It Never Rains in Seattle

[This is #1 in a series of Meditations on Risk]

So often we base our sense of risk on our limited experience. But often this experience is so limited that is of almost no value.

The mind plays tricks based on the recent past. If you visit Seattle 2 summers in a row and it’s sunny during your stay, you start to think all the noise about it being rainy all the time is just a ploy by the locals to keep you from moving there. The next time you go, you won’t even take your umbrella because it never rains in Seattle.

I have been up the Grand Teton 5 or 6 times, but I learned a lot from the first 2 times The first time was a glorious day. Warm and sunny. I remember taking a nap on the summit in shorts. Based on my experience, all the talk of dangerous afternoon thunderstorms was just over-cautious worrying.

Based on my first experience, I wasn’t too worried on the second. This casual attitude led to starting late and getting to the summit ridge late. Once on top, we found ourselves in the middle of a thunderstorm. It was the scariest experience I have ever had in the mountains. I remember my ice axe buzzing from the static.

I had based my sense of risk from ONE experience, and as a result, was actually lucky to get off the mountain.

This happens all the time. We are hard wired to view the future through the lens of the recent past.

When it comes to investing, this wiring leads to some MAJOR mistakes:

[1] Selling AFTER a major decline, just to wait until “things clear up.” There might be legitimate reasons to sell, but this is not one of them.

[2] Buying AFTER a 54% run, because the “coast is clear.” The news is good. Everyone is happy. The recession is over.

The real problem of course is when you do both. Selling low and buying high is just dumb. It seems so obvious, but most of us do it. We know because the data shows it. People could not sell fast enough in March when the S&P hit 666, and now everyone feels like buying again.

I am not saying buying now is a bad is because I don’t know. I am saying that the mind plays serious tricks based on our recent past. We think that because it was sunny on the top of the mountain last time, that it will be this time.

Like G.I. Joe always says: “Knowing is half the battle.“

By Carl on 08.31.09 > Link

Tagged as: limited experience, risk

  • I don't agree.

    'Rational' is an opinion, not a fact. Thus, if one investor follows a strategy that he/she deems rational, it may not be considered to be rational by someone else. And you seem to feel believe that you can decide what is rational for everyone else (PE 10 or lower).

    Shortring the market is no less rational than being long the market. The fact that you believe it to be true tells me that you also swallow the advice of the salesmen who tell clients to buy, buy, buy and then hold. Being short is part of the investing game.

    But the biggest part - the part that you ignore - in achieving investment success is the need to have outstanding protection against losses. I know that 'proper' asset allocation cannot do the job. Not in today's world. I agree that history tells you that asset allocation has done a good job. But the world has changed. Too many people are well diversified and when it hits the fan, too many different assets get crushed simultaneously. It did not always work that way.

    If you limit your equity investing to times when PE is 10 or less, you will not be invested much of the time. If you want to talk about history - then history has demonstrated that equity investing is necessary to achieve satisfactory long-term appreciation. Your plan involves being out of the market (or at least, substantially under-invested in equities) for vast periods of time. Perhaps most of an investor's lifetime. That is not rational - based on historical results.

    If you truly believe in what you say, do you own zero equities at this time, and have been at that zero level for a long time? After all, current S&P PE is well over 100.

    The bottom line is that you and I will never agree.
  • I don't agree.

    I understand, Mark.

    if one investor follows a strategy that he/she deems rational, it may not be considered to be rational by someone else.

    I think that's a fair comment.

    And you seem to feel believe that you can decide what is rational for everyone else (PE 10 or lower).

    I can say what I believe. But each investor has to decide for himself or herself how to invest his or her money.

    If you limit your equity investing to times when PE is 10 or less, you will not be invested much of the time.

    A P/E10 level of 10 is great. Stocks are at insane prices only when the P/E10 value is above 25. That's rare. However, it is true that stock remained at insanely dangerous price levels for the entire time-period from 1996 through 2008. You and I have somehow been "lucky" enough to live through the most dangerous time to own stocks in the history of the United States.

