Question #1 Re The True Cause of the Current Financial Crisis: Why Did the Economy Collapse in Late 2008?
The economy collapsed because of the reckless promotion of Buy-and-Hold Investing for 28 years after the academic research showed that there is zero chance that this strategy can work for the long-term investor.
Question #2 Re The True Cause of the Current Financial Crisis: But Isn’t Buy-and-Hold Investing the Responsible Way to Invest for the Long Term?
That’s what most people think. That’s the problem. When a majority of investors come to view the most reckless way to invest as a safe way to invest, many people come to suffer very large financial losses. Our economic system is imperiled as a result.
Question #3 Re The True Cause of the Current Financial Crisis: What’s Not Safe About Buy-and-Hold Investing?
Like all assets that can be bought and sold, stocks offer a great value proposition at some prices and a poor value proposition at other prices. Buy-and-Hold Investors (they are often referred to as Passive Investors) do not change their stock allocations when prices change. That is, they direct just as much of their money to stocks when stocks offer a strong value proposition as they do when stocks offer a poor value proposition. When most investors become Buy-and-Hold Investors (or Passive Investors), price discipline disappears from the market. When price discipline disappears, the market becomes unstable and price crashes follow.
Question #4 Re The True Cause of the Current Financial Crisis: Why?
The purpose of a market is to set prices properly. When prices get pulled too far from fair value, they must be pulled back to fair value or the market will collapse. When we leave the market no other means of restoring prices to fair value, we force a crash. When we invest passively, we leave the market no other means of restoring prices to fair value. It is the buy-and-hold concept and the millions of investors who bought into it that caused the crash.
Question #5 Re The True Cause of the Current Financial Crisis: If the Purpose of the Market Is to Set Prices Properly, Why Did It Permit Stocks to Become So Insanely Overvalued in the First Place?
We are the market. In the short term, we have the power to set prices wherever we want to set them. We naturally feel a temptation to set prices above fair value because doing so appears for a time to be a way of voting ourselves big raises.
Question #6 Re The True Cause of the Current Financial Crisis: You’re Saying That We Like to Set Prices High But that We Also Like Fair-Value Prices. Which Is It?
It’s both. We feel a great short-term temptation to set prices insanely high. But we ultimately are governed by the long-term economic necessity that prices reflect fair value. It’s the tension between the short-term desire for high prices and the long-term requirement of fair-value prices that causes all stock crashes. If prices never get too out of control, the tension can be resolved through modest price drops. But when the idea that price doesn’t matter (Buy-and-Hold Investing or Passive Investing) catches on, prices go so high that a crash becomes an inevitability.
Question #7 Re The True Cause of the Current Financial Crisis: Why Do You Say that Buy-and-Hold Investors Believe that Price Doesn’t Matter? The Believe in Rebalancing, Don’t They?
Rebalancing doesn’t solve the mispricing problem. The goal of rebalancing is for the investor to remain at the same stock allocation at all valuation levels. That’s not a rational response to mispricing. The rational response to mispricing is a lowering of one’s stock allocation. It makes no sense for an investor to maintain his stock allocation when returns have been reduced and risks have been increased.
The historical stock-return data shows that the most likely 10-year annualized return on stocks when they are priced as they were in the early 1980s is 15 percent real. The most likely 10-year annualized return on stocks when they are priced as they were in January 2000 is a negative 1 percent real. There is no one stock allocation that makes sense at both price levels. An 80 percent stock allocation makes sense when the most likely long-term return is 15 percent real but not when it is a negative 1 percent real. A 20 percent stock allocation makes sense when the most likely long-term return is a negative 1 percent real but not when it is 15 percent real.
Question #8 Re The True Cause of the Current Financial Crisis: Aren’t Stocks Always the Best Choice for the Long Run?
