As they say, you can drown in a river that has an average depth of 6 inches (should you attempt to cross and find that, at this particular point, the river is 8 feet deep).
Similarly, investors must be cautious about data regarding average returns offered by investments.
For example, if an investor were to look look at calendar years from 1928-2008, he would see that the stock market has earned an (arithmetic) average after-inflation return of 7.9%. Not bad! But to count on earning an 8% real return is to set oneself up for failure. For example:
- In 28 of those 81 years, the stock market actually lost money.
- In 8 different years, the market lost more than 20% of its value.
- In 4 different years, the market lost more than 1/3 of its value (with the worst year being 2008, with a loss of 36.6%).*
And, as investors were reminded in the last year, even lengthier periods can be subject to wildly variable rates of return. Again, looking at calendar years from 1928-2008, we can see that:
- In 10 of the 72 ten-year periods, the market lost money.
- Over the 10-year period ending in 1974, a stock market investor would have lost more than 37% of his money, with a compounded real rate of return of -4.6%.
Takeaway Lesson: When making an investment plan, be sure to take into account not only average returns, but the variability of returns as well.
*I only noticed while writing this that on an after-inflation basis, 2008 (real return of -36.6%) was in fact worse than 1931 (real return of -33.8% due to annual deflation of approximately 10%).
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{ 13 comments }
Mike,
This is a good illustration of why it’s important to look at annualized returns instead of average returns. The annualized return takes compounding into account. Example: Over two years, you might have a return of 100% then a loss of 50%. Your average return is 25% (100 – 50 = 50/2 = 25%), but your annualized return would be 0%. You started with $100, went to $200, then lost half of that putting you back down to $100 again.
Using annualized returns, the S&P 500 only gives you about a 7% real return from 1928-2008. Doesn’t sound like much of a difference, but we both know it is.
Interesting note on the difference between 2008 and 1931 as well!
As always, the key is not investing passively (that is, not going with the same stock allocation at all price levels).
The overall average long-term stock return is 6.5 percent real. This is the number that The Stock-Selling Industry likes to quote. If you focus on this number, you can easily be led to believe that stocks are always a good place to put your retirement money.
The Rational Investor (the Rational model is the opposite of the Passive model in every way) takes note that the average long-term return changes with changes in valuation levels. At low valuations, the average long-term return goes up to 15 percent real. At insanely high valuations, the average long-term return is a negative number.
The 6.5 percent number is a myth. No one can invest at an average price level. We all invest at some particular time and at some particular price level. We all need to check what the average long-term return is for those buying stocks at the particular prices at which they are available at a particular time.
Rob
When looking at averages it is far more important when returns happen than what the returns actually are.
The following four returns average 8%:
12%
-5%
23%
2%
In any sequence, those numbers average 8%; however, if you were saving $10,000 per year and averaged 8% with those returns, your balance after 4 years could be as high as $53,476 or as low as $43,391, depending on what order they came in. That’s over a $10,000 difference in just four years using realistic numbers. Over a lifetime, the sequence of returns can make or break your plans, even if you got the average you thought you needed.
You can even experience one sequence of returns that has a lower average but still results in more money than another. You can even beat the long-term average and end up with less money. It all depends on when the higher returns that contribute to the average happen. If the bigger returns happen when you have accumulated a lot of assets, they will be more meaningful.
Note to Rob: Your constant commenting about taking valuations into account is becoming tiresome. We know your position. I don’t think you need to repeat it with nearly every post Mike does. This is a blog about passive investing. You’re constant opposition is irksome. I’m asking you nicely: please stop.
“No one can invest at an average price level. We all invest at some particular time and at some particular price level.”
Rob,
I don’t know about you, but I’m not investing my retirement money all at once in a big lump at one particular price level. I’ll be buying for the next 45 years. By the time it’s all done, I think my money will have been invested at the average price level.
Your rational investing model or whatever you call it is nothing more than another timing the market based on valuations scheme. There’s plenty of research to show that there’s no consistent evidence that anyone has been able to make it work – as sensible as it may sound.
As another note (just a friendly suggestion), your website is so verbose that you’re not going to find many people who will take the time to really read and understand your position. From a marketing standpoint, you’ll never reach many people with your message. If that’s your goal, you need to look at how you’re approaching your message.
This is a blog about passive investing. You’re constant opposition is irksome. I’m asking you nicely: please stop.
The reckless and irresponsible promotion of Passive Investing by The Stock-Selling Industry has caused the greatest loss of wealth to middle-class investors in the history of the United States, Dylan. It has also brought the strongest economy in the world to its knees. There is no “nice” way to ask someone to post dishonestly on investing questions. It is my intent to continue to post my honest views on the Passive Investing question.
