurd levels when earnings are nothing out of the ordinary. In time, though, the economic realities prevail. In time, both the absurd highs and the absurd lows are revealed for what they are. In time, stock prices always return to levels approximating the fair value of the income streams of the underlying companies.

Stock Market Timing

Imagine yourself pulling the lever of a slot machine. The economic realities that govern gambling at a slot machine favor the house. Does that mean that you have no chance of coming out ahead after ten pulls of the lever? it does not. Anything can happen in ten pulls of the lever. Ten pulls of the lever are not enough for the economic realities to assert themselves.

What are your chances of being ahead after 10,000 pulls of the lever? Virtually zero. Ten-thousand pulls of the lever are enough for the economic realities to assert themselves.

That’s how it works with stock investing too. Those who ignore the economic realities can come out ahead for one year or two years or three years or four years. The economic realities always assert themselves in the long-term, however.

Long-term timing works.

Stock Market Timing Strategy #3 — All-In/All-Out.

An all-in/all-out market-timing strategy is not likely to work, in my view.

The problem with an all-in, all-out strategy is that, while it may be proven right in the long-term, it may be proven very wrong in the short-term. Most of us humans are focused on the short-term. Most of us humans can only take so much short-term pain before abandoning the long-term strategy responsible for it. Timers following all-in/all-out market timing strategies are the investors most likely to abandon their timing strategies just at the worst possible time for doing so.

Say that you looked at the historical stock-return data in 1996 and learned that stocks were at red-alert danger levels. Say that you took all of your money out of stocks as a result. What would have been your reaction to watching stock prices soar in 1997, 1998, and 1999? There’s a good chance that you would have given up on all that historical data jizz-jazz in late 1999 and bought stocks just at the worst possible time in the history of the U.S. stock market for doing so.

Successful market timers focus on the long-term. But we cannot afford to ignore the short-term. The long-term is comprised of a series of short-terms. We need to keep short-term possibilities in mind when developing long-term strategies.

I generally advise against all-in/all-out market timing strategies. Your aim should be to gradually lower your stock allocation as prices rise and to gradually increase your stock allocation as prices fall.

Stock Market Timing Strategy #4 — Frequent Allocation Shifts.

It is a mistake to make frequent changes in your stock allocation.

Stock Market Timing Strategies

The purpose of long-term market timing is to hold more stocks when they offer an especially powerful value proposition and to hold fewer stocks when they offer an unusually poor value proposition. We learn whether the price being charged for stocks is on the low side or on the high side by checking to see what P/E10 level applies for the S&P index. A P/E10 value of 8 is absurdly low. A P/E10 value of 14 is fair value. A P/E10 value of 20 is absurdly high.

If you set your stock allocation when the P/E10 value was 14 and it is now 20 and you are still holding the same allocation, you are making a mistake, in my view. The risks associated with owning stocks are now far greater than they were at the time you set your stock allocation. You should lower your stock allocation to bring your risk level back to what you determined was the right level for you when you initially set your stock allocation.

Does it follow that you should adjust your stock allocation when the P/E10 value rises from 14 to 16? It does not.

As a theoretical matter, the risks of owning stocks are a bit greater when the P/E10 value is 16 than they are when the P/E10 value is 14. The reality, though, is that our tools for measuring valuation levels are not sufficiently precise to tell us whether there is a significant difference in the value propositions for stocks at those two valuation levels. If you change your stock allocation every time there is a tick upward or downward in the P/E10 level, you are going to be making too many buys and sells. You are going to be driving yourself crazy with unjustified mood swings and you are going to be incurring unnecessary costs.

The case that stocks offer a dubious value proposition when the P/E10 level exceeds 20 is rock-solid, in my assessment. The case that stocks offer a significantly less attractive value proposition when the P/E10 value is 16 than they do when the P/E10 value is 14 is not at all strong, in my assessment.

Engage in long-term market timing by all means. But please resist the temptation to get too cute in your implementation of the insights you have developed from your study of the historical stock-return data.

Stock Market Timing Strategy #5 — Selling Stocks When Prices Exceed Fair Value.

The P/E10 value that represents fair value is 14. Should you sell stocks whenever the P/E10 value goes above that level?


The flaw in this strategy is in its implicit assumption that stocks offer a good value proposition only when they are being sold at fair value. It’s not so.

