The Returns-Sequence Reality Checker – A Stock Cycles Calculator

The Returns-Sequence Reality Checker is a unique stock cycles calculator that identifies the return patterns that yield the best long-term results for stock investors.

Stock Cycles
Sam Parler performed the statistical work needed to create the calculator. As has been so in the development of all the calculators available at the site, my role was to ask lots of annoying questions, slow down progress and just generally muck things up.

I have been writing for nine years now about the dangers of Buy-and-Hold Investing and about the need for us all to make the transition to Valuation-Informed Indexing. The only difference between the two models is that Buy-and-Holders stay at the same stock allocation at all times while Valuation-Informed Indexers adjust their stock allocations as needed to keep their risk profiles roughly constant.

Buy-and-Hold was developed at a time when the academic research was thought to support the Efficient Market Theory. If the Efficient Market Theory were valid, Buy-and-Hold would indeed be the ideal strategy. However, Yale Economics Professor Robert Shiller published research in 1981 showing that valuations affect long-term returns and that the Efficient Market Theory is thus invalid. Given this reality, staying at the same stock allocation at all times is a terrible mistake. By following Buy-and-Hold strategies, investors greatly increase the risks of stock investing while dramatically lowering their long-term returns.

There is today a mountain of evidence showing that this is so. Yet Buy-and-Hold remains popular! Experts in the field have told me that they continue to recommend Buy-and-Hold because the investing realities are “information most people don’t want to hear.” We are emotionally addicted to investing strategies that are making us poor!

I have struggled to understand why it is that investors are so reluctant to accept the need to change their stock allocations from time to time. This is very much a counter-intuitive reality. All of us consider price when buying cameras and computers and cucumbers and comic books. All that the research of the past three decades is saying is that we need to consider price when buying stocks (that is, that we should go with higher stock allocations when prices are low and lower stock allocations when prices are high) as well. Why doesn’t everyone agree? Why does the claim that Buy-and-Hold (staying at the same stock allocation at all times) is a bad idea inspire controversy?

It is because the stock market functions unlike any other market.

Reversion to the Mean

Consider the market for used cars. When a car is offered for sale, there is one party to the transaction (the owner of the car) who wants the price to be set as high as possible and there is another party to the transaction (the buyer) who wants the price to be set as low as possible. The two parties each aim to press their points as hard as they can without causing the negotiations to fail. The result is a price that reflects both the perceived benefits of the particular car and the perceived shortcomings of the particular car, a price that is roughly right.

This dynamic does not apply in the stock market. Even though most investors will be net buyers of stocks for most of their lifetimes and thus should favor low prices, the vast majority applaud price increases and react with dismay to price drops. Most investors favor outcomes opposed to their self-interests!

So long as this remains so, the market will remain dysfunctional. Investors will continue pushing prices up until they rise so high as to cause a price crash (prices must at some point return to fair-value levels if the market is to continue to function). The loss of wealth resulting from the crash will cause millions to pull back on spending, which will cause an economic crisis (every major bull market since 1900 has led to an economic crisis and we have not experienced a single economic crisis since 1900 that was not preceded by a major bull market). The economic crisis will in time pull stock prices to levels as insanely low as they once were insanely high (every major bull market since 1900 has been followed by a time when prices fell to levels 60 percent down from where they stand today — this article was written in April 2011). These bull/bear, boom/bust stock cycles cause huge wealth destruction for all of us. In severe cases, such as in the Great Depression (caused primarily by the bull market of the 1920s and the price crash that followed inevitably from it) these insane stock cycles can even threaten to bring about a loss of confidence in our political system.

We need to bring an end to these crazy stock cycles!

If we could bring an end to the stock cycles, we would never again see an out-of-control bull market. Which means that we would never again see an out-of-control bear market. Which means that there is a good chance that we would never again see the sort of economic crisis that we are living through today. Which means that we would all obtain far higher returns from our stock investments while taking on far less risk and that our economy could become much more productive.

The purpose of The Returns-Sequence Reality Checker is to bring an end to the irrational stock cycles that for over 100 years have been causing us such economic turmoil. The calculator aims to do this by educating investors as to the types of return sequences that are truly in their best interests.

The Reality Checker permits the investor to assume any annualized return he chooses for a 30-year time-period. The average return we have seen throughout U.S. stock market history is 6.5 percent real. So you might want to use that as your assumption. But if you believe that the U.S. economy will be more productive in the future than it has been in the past, you may choose 7 percent or 8 percent as the annualized 30-year return, and if you believe that the U.S. economy will be less productive in the future than it has been in the past, you may choose 6 percent or 5 percent as the annualized 30-year return.

Secular Bear Market

After choosing a 30-year return, the investor assigns hypothetical returns to as many of the 30 years as he pleases. The calculator then fills in the returns that would need to apply in the remaining years for the annualized return specified for the entire time-period to apply.