It depends on what you mean by the phrase “the long run.” It is true that stocks are almost certain to provide a great return after 30 years regardless of the price at which they are purchased. However, this is not so at 10 years or 15 years or 20 years or even in some cases 25 years. Someone buying stocks at the prices that applied from January 1996 through September 2008 might not see a return better than what he could have obtained from far safer asset classes for as long as 25 years. It is possible that those who purchased stocks at the top of the bubble will not be able to equal the returns that were available at the time from Treasury Inflation-Protected Securities (TIPS) for 60 years! That’s a long, long, long “long-term.”
Question #9 Re The True Cause of the Current Financial Crisis: Are You Recommending Market Timing?
I agree with those who say that short-term market timing (changing your stock allocation with the expectation of seeing a benefit for doing so within a year or so) is a bad idea. However, I also say that long-term timing (changing your stock allocation in response to big price changes with the understanding that you may not see a benefit for doing so for as long as 10 years) is a good idea. It is common sense to take the price at which stocks are being sold into consideration when deciding how much of your money to put into stocks. The historical record shows that long-term timing always works. In fact, it shows that those who fail to engage in long-term timing cannot achieve investing success in the long term.
Question #10 Re The True Cause of the Current Financial Crisis: Didn’t Many Buy-and-Hold Investors Do Well for a Long Time?
All investors heavily invested in stocks did well from 1975 through 1995. They didn’t do well because they invested passively. They did well because stocks were priced to provide strong long-term returns. By January 1996, prices had risen high enough that that was no longer so. It was only from 1996 through 1999 that Buy-and-Hold Investors did well because they invested passively (that is, because they failed to follow the common-sense inclination to lower their stock allocations in response to insanely high stock prices). Rational Investors (those who take price into consideration) have done better since January 2000. Rational Investors are now ahead on an overall basis and that differential will grow over time because of the compounding returns phenomenon.
Question #11 Re The True Cause of the Current Financial Crisis: How Much Does That One Case Prove?
It’s not only the one case. The P/E10 value (P/E10 is the price of the S&P Index over the average of the last 10 years) has gone over 25 four times in U.S. history. On those four occasions, stock investors suffered an average loss of 68 percent real. On each of those occasions, we experienced an economic crisis. We have not once since 1900 experienced an economic crisis that was not preceded by a P/E10 value exceeding 25. It is insanely dangerous stock prices that are the primary cause of economic crises.
It is not hard to understand why. Once we get to insanely high stock prices, stocks must crash if the market is to continue to function. Stock crashes cause massive losses of wealth. Massive losses of wealth cause consumers to cut back their spending dramatically. Dramatic spending cutbacks cause businesses to fail. Business failures cause millions to lose their jobs.
Teaching investors to ignore the prices of the stocks they buy sets in motion a chain of events that sooner or later inevitably produces an economic crisis. Persuading millions to follow a buy-and-hold strategy is the financial-world equivalent of persuading millions to remove the brakes from their cars. Cars without brakes always crash sooner or later. So do economies in which all price discipline has been removed from the stock market.
Question #12 Re The True Cause of the Current Financial Crisis: It Sounds As If You Are Saying That Long-Term Stock Returns Are Predictable. That Would Be a Little Bit Too Good To Be True, Wouldn’t It?
How so? If you think a moment about where it is that stock returns come from, I think you will see that it should come as no surprise to us to learn that stock returns are highly predictable. Stock returns are not set by a Random Number Generator in the Sky. When you buy a share in a broad U.S. stock index, you are buying a share in U.S. productivity. U.S. productivity has been strong enough to finance an average annual stock return of something in the neighborhood of 6.5 percent real for many, many years. It certainly is possible that that number could drop to 6 percent or rise to 7 percent. But it seems unlikely that we will see dramatic changes. So why would anyone think that long-term stock returns would not be at least to a large extent predictable?
Question #13 Re The True Cause of the Current Financial Crisis: Are There Any Experts Who Agree With You That Long-Term Returns Are At Least Somewhat Predictable?