We all should be working to help those who have been taken in by the Passive Investing marketing slogans. That goes double for those of us who endorse indexing strategies and many of the other ideas that have been advanced by John Bogle as part of The Indexing Revolution. We caused this mess by failing to speak up when the academic research first showed that Passive Investing can never work in the long term (this was in 1981). That means that we have a special responsibility to help get things back on the right track.
I do not agree that this is a blog “about Passive Investing.” Many of the ideas advanced by Mike are winners. Passive Investing is pure poison. Yes, Mike does at times post in support of Passive Investing or at least fail to point out the dangers. That does not make it fair to say that the entire blog is “about” Passive Investing. The blog is today about a mix of things, some very, very good and some very, very bad.
My hope is that there will come a day when the blog is entirely about good things, non-Passive strategies that work. That’s not going to happen if those of us who are aware of the dangers of Passive Investing fail to point them out. My strong belief is that we need more community members here (and elsewhere too, of course) pointing out the dangers of Passive, not fewer. It is when we reach critical mass on this question that we will enter The Golden Age of Middle-Class Investing (the post-Passive Era of Indexing).
Rob
“I am not aware of any research showing that this does not always work for the investors who employ the strategy.”
Rob,
Every time I’ve seen someone attempt to translate your vague verbosity into a set of specific rules and then back test those rules, they under-performed. It’s “interesting” that each time this happened, you simply ignored the result. I guess that’s how you can claim to be “not aware” even though you continued to post at the boards where the results appeared.
“I would certainly be grateful if he or she would let me know about it.”
This has already happened on multiple occasions.
There’s plenty of research to show that there’s no consistent evidence that anyone has been able to make it work – as sensible as it may sound.
I’m grateful to you for saying that long-term timing (lowering one’s stock allocation at times of insanely high stock prices with the understanding that this may not bring benefits for five years or in some cases even 10 years) sounds sensible. I am not aware of any research showing that this does not always work for the investors who employ the strategy. I certainly acknowledge that there is a mountain of evidence showing that short-term timing (changing one’s allocation with the expectation of seeing a benefit within a year or so) never works. But that is of course something very different.
As another note (just a friendly suggestion), your website is so verbose that you’re not going to find many people who will take the time to really read and understand your position.
I am grateful for the feedback, which is obviously well-intended, Paul. I am confident that you are right about the marketing problem I face. The other side of the story is that the claim that I am making (that the dominant model of stock investing does not accurately describe reality) is a bold claim. That means that I have a responsibility to describe things as carefully as I can. That sometimes means writing a long post or recording a long podcast. I wish that people could just see my claim and quickly have all the question answered in their minds. But that just is not the reality today.
There is nothing at all complicated about Valuation-Informed Indexing (the non-Passive approach to indexing that I recommend). It’s all based on the common-sense belief that the price we pay for stocks affects the value proposition we obtain from them, just as the price we pay for any other asset that can be bought affects the value proposition obtained from it. All the confusion stems from the fact that the phrase “timing doesn’t work” has been repeated about 10 million times and people have come to believe that there must be something to it.
I have spent the last seven years of my life investigating this and I have never been able to find one sliver of data showing this to be so. The entire historical record shows that short-term timing never works and long-term timing always works. If anyone ever comes up with any reason to believe otherwise, I would certainly be grateful if he or she would let me know about it.
Rob
Paul: Excellent point above about annualized returns vs. geometric average returns. It’s a big difference indeed.
Dylan: You also raise a great point about the importance of order of returns–especially once an investor is retired and liquidating his/her investments.
Every time I’ve seen someone attempt to translate your vague verbosity into a set of specific rules and then back test those rules, they under-performed.
I don’t view the claim that the price we pay for stocks affects the value proposition we obtain from buying them to be even a tiny bit vague, Linda. I view this as simple common sense. Common sense says that it must be so, and the historical data confirms that in fact it always has been so. The vagueness is in the claim that there is some reason somewhere to believe that Passive can work. I have never seen any rational argument put forward for this claim or any historical data supporting the claim.
The historical data can be checked by anyone who cares to take 15 minutes to do so. Robert Shiller provides access to it at his site. There are four different calculators at my web site that report what the historical data says on various questions. Here is a link to a thread at Financial WebRing Forum showing with graphics that “Valuation-Informed Indexing… is everywhere superior to Buy-and-Hold over ten-year periods”:
http://www.financialwebring.org/forum/viewtopic.php?t=106998
The one “rule” that has worked every single time it has been tested is that taking valuations into consideration when setting your stock allocation always provides higher returns at lower risk. There is not one exception in the historical record. There are times when the benefits are only good and other times when the benefits are just amazing. But there has never been one time in the history of stock investing when Passive Investing (failing to change one’s stock allocation in response to price changes) has ever helped. This is why Rob Arnott said recently that the conventional investing wisdom of today is rooted in “myth and urban legend.”