Timing the Market

The long-term real return on stocks when they are being sold at fair value is about 6.5 percent. That’s not just a good return. It’s an extraordinary return. It beats the return offered by most alternative asset classes by a country mile. When the P/E10 value rises above 14, the value proposition of stocks is diminished. But not enough to make stocks a poor investment choice.

Stock Market Timing Strategy #6 — Waiting Until Stock Prices Enter a Serious Decline to Sell Stocks.

There are some investors who understand that stocks are risky at today’s prices but who are holding off on lowering their stock allocations until stock prices enter a serious decline. The thinking here is that the investor can continue to take advantage of any price rises that take place before we begin traveling in earnest the road back to reasonable valuation levels.

Color me skeptical.

It’s certainly true that stock prices could head upward from these price levels. So there is a potential loss that might result from lowering your stock allocation today. The more important reality is that the potential downside is today far greater than the potential upside. If the risk level for your overall portfolio is too high, you should be taking steps to address the problem immediately.

The thought behind the strategy of waiting until prices enter a serious decline to sell stocks is that it is possible to distinguish a serious decline from a non-serious decline at the time the decline is taking place. I don’t think it is possible. It seems to me that those following this strategy are following a form of short-term timing.

The question that those who follow this strategy need to ask themselves is — How far would stock prices need to fall to persuade you that the price decline is a serious one? Say that your answer is “10 percent.” Stocks fall 10 percent and you sell. Then stocks go up 20 percent. Do you buy?

I don’t recommend mixing short-term timing strategies with long-term timing strategies. Long-term timing works and short-term timing does not work. Mix the two and you’ll end up with a strategy that might work and that might not. That’s a dangerous path to travel, in my view.

Long-term market timers do not try to predict short-term results. We instead focus on value propositions. When stocks represent a good buy for someone in our circumstances, we buy. When stocks represent a poor buy for someone in our circumstances, we sell until we get our allocations down to a level at which the stocks we own provide a solid value. We don’t even try to guess how far up or how far down any particular upturn or downturn is going to go before exhausting itself.

Stock Market Timing Strategy #7 — Waiting Until Stock Prices Hit Their Bottom Before Buying.

Stock prices have been at today’s level (this article was written in October 2006) three times before in the history of the U.S. market. The average percentage loss suffered on those three earlier travels to la-la land was 68 percent. When stock investors learn that they made a mistake buying overpriced stocks, they usually overreact. They continue to sell after stock prices have reached fair value, sending them down to price levels as absurd on the low side as they earlier were on the high side.

So is it smart to hold off on buying stocks until the P/E10 value drops to 7 or 8 or 9?

Not in this boy’s opinion.

Time the market The long-term returns that apply when stocks are purchased at a P/E10 value of 7 or 8 or 9 are truly mouth-watering. I can’t blame you for hoping that we see those sorts of prices someday in the not-too-distant future. I don’t recommend holding off on purchasing stocks until we get there, however.

Again, your focus should be on value propositions. At a P/E10 value of 14, stocks offer an outstanding value proposition. It is true that the historical record suggests that stocks you buy at a P/E10 value of 14 may later be selling at a P/E10 value of 7. You may suffer a 50 percent loss on shares you purchase at fair value as we head downward from the sky-high prices that apply today to the rock-bottom prices that the historical record suggests we may be seeing in the not-too-distant future.

That shouldn’t concern you too much. If you buy stocks when they are selling at a P/E10 value of 14, you are likely to see an astounding long-term return from that purchase. A potential 50 percent price drop is the price you pay to obtain that astounding long-term return. If things play out that way, don’t let it bother you too much. Keep your eyes on the prize.

It does make sense to hedge your bets. It seems to me to make sense to start buying stocks when the P/E10 level drops below 20, and then to buy more when the P/E10 value hits 14, and then to buy even more still if the P/E10 level hits 8. That way you are covered for all possibilities. If prices shoot upward after the P/E10 value hits 14, you will be in on the action. If prices continue downward after the P/E10 value hits 14, you will not be hurt too bad and will be positioned to reap the gains that come from increasing your stock allocation at a time when rock-bottom prices apply.

Stock Market Timing Strategy #8 — Selling All Stocks at High Valuations.

Performing a regression analysis of the historical stock-return data tells us that there is a good chance that the S&P index will provide an annualized real return of 1 percent or less over the next 10 years. Should you sell all of your stocks?

I see that as an over-reaction in the typical case (there are exceptions). The 10-year return on stocks is not likely to be good. The 20-year return on stocks is not likely to be good. But the same historical data that tells us that the 10-year return and 20-year return are not likely to be good also tells us that the 30-year return is likely to be not so bad. The 30-year return for a purchase of the S&P index made at today’s prices is likely to be a bit above 5 percent real. Not too shabby.