Yes, there are a good number of them. The list includes: (1) Robert Shiller; (2) John Walter Russell; (3) Rob Arnott; (4) Warren Buffett; (5) William Bernstein; (6) John Bogle; (7) Cliff Asness; (8) Ed Easterling; (9) Scott Burns; (10) Andrew Smithers; (11) Michael Kitces; and (12) Jeremy Grantham. Even many Passive Investing advocates acknowledge that long-term returns are at least somewhat predictable.
Question #14 Re The True Cause of the Current Financial Crisis: If A Good Number of Experts Agree That Long-Term Returns Are At Least Somewhat Predictable, Why Are We Told So Often to Invest Passively?
Most of those cited as “experts” on investing have ties to The Stock-Selling Industry. All industries like to see their customers buy as much of their product as possible and at all times and prices. Buy-and-Hold Investing has brought in millions to The Stock-Selling Industry.
Question #15 Re The True Cause of the Current Financial Crisis: Are You Saying That Most of Today’s Investment Experts Are Corrupt?
No. I don’t believe that. I believe that most of today’s investment experts are smart and good and hardworking people who want to serve their clients effectively. I also believe that most of today’s investment experts arecompromised.
There was a time when the academic research really did support Buy-and-Hold Investing. My sense is that, as the evidence came in that big mistakes had been made in the first formulation of the Buy-and-Hold model, cognitive dissonance kicked in and the “experts” used their high-octane brains to develop ever-more-convoluted rationalizations for ignoring the evidence that valuations affect long-term returns and the implications of that reality. Stock prices continued to go up until 2000, so for years the was little pressure from investors to fix the holes that had been revealed in the theory. After the 2008 crash, investors have become more restless. But now the embarrassment that comes with acknowledging the mistakes that were made for years is greater than ever.
The financial pressures not to question Buy-and-Hold Investing are enormous. An investing expert who finds fault with Buy-and-Hold Investing courts social ostracism and perhaps the loss of a career that is highly rewarding and that pays very, very well. It is human nature in such circumstances not to look too closely at ideas that would rock a happy boat. The psychological literature tells us that in these circumstances it is possible for large numbers of “experts” to feel such reluctance to share the realities as to hold back from learning what they need to learn to appreciate the realities themselves. Today’s investment experts are highly incentivized to know as little about how stock investing really works as possible. Achieving true expert status is a career limiting move.
Even among personal finance bloggers (who obviously do not face the same financial pressures), we have seen a great reluctance to acknowledge mistakes. We are suffering from what the economists call a “Tragedy of the Commons” problem. No one benefits from our failure to inform investors of what really works. The economic crisis hurts us all. But each individual blogger fears that he will lose links and annoy those of his readers who still believe in Buy-and-Hold Investing if he points out that the experts have been giving wildly dangerous advice for years now, and each “expert” fears that he will lose the confidence of his clients if he “tells.”
We need to persuade a few leaders to step forward. My sense is that thousands of others will happily get with the program once they come to feel that it is “safe” to do so, that they will not be violating a social taboo to let their clients know the realities of stock investing as revealed by the academic research of the past three decades.
Question #16 Re The True Cause of the Current Financial Crisis: You Are Saying that the Evidence That Buy-and-Hold Doesn’t Work Is Strong And Yet That the Experts Who For a Long Time Have Been Promoted It Heavily Are Not Corrupt. Isn’t That a Contradiction?
It’s a contradiction. I once recorded a podcast (RobCast #73) entitled “It’s Not a Conspiracy, It’s Cognitive Dissonance.” It tells the story of two academic researchers who joined a cult to learn what makes cult members tick. The members of the cult had given up their marriages and their jobs and their live savings to be a part of a cult that believed that the world was coming to an end on a specified date. When the date came and the world did not end, the researchers watched to see the cult members turn on their leader. The leader said that he would need to check with the aliens who had earlier revealed to him that the end of the world was approaching as to what had happened. He came back to report the happy news that the cult’s strong belief had persuaded the aliens that it was not necessary to bring the world to an end just yet. He congratulated the cult members for the important mission they had accomplished through their many sacrifices. The failure of the world to come to an end on schedule was interpreted by the cult members as confirmation that they were doing the right thing to devote their lives to this cause.