    Your plan involves being out of the market (or at least, substantially under-invested in equities) for vast periods of time. Perhaps most of an investor's lifetime. That is not rational - based on historical results.

    The historical data shows that lowering your stock allocation when prices go to insanely dangerous levels allows you to retire at least five years sooner. The short-term payoff is sometimes small. But the edge gained by those willing to take price into consideration grows and grows and grows over time as a result of the compounding returns phenomenon.

    After all, current S&P PE is well over 100.

    The P/E10 level today is 18. That's a little high but not too bad. It's a lot better than anything we saw from 1996 through 2008.

    The bottom line is that you and I will never agree.

    Never say never, Mark. You might end up being right. Or I might come over time to see things from your perspective. Or you might over time come to see things from my perspective. Stranger things have happened in this mixed-up world of ours.

    I'm grateful to you for engaging in a little bit of back and forth, in any event. It's by hearing both sides that over time we all come to a better understanding (in my view!)

    Rob
  • The back and forth is good.

    Please cite the source for claiming that PE is currently 18. I've seen (but have not tried to verify) statements telling me that PE for S&P 500 index is significantly higher than 100. Here is a recent source, claiming current is 25-26.

    Regarding asset allocation. I agree that it has worked. My argument is that it will work less and less efficiently going forward. Why? Too many people using that strategy now. And when investors panic in equities, those same investors will panic in other assets as well.

    Mark
  • Please cite the source for claiming that PE is currently 18.

    It's not the PE that is 18. It is the P/E10. They are not the same thing. My partner John Walter Russell calculates the P/E10 for use in the calculator ("The Stock-Return Predictor") that we co-developed which is housed at both of our sites. John gets his data from Robert Shiller's web site.

    The number that you are citing (PE) might be referred to as "P/E1." That number is just a comparison of the price of the index and the earnings generated in the last year by the companies in the index. P/E10 is a comparison of the price of the index and the earnings generated on average over the past 10 years.

    I view P/E10 as superior to P/E1. The reason is that P/E1 is too much affected by a single year's earnings. We are now in a recession. That means that earnings are artificially low. When you compare the price with artificially low earnings, you get a number that indicates that the price is higher than it really is. With P/E10, you are smoothing out earnings because both good and bad economic times are included in the 10-year period from which you are calculating an average earnings figure. So the price is being compared to a more realistic earnings figure. In today's environment, P/E10 is showing stocks to be only a little bit overvalued (the fair-value P/E10 is 14 or 15 and we are today at 18).

    Rob
  • If you believe future earnings can be based on the earnings of the past 10 years, that is your problem. I believe it is a bad idea to try to convince anyone else that this is a viable approach to the markets. We can all back test any per theory and make it fit the data. I'm only interested in what's going to happen in the future.

    Some companies grow and grow. The PE 10 may work for those. But fashions change and that makes retailers an exception. Technology changes and that makes the technology industry exceptions. New drugs hit the market and that makes biotechnology, and perhaps even big Pharma an exception. Trends change, so that means makers of boats, cars, planes are an exception.

    I see little use for PE 10. If you see use for it, good for you.

    Concentrating on our discussion, if you deem earnings to be artificially 'low' then (in my opinion) that blows your entire argument. Because it also means that you don't see today's prices as artificially high. Your premise is not to invest when prices are high - and as I mentioned he big problem is determining when they are high. Your method involves 10-year earnings history. Today's world changes rapidly and I cannot believe you want to rely on old data. I hope you at least weight the data so that recent counts more than 9 years ago.

    You justify buying equities at prices others consider to be high prices by claiming earnings are 'just too low. They will improve.' You cannot possibly know that. If you want to BET that the recession will end soon. If you choose to WAGER that the economy will recover and resemble the old economy, that is your right. But you have no credibility with me when you state that the PE 10 is at a level that should not cause concern - and that prices are not ridiculously high.