Why not keep 30 percent of your portfolio in stocks even at today’s prices? In the event that stock prices go up in the short term (don’t think it cannot happen), you’ll be glad you kept some skin in the game. In the event that we see a 50 percent price drop, you’ll only experience a 15 percent loss in your total portfolio value. That probably won’t be a devastating enough hit to cause you to sell the shares. So long as you don’t sell when prices are down, you will someday far out in the future see a solid return on that investment.

Valuation-Informed Indexing aims to avoid the extremes both of the “Stocks Are Always Best So Valuations Just Do Not Matter!” School and of the “Prices Have Gone So High That the Sky Will Soon Be Falling!” School. Ours is an investing approach that disdains exclamation points.

Market timing ideas

We’ve seen prices like those that apply today before. Millions of investors were wiped out as the result of tall tales that were told about how stocks perform in the long run on those earlier trips to la-la land, so we naturally want to avoid the sorts of illusions that fueled those earlier price crashes. Let’s not get swept up in the opposite sorts of emotions either, though.

Successful market timers keep their heads about them when their fellow investors are losing theirs. Successful market timers reject the most extreme claims of both the bulls and the bears. Perhaps we should think of ourselves as dolphins, creatures known for applying a measure of intelligence to the task of living life in an emotionally healthy way. Valuation-Informed Indexing is an investing approach for those capable of seeing the appeal of a moderate course.

Stock Market Timing Strategy #9 — Rewriting Your Plan Each Time Conditions Change.

It is a mistake to develop your market-timing strategy on the fly. When prices fall, most investors will respond emotionally. The media will respond emotionally. Most experts will respond emotionally. Long-term market timing works because it is an investing approach that is rooted in reason rather than emotion. To avoid getting caught up in the emotion of the moment, you need to prepare in advance a plan that guides you as to how to respond to all possible scenarios.

It is best to put your long-term market-timing plan in writing. It is best to be as detailed as possible in preparation of it.

Stock Market Timing Strategy #10 — Inflexible Implementation.

Valuation-Informed Indexing is a new approach. We are developing the rules of the road together each day in the discussions that we have at this site and at all of the various Retire Early boards. While we want our plans to be as detailed as possible and while we generally want to stick to our plans rather than allow ourselves to get caught up in the emotion of the moment when prices start to fall hard, we need to be realistic about the limitations of our knowledge of this new approach to long-term investing. When we discover errors in our understanding of the economic realities, we need to adjust our plans to reflect our revised understanding. We need to remain flexible in implementation of our market timing plans.

Is it possible to time the market?

Is it paradoxical to say both that we should stick with our plans rather than allow ourselves to be influenced by the emotion of the moment and also to say that we need to be flexible in the implementation of our plans so that new discoveries can be reflected in our investing decisions? It is.

Life is paradoxical at times. Humans are paradoxical at times. How could investing strategies designed to work in real life for humans not evidence a measure of paradox as well?

Good luck with your long-term market timing strategies, my fellow dolphin!

The 10 Most Common Objections to Following a Realistic Investing Strategy

Our common sense tells us to lower our stock allocations when prices go too high. That’s the only realistic investing strategy.

Investing Strategy

So why do so many middle-class investors resist the call and take on excessive levels of risk just because other investors have elected to bid stock prices up to unsustainable levels? In most cases, it’s because there are other less-friendly voices objecting to the common-sense plea.

Objection #1 to Following a Realistic Investing Strategy — Short-Term Timing Doesn’t Work

You mention that you are thinking of taking your next vacation at the beach. A friend responds that he doesn’t enjoy hiking in the mountains all that much.

You ask the man at the cash register for a pack of chewing gum. He says that he’s fresh out of sausage biscuits.

You ask your wife if she knows whether it is likely to rain tomorrow. She says that she heard that the Fed is going to raise interest rates.

In our non-investing lives, we are able to recognize absurdly irrelevant responses for what they are. If only the same were so in InvestOWorld. In InvestOWorld, if you suggest that it’s a good idea for long-term investors to lower their stock allocations when price get out of hand, you are all but certain to be met with references to 20 experts who have noted that short-term timing doesn’t work.