Like it or not, that’s how we operate. I have seen Buy-and-Hold dogmatics threaten to kill those who post accurate reports of what the academic research has been saying for 30 years now. I think it would be fair to characterize such behavior as highly defensive. Yet I can also report that the same community members who feel an intense desire to block honest posting on the flaws in Buy-and-Hold Investing themselves follow it. We cannot say that just because people show that they are aware of the weak points of the Buy-and-Hold concept it is clear that they themselves have lost faith in the idea. My sense is that the vast majority of Passive Investing advocates believe that it works (while also feeling doubts that make them intensely defensive when questioned as to why they believe).
Question #17 Re The True Cause of the Current Financial Crisis: You Said Above That There Was a Mistake Made in the Formulation of the First Draft Version of the Buy-and-Hold Approach. What Was This Mistake?
The academic researchers learned in the 1960s that short-term timing does not work; that is, it is not possible to predict effectively what the stock return will be over the next year or so. There are two possible explanations for this reality. One is that the market does such a good job at setting prices that it is not possible for any investor to reliably do a better job. The second is that the market does such a poor job at setting prices, at least in the short term, that the best that any investor engaged in short-term timing can do is take guesses as to where prices will be in the next year or so.
The academic researchers took a guess that the first explanation was the one that applied. All of today’s conventional investing wisdom is rooted in a belief in the accuracy of this guess. It is because most experts believe that the market does a good job of setting prices that you are told that you cannot beat the market, and that timing never works, and that stocks are always the best investment choice for the long run.
Yale Professor Robert Shiller published research in 1981 showing that it was not the first explanation but the second explanation that actually applies. Shiller showed that valuations affect long-term returns; that is, stocks provide higher returns starting from times of good prices than they do starting from times of bad prices. If the first explanation (that the market does a good job of setting prices) applied, there could never be any significant amount of overpricing (overpricing is mispricing, not accurate pricing).
However, Shiller’s findings are entirely consistent with the second explanation. Shiller showed that valuations affect long-term returns. If the market does a poor job of setting prices in the short-term but a good job of setting prices in the long term, it would follow that returns would be poor starting from times of high valuations and that returns would be good starting from times of low valuations.
Prices can go just about anywhere in the short term. But they are always in the process of moving to fair value. When prices are insanely high, they are fated in not too long a time to crash. When prices are insanely low, they are fated in not too long a time to shoot upward. The market is not immediately efficient but only gradually so.
Shiller’s findings have been confirmed by dozens of studies published over the past three decades. There has never been a credible study published supporting a claim that long-term timing doesn’t work. The often-repeated claim that “timing doesn’t work” is a falsehood. The reality (as revealed by the historical stock-return data) is that timing always works and is required for those investors hoping to have a reasonable chance of achieving long-term investing success. Oops!
Question #18 Re The True Cause of the Current Financial Crisis: Can We Be Absolutely Sure That Long-Term Timing Will Continue to Work?
I don’t think we can be absolutely sure.
Common sense tells us that long-term timing must work. For there to be a time when long-term timing did not work, there would have to be a time when the price we paid for stocks had no effect on the value proposition obtained from them. I think it would be fair to describe that as a logical impossibility.
And the historical stock-return data confirms that what our common sense tells us must be so in fact always has been so in the real world.
I don’t think we can say more than that. There are no guaranties. Many were surprised by Shiller’s findings. It may be that we will be surprised again in coming days by findings that few anticipate today. The future is unknown.
That said, I think it would be fair to say that the prudent way to invest is to assume that stocks will perform in the future at least somewhat as they always have in the past. Buy-and-Hold Investing is the longest of long shots. We should not be advising millions of middle-class investors to take the longest of long shots with their retirement money, in my assessment. At the very least, we should be cautioning those who elect to invest passively that the historical data offers little support for their choice.