An option is provided for the investor to choose historical return sequences. For example, the default results (the results that appear before you enter any numbers of your own) compare the 30-year returns sequence we saw beginning in 1971 and the returns sequence we saw beginning in 1981.

The lesson taught by the Reality Checker is that stock cycles always apply and that the nature of the stock cycles that turn up during a particular time-period have a big effect on the return enjoyed by those investing in stocks during that time period. Few of today’s investors pay much attention to stock cycles. The calculator teaches us that we all need to be paying a great deal of attention to them.

Please take a look at the default results. These results show us that an investor who started with a portfolio value of $10,000 and then added $10,000 in contributions for every year of a 30-year returns sequence did much better if he began investing in 1971 than if he began investing in 1981. The 1971 starting-point produced a final portfolio value of $1,945,781 while the 1981 starting point produced a final portfolio value of only $921,287.

This is the opposite of the result that most investors would have expected to see. The 1970s were perceived as bad years to own stocks. The 1980s and 1990s were perceived as great years for stock investors. So why did the 30-year time-period beginning in 1971 generate better results? It’s because investor perceptions are precisely the opposite of the realities. Price drops are better for most investors than price gains. The price drops experienced in the 1970s permitted investors to buy stocks at lower prices and buying at lower prices permitted them to earn far higher long-term returns.

The 1971 and 1981 returns sequences are not precisely comparable. The stock market return for the returns sequence beginning in 1981 was 7.80 percent while the return for the returns sequence beginning in 1971 was only 7.28 percent. This difference is not the primary cause of the difference in the results.

Mean Reversion

You can check this by having the historical returns sequences apply only for 29 years and having the same 6.5 percent return apply for both 30-year sequences. Go to the box where the number of years for which the historical sequence should apply is specified, change the number from “30” to “29” and the calculator will generate the changed numbers. When the return for the two 30-year sequences is held steady, the 1971 sequence still produces an ending portfolio value of $1,354,736, a far larger sum than the $741,850 ending balance generated by the 1981 sequence. The primary cause for the difference in results is that the order of the returns is different. Low returns in the early years increase the payout to investors.

Most investors should be rooting for low returns! That’s the moral of the story.

Try entering 10 percent gains for each of the first 10 years of one 30-year sequence and 10 percent losses for each of the first 10 years of the other 30-year sequence (you need to enter zeros in the boxes used to tell the calculator to pull returns from the historical record). The results that turn up illustrate the power of stock cycles in a dramatic way. The returns sequence beginning with 10 years of gains produces a closing balance of $796,051. The returns sequence beginning with 10 years of losses produces a closing balance of $2,435,295. Please understand that both of these 30-year returns sequences are generating the same annualized return of 6.5 percent real. The difference in results is solely due to the different ordering of returns. Stock cycles with early losses benefit most investors. Stock cycles with early gains hurt most investors.

Stock gains are price increases! That’s the point being illustrated here. It is a finding of far-reaching consequence.

If investors were to come to understand that price gains are generally bad news and price drops are generally good news, investors would no longer get caught up in the emotionalism of Buy-and-Hold strategies. Price volatility would be greatly diminished. Investors would not bid stock prices up to insanely high levels. Thus, we would never again see price crashes and the economic crises that follow from them. Stocks would continue to provide the great returns that have long been associated with this asset class but stock investors would experience only a small fraction of the risk that applied to stock investors of the past. Non-volatile stocks are non-risky stocks.

Does this sound like a fantastic dream?

There is nothing unrealistic to what I am describing here. Stocks are like everything else we buy. They offer an amazing value proposition at some prices, a strong value proposition at other prices and a poor value proposition at still other prices. Once most investors come to understand that, we are on our way to understanding how stock investing works to an extent that no group of people in the past has ever understood how stock investing works. The key to bringing rationality to the stock investing project is getting clear on why price gains are bad and price drops are good: Most of us are net buyers of stocks and so we naturally should applaud lower prices and curse the fates when prices rise too quickly.

Stock Cycles Calculator

This one change in investor psychology is going to bring on the most important change in stock investing in history. I encourage you to spend some time testing different possibilities with The Returns Sequence Reality Checker. You want to understand how stock cycles work. Once you do, the stock investing experience will be much easier to understand and far less stressful.

Please tell your friends about the importance of stock cycles and about how the Reality Checker can help them come to a better understanding of the realities. The key to overcoming today’s economic crisis lies in restoring the confidence of middle-class workers in their financial futures. Letting people know that there is a far better way to invest in stocks, a less risky way that yields far better long-term returns, will get us all on a far more positive and enriching (in all senses of the word) and life-affirming track.

No more bull markets! No more bear markets! No more economic crises! No more boom-and-bust stock cycles!

Let’s all work together to make it happen soon!

Note: I wrote a Guest Blog Entry for the Online Investing AI Blog that explains how the Reality Checker can be used to come to a better understanding of the importance of stock cycles. A second article appears at the Arbor Investment Planner Blog. That one is titled Bull Market vs. Bear Market: What Should Investors Hope For?