There is indeed a good bit of evidence that short-term timing doesn’t work. So? There is also a wealth of evidence that long-term timing does work. So long as an investor seeking to follow a realistic investing strategy by engaging in long-term timing (making a change in his stock allocation with no expectation that it will pay off for one or two or three years or longer) understands that short-term timing does not work, there is no reason why he should even taken into consideration the evidence that short-term timing does not work. This is a completely irrelevant investing reality.

This objection has great power. If anything, the strength of the case against short-term timing is a point in favor of long-term timing; the same historical data that shows that short-term timing has never worked also shows that long-term timing has always worked. Still, many investing “experts” are sloppy with their use of the word “timing;” they fail to make the critical distinction between the type of timing that works and the type of timing that does not work. Many investors do not have the time or inclination to study these sorts of matters on their own and fall victim to the word games employed by those more interested in selling stocks or their own “expertise” than in promoting a realistic investing strategy.

Objection #2 to Following a Realistic Investing Strategy — Most Other Investors Don’t Lower Their Stock Allocations When Prices Are High

The great irony of stock investing is that, if most investors followed a realistic investing strategy, we wouldn’t see out-of-control bull markets or out-of-control bear markets. If investing were primarily a rational endeavor, prices would never reach truly absurd levels.

Investing is primarily an emotional endeavor. Stocks are least risky when most middle-class investors see them as full of risk. Stocks are most risky when most middle-class investors see them as virtually risk-free.

Strategy Investing

Still, many of today’s investors take comfort in the knowledge that there have been few times in history when investors thought that U.S. stocks were as free of risk as they are today.

Objection #3 to Following a Realistic Investing Strategy — Most “Experts” Pooh-Pooh the Idea of Keeping One’s Risk Level Constant By Selling Stocks When Prices Get Too High

Surely the experts know better than you, right?

No, not right.

The experts may know more about how to keep commissions up than you do. The experts may know more about how to remain popular among the majority of investors than you do. The experts don’t see it as their primary job to protect your life savings. They see that as your job. Remember Dylan’s line in “Just Like Tom Thumb’s Blues”: “The cops don’t need you and, man, they expect the same.” That’s how it works with most investing experts.

You need to start seeing it as your job too. The experts have no intention of bailing you out when you suffer the losses likely to follow from following a less-than-realistic investing strategy. Listen to what the experts have to teach you, by all means. Always be sure to put what the experts tell you through a common-sense filter, however. Your common sense isn’t trying to sell you something.

Objection #4 to Following a Realistic Investing Strategy — It’s Silly to Think that the Historical Stock-Return Data Can Tell Us Something About How Stocks Will Perform in the Future

Just about every investing strategy features claims rooted in findings developed from an examination of the historical stock-return data. How do we know that stocks are generally a fantastic asset class? By looking at the historical data. How do we know that buy-and-hold investing is the way to go? By looking at the historical data. How do we know that stock investing is less risky for those with a long-term focus? By looking at the historical data.

So it shouldn’t shock you to learn that the historical data tells you when stocks offer a strong long-term value proposition and when stocks offer a poor long-term value proposition. It shouldn’t, but it does. I was talking to my brother the other day about the wonders of the Stock-Return Predictor (see tab at left). My own brother expressed skepticism as to whether it is possible to predict long-term returns effectively. The Goons have infiltrated my own family!

It’s the same historical data that tells us all that other stuff that also tells us that stocks offer a dubious long-term value proposition when prices reach the levels that apply today (this article was posted in July 2007). There’s a voice within each of us that tells us that the same historical data that guides all of our other investing strategies may safely be ignored when it warns us of the dangers of failing to respond to high prices in a sensible way. That’s the voice of the gambler, not the voice of the common-sense long-term investor.

Objection #5 to Following a Realistic Investing Strategy — There’s Not Enough Data to Make Precise Predictions About How Much Those Who Ignore Common Sense Will Be Hurt By Doing So This Time

There’s no such thing as too much data. It would be nice to have more data. The reality remains that there is enough data for us to make statistically valid (but not precise) predictions about how today’s valuations will affect the stock returns we will have obtained at the end of the next 10 years.

It’s a sensible voice telling us to make note of the lack of precision of the predictions. It’s not a sensible voice telling us to ignore the predictions.

Objection #6 to Following a Realistic Investing Strategy — Things Can’t Be As Bad as the Historical Data Indicates

How Investors Hurt Themselves

The historical data paints a bleak picture for those who fail to heed the message of the historical data. Things don’t look nearly so bad for those following a common-sense investing strategy.