Question #19 Re The True Cause of the Current Financial Crisis: The Experts Who Promote Buy-and-Hold Investing Have Studied Investing Far More Than You Have and Many Manage Large Funds. Do You Really Think It Is Possible That You Know More About This Than They Do?
I do. The “experts” are smarter in an intellectual sense. The problem here is not intellectual in nature. The problem is emotional in nature. The experts very much want to believe in Buy-and-Hold Investing and the millions of middle-class investors who follow this strategy very much want to believe in it. I am not emotionally attached in this strategy. On this one issue, I believe that I am right not despite my lack of a background in this field but becauseof it. The experts have too much to lose (or at least see themselves as having too much to lose) by acknowledging how strong the case is that Buy-and-Hold Investing does not work and that their promotion of this approach caused the current financial crisis to accept clearly established (in my view!) realities.
Question #20 Re The True Cause of the Current Financial Crisis: Do You Acknowledge That This Is An Incredible Claim?
Yes. It is also the best explanation that my mind is able to come up with to explain an exceedingly strange series of events. On the morning of May 13, 2002, I reported to a Motley Fool discussion board that the studies that financial planners use to help us plan our retirements (these studies are called “safe withdrawal rate” studies) fail to account for the effect of the valuation level that applies on the day the retirement begins and thus get all the numbers wildly wrong. My findings have been confirmed by numerous experts. Yet not one of the discredited studies has been corrected in the seven years since. Instead honest posting on safe withdrawal rates has been banned at numerous discussion boards and blogs. If you are able to come up with a better explanation of this verifiable reality than widespread cognitive dissonance among those who advocate Buy-and-Hold Investing, I would be grateful if you would share it with me.
Question #21 Re The True Cause of the Current Financial Crisis: Are You Saying That 90 Percent of Today’s Investing Experts Are Certifiably Nuts?
I’ve learned wonderful things from a good number of the experts who promote Passive Investing strongly. I feel a good bit of respect and affection for these people. I believe that they are good and smart and hardworking people who fell into a trap when they came to believe in Buy-and-Hold Investing. I believe that they have caused great human misery through their advocacy of this dangerous idea.
Are they nuts? Kinda, sorta. I believe that the wisdom of the television commercial for the Mounds and Almond Joy candy bars applies here: “Sometimes you feel like a nut — and sometimes you don’t!”
We all are kinda sorta nuts re certain issue at certain times and in certain circumstances, are we not? Think of the Passive Investing Era as the time-period when the majority of investing experts drove drunk or got addicted to cigarettes or dated people obviously not right for them. We need to put aside the idea that there is a rational explanation for all human behavior. It’s not so. It’s holding us back. It’s become dangerous for us to continue to entertain this excessively rationalistic (and not even a little bit rational!) fantasy.
John Bogle is a whole big bunch smarter than Rob Bennett in an I.Q. sense. But Rob Bennett has been placed in circumstances that have permitted him to zoom past John Bogle in his understanding of what works in stock investing. I didn’t ask for this to happen. It happened. Given the circumstances in which we find ourselves, I do not think that it would be responsible for me to pretend that I believe that John Bogle is incapable of making mistakes. I am personally aware of a number of very important mistakes that he has made. I would like to help him come to understand where he got on the wrong track and thereby help him to become once again a leading figure in helping middle-class investors to invest effectively.
I don’t blame Bogle or any other Passive Investing advocate for the mistakes that have been made. But I see it as my job to press as hard as possible for correction of the mistakes. For the mistakes to remain uncorrected puts us all (including the Passive Investing advocates) at great risk.
I wish that we all could get past the temptation to play the blame game and get about the business of repairing the damage done to our economic and political systems through the reckless promotion of Buy-and-Hold Investing for 30 years since it was revealed to be an unworkable idea. Once we do that, I believe that we will find ourselves on a path that takes us up, up, up, rather than on the one that for a long time now has been taking us down, down, down.
Question #22 Re The True Cause of the Current Financial Crisis: How Could So Many Good and Smart People Get It So Totally Wrong for So Terribly Long?