Every sliver of historical data that I have looked at in studying these questions every day for seven years running has indicated that Arnott (and the scores of others who have said similar things) is on the mark. I think it would be fair to say that our economic crisis would quickly be brought to an end if we all worked up the courage to share what we know about how stocks really work with the millions of middle-class American who have been denied this knowledge for the 28 years since the first academic research showing that valuations affect long-term returns was published.
Rob
Rob:
You say that, “My hope is that there will come a day when the blog is entirely about good things, non-Passive strategies that work.”
I’m sorry to disappoint, but that’s not going to happen. Quite in fact, the only people I’ve seen successfully accumulate wealth via investing have been passive investors. (At least in the sense that they implement simple buy & hold strategies. They haven’t all used index funds.)
That’s precisely why I started this blog in the first place. I think people need to be offered a simple investment program that they can understand easily and fully enough to implement and stick with. To me, long-term, buy & hold investing via index funds fits the bill perfectly.
I’m not here to argue that your method of investing is not successful, has not been successful, or will not be successful in the future. I do not, however, think that it’s absolutely necessary for success. I’ve met hundreds of people who are living proof that it’s not.
I appreciate that you believe deeply in your message and that you’re doing what you can to spread it.
That said, I too would appreciate it if we could keep the discussion on topic. Every post does not have to be a discussion about the interplay between asset allocation and valuation levels.
We’ve discussed that topic before, both in the comment threads on numerous posts, as well as in your guest post on the topic. (For any readers who are interested, you can find Rob’s guest post here
.) Readers know where you stand on it and where I stand on it. And they can decide for themselves from those discussions what their own opinions are.
I really would appreciate it if we could leave it at that.
I too would appreciate it if we could keep the discussion on topic. Every post does not have to be a discussion about the interplay between asset allocation and valuation levels.
I will of course never give even a second’s consideration to the idea of not posting on topic, Mike. As you know, I never brought up the problems of Passive Investing on a thread on which those problems were not at issue.
You are certainly correct that every post does not need to be a discussion between the interplay between asset allocation and valuation levels. But that is obviously a matter of great importance. The decisions that an investor makes about his stock allocation are the most important decisions he ever makes. Many leading names have said that getting the allocation right is 80 percent or 90 percent of investing success. In the event that there is anything to what the academic research of the past 30 years has revealed to us, Passive Investing can cause investors to get their stock allocation wrong by 60 full percentage points and for stretches of many years. That’s no small thing. The historical data shows that an investor who elects to go passive thereby elects to delay his retirement by five years.
You say that you have seen investors achieve success using passive strategies. How can you know whether this “success” is permanent or not? On the three earlier occasions when we went to insane valuation levels, we eventually saw drops to valuation levels more than 50 percent below those that apply today. If the investors who you believe have achieved success see another price drop of over 50 percent, will they still be “successful”? There have been many times in history when passives have achieved short-term success. There has never yet been one in which this strategy has brought investors long-term success.
You say that you will never change your views on Passive Investing. I think it is unfortunate that you feel that way and I think that view (which is common among Passives) is a big part of the problem. It’s a close-minded view, Mike. You write about investing issues and I believe that you owe it to your readers and yourself to remain open to learning. The discovery (28 year ago!) that Passive can never work is a huge development. I believe that you should be learning about it and reporting on it. In any event, I don’t think that you can say whether you will ever change your mind or not. There are many in the world who have said that they would not change their mind on all sorts of questions who eventually did so when subsequent events forced their hands. Passive has become popular for short periods of time before, but it has always become extremely unpopular in the years following when its huge destructive impact came to evidence itself.
I do believe that Rational Investing (taking the long-term value proposition of stocks into consideration when setting one’s stock allocation) is essential for long-term success. Passive not only greatly reduces returns and greatly increases risk. It also causes the investors who follow it to become highly emotional about all of their investing decisions (almost all investing questions are affected by taking on large amounts of unnecessary risk). Becoming excessively emotional about your investment decisions can hurt you a great deal in the long run, in my assessment.
I of course wish you well with the strategies you elect to follow (whether Passive or Rational), Mike. And my personal assessment (based on prior interactions with you) is that you are at least a bit more open to new ideas than your words above suggest. I hope that you open up a bit more over time, and, in the event that you find flaws in what I say, I hope that you will be kind enough to point them out to me and to thereby help me to enjoy a learning experience here as well.
Rob
This thread has motivated me to create a new comment policy. Here it is in total: “Please keep comments on topic and respectful. Any comments that (in my opinion) do not follow these two simple rules will be deleted.”
I’ll be posting that policy site-wide at some point today, and I will be implementing it immediately on this thread. [Note for any readers: This means that several comments on this thread have now been deleted.]
For future reference, any discussions about what did or did not happen on somebody else’s blog or forum count as “off topic” and will be deleted. The place for those discussions is elsewhere.
Thank you for your understanding.
I’m just a long-time lurker here, but would like to thank Mike for the new rule. Hopefully, it will return the quality of the discourse back to where it had been before every other thread was off-topic.
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