If you see drops of water coming down from the ceiling of a room in your house, the common-sense response is to take this as a sign that repairs are needed. Ignore the need for repairs, and the outlook is indeed bleak. Tale reasonable steps promptly, and there’s no reason to think that anything so terrible is going to happen.

It’s not the historical data that makes things bleak for those overinvested in stocks today. It’s the voice within that causes those overinvested in stocks today to fail to take appropriate action to deal with the problem.

Objection #7 to Following a Realistic Investing Strategy — Acknowledging that Valuations Matter Means Acknowledging that the Real Value of Today’s Stock Portfolios Is a Good Bit Less than the Newspaper Numbers Indicate

This is the big one. Most middle-class investors are worried about having enough saved to finance a decent retirement. Most of us feel that we are barely keeping our heads above water. The last thing that we want to hear is that our stock portfolios are not worth as much as we have come to believe they are worth.

Your stock portfolio is not worth what you have come to believe that it is worth.

I know you don’t want to hear it. I get that message loud and clear. It’s my job to tell you the reality all the same.

It is only by knowing the reality that you can take effective action to protect yourself from a price drop. Sell some stocks today and you will have more money to invest in stocks when prices are lower and the long-term value proposition is again outstanding. Ignoring the realities does not make them go away. Taking effective action before the price drop is the best means available to you to protect your hopes of attaining your retirement goals at the time you hope to attain them.

A head-in-the-sand investing strategy is a fear-based investing strategy. Those seeking financial freedom early in life need to work up the courage to follow a realistic investing strategy.

Objection #8 to Following a Realistic Investing Strategy — It’s Anti-Stock to Think that Valuations Affect Long-Term Returns

This is the most tragic of all the objections raised to the idea of following a common-sense investing strategy.

Stock prices are largely predictable in the long-term. That’s a good thing for stock investors. If stock prices were not at least somewhat predictable in the long-term, stock investing would be pure gambling. Stocks are my favorite asset class. But I would not want to be invested in stocks at all if I thought that long-term prices were not to a large extent predictable.

Investors Are Their Own Worst Enemies

We all should be grateful that we now have the statistical tools available to us to form realistic expectations of how stocks will perform in the long term starting from various starting-point valuation levels. We all should be studying the historical stock-return data to learn what it says and to develop sensible investing strategies. We all should as a consequence be lowering our stock allocations from where we set them at times of reasonable prices.

The days of having to take wild risks as the price of participating in the stock market are over. That’s a good thing. The fact that some have come to see it as a bad thing reveals to us just how emotional an endeavor stock investing can become at times of wildly out-of-control prices.

Objection #9 to Following a Realistic Investing Strategy — The Future Might be Different than the Past

It’s true that the future might be different than the past. There are always surprises. Sensible investors should take that reality into consideration in the formation of their investing strategies.

Still, the chances are good that stocks will perform in the future at least somewhat as they always have in the past. Counting on stocks performing in totally new ways is a long-odds bet.

Objection #10 to Following a Realistic Investing Strategy — Prices Have Been High for a Long Time and Yet Stocks Have Not Done All That Bad

The valuation-informed investor has had available to him safe investment classes providing an annualized real return of 3.5 percent or better since January 1998. The returns provided by those investment classes have beat the return provided by an investment in the S&P index for close to ten years running, and at far less risk. Stocks have not been performing as we were told they are “supposed to” by those who argue for ignoring valuations for a long time now.

The historical data indicates that the story for those overinvested in stocks is likely to get worse before it gets better. No one can effectively predict the short-term. The economic realities control the long-term. The economic realities say that we are likely to see something in the neighborhood of a 40 percent real drop in the purchasing power of our stock investments (this figure includes the effect of dividends earned during the time of the price drop) in the not-too-distant future. It could be more or it could be less.

Investing in the Real World The fact that stocks performed exceedingly well during the 1990s offers little comfort to the investor seeking to follow a realistic investing strategy. The money used to finance the excess returns of the 1990s did not fall from the sky. Those returns were paid for by the stock investors of the future. The future is now. Today’s stock investors are being paid too little for the risk they have taken on because yesterday’s stock investors were paid too much for the risk they took on.

Prices go to unrealistic and unsustainable levels in wild bull markets. Common-sense investors ignore that junk. We invest in stocks, yes. But we aim to follow a realistic investing strategy when doing so. We lower our stock allocations when prices get out of hand. That’s one of the reasons why we are able to achieve financial freedom so much earlier in life than most others.