This is not the first time that such a thing has happened. There was a time when millions of people believed that the earth was flat. There was a time when millions of people believed that the earth revolved around the sun. There was a time when millions of people believed that man would never walk on the moon.
These things happen.
The good news is that the reckless promotion of Buy-and-Hold Investing has been an anchor on economic growth for so long now that it is hard to overestimate how good we could have it if we made the shift to a more realistic approach. Rational Investing (the investing model proposed as an alternative to Passive Investing in a number of articles and podcasts at this site) is such an advance that making the shift from Passive to Rational may well provide the lift to middle-class spirits (and pocketbooks!) needed to escape today’s economic and political crisis.
It frustrates me that The Great Safe Withdrawal Rate Debate has often been perceived as a negative story. The abusive posting we have seen is indeed a dark business. But many community members have given generously of their time to help us craft together an exciting new model for understanding how stock investing works. I believe that the ugly stuff will in time be blown away in the wind. The good stuff is going to be enhancing middle-class lives for many, many years to come. This is an up story. Please don’t let anyone tell you different!
Question #23 Re The True Cause of the Current Financial Crisis: What’s Next?
I believe that we need to launch a national debate about the flaws of Passive Investing and that the advocates of Rational Investing principles need to work with the advocates of Passive Investing principles to build a better model for the benefit of all investors. I am not able to imagine how such a debate could work to the detriment of anyone alive on Planet Earth today. I see this as a win/win/win/win/win. Understanding how investing works in the real world will permit us all to obtain far higher returns while taking on far less risk.
Question #24 Re The True Cause of the Current Financial Crisis: Are You Not Telling Us That You Have Found the Proverbial Free Lunch?
I am. I view the idea that there is no such thing as a free lunch as one of the most unfortunate ideas popularized by widespread promotion of the Passive Investing concept. All learning experiences permit us to partake in free lunches. John Bogle’s launching of the Indexing Revolution brought a free lunch to millions. Life itself is a free lunch — did any of us pay for an admission ticket to this wild adventure? Being able to obtain higher returns at reduced risk is our reward for learning how stock investing really works. We should not be reluctant to grab this free lunch and gobble it down hungrily.
Question #25 Re The True Cause of the Current Financial Crisis: You Acknowledged Above That the U.S. Economy Generates Only Enough Productivity to Finance an Average Long-Term Return of 6.5 Percent Real. How is the Rational Investing Free Lunch Going to Be Paid For?
Promotion of the Buy-and-Hold concept leads to huge market imbalances. At the top of the bubble, stocks were priced at three times fair value. That means that, for every $1,000 that we invested in stocks, we obtained about $350 worth of stocks and about $650 worth of cotton-candy nothingness that was fated to go “Poof!” in days to come. We all possessed huge amounts of pretend wealth. Those with portfolio statements saying that they possessed an accumulated wealth of $100,000 in reality possessed an accumulated wealth of $35,000. Those with portfolio statements saying that they possessed an accumulated wealth of $500,000 in reality possessed an accumulated wealth of $175,000.
The result is that millions of us were spending large amounts of money on houses and cars and vacations that we could not afford to spend. We started businesses that we thought were properly capitalized but that in reality were much undercapitalized. We handed in resignations from jobs in the belief that we were ready to retire when in reality we were not close to being ready to retire. We miscalculated risk in thousands of different ways.
That comes to an end when we begin reporting accurately the numbers we use to plan our financial affairs. In a Rational Investing world, you would never see a report of the S&P value or the Dow Jones value without seeing next to it an indication of the reduction in the nominal number needed to adjust for the effect of overvaluation. For the first time in history, we would be using accurate numbers to plan our financial futures. The implications are almost unthinkable (unthinkably good, not unthinkably bad).
We live in scary but exciting times. If we play our cards right, we could turn this economic crisis into a very good thing for all of us. The hard part is working up the courage it takes to say the three hardest words to pronounce in the entire English language — “I” and “Was” and “Wrong.” After that, it’s all downhill sledding.
The economic crisis is over — if we want it to be.