    You may choose to use PE 10 to time your buying of stocks. I prefer to own an option position that limits profits but guarantees no big losses (collars).

    Difference of opinion is what makes the markets thrive. I'll take a guarantee against large losses and you can allocate assets based on data that covers the past 10 years. It may have worked before now, but I don't see how it can continue.
  • We can all back test any per theory and make it fit the data. I'm only interested in what's going to happen in the future.

    I agree with you about the dangers of backtesting, Mark. I would point out here that just about every advocate of every strategy that exists points to backtests to support his or her approach. I have no problem with the idea that people should reject all backtests and just use their common sense to figure out what works.

    I did not develop the Valuation-Informed Indexing strategy by backtesting. I considered stock investing from a common-sense standpoint. Just assume for a moment that stock investing works according to the same principles that govern all other human endeavors. If that were so, then the price you paid for stocks would determine whether stocks were a good buy or not, no? That idea is what makes Valuation-Informed Indexing so different from Passive Investing.

    Yes, I ended up doing backtests. Not because I felt they were critical. I did backtests because there were lots of skeptics who said that it was impossible that common sense could ever work in investing realm, that the "experts" had rejected common sense and therefore it should never be considered again. I don't buy it. So, yes, I checked the numbers.

    Surprise, Surprise! All the backtests showed that Valuation-Informed Indexing has been beating Passive Indexing ever since the market first opened for business. The reason this works is not because it backtests well. The reason it works is that common sense says it must work. The backtesting merely confirms what common sense tells us must be so.

    You say that you want to know what is going to work in the future. But my sense is that you have closed your mind to the idea that prices might just go on continuing to affect long-term returns just as they always have in the past. We all have to put our money down on some theory of how investing works. This is a theory that I am able to feel confidence in because to me it is the only theory of investing that makes sense.

    Are you able to say why you are so sure that prices will not affect long-term returns in the future?

    Rob
  • Rob,

    I must admit, you have all the tricks of a charlatan.

    You make an incorrect assumption, then challenge me as to why your assumption is true. Cute.

    <<Are you able to say why you are so sure that prices will not affect long-term returns in the future?>>

    Never said that. Never suggested that. In fact, it was I who asked you why you believe the future would resemble the past. I have drawn no conclusions. I do not know what the future holds. I do not claim it will or will not resemble the past.

    What I do claim is that option collars guarantee no big losses at the cost of limiting future earnings. I am willing to bear that cost. I am not willing to depend on asset allocation to protect my net worth. I am not going to buy stocks based on their earnings of 5 to 10 years ago. I think that's silly - but I also think you should invest as you deem best.

    What you claim is that using 10-year history is better than using 1-year history. That sounds reasonable. But, you ignored my challenge to that rationale: the world is changing much faster than it ever did before. You are ignoring that fact. Why is that?

    True, we place our money down and take our chances. My preference is to own insurance that is guaranteed to limit losses. How can you tell me that's a bad idea? It may not be for you. So what?

    Shouldn't we return the use of this blog to Carl?
  • [i]But, you ignored my challenge to that rationale: the world is changing much faster than it ever did before. You are ignoring that fact. Why is that?[/i]

    The world has to change for stocks to provide any return whatsoever, Mark. Stock returns come from earnings. Earnings come from sales. Unless you make things or provide services, you don't have any sales. When you make something or provide a service, you are making a change, you are making the world a better place.

    It doesn't follow that the long-term average return on U.S. stocks is going to change dramatically. That number has been 6.5 percent real for a long, long time. And all through that time, we have seen change. So whether we are going to see change or not is not the issue.

    If that long-term average return continues to apply, Valuation-Informed Indexing will continue to work.

    And don't forget -- Passive Investing too presumes that stocks will continue to provide a long-term return of something in that neighborhood. The only difference is that Passive Indexing ignores the effect of price and Valuation-Informed Indexing does not.

    Shouldn't we return the use of this blog to Carl?

    If you have further questions, I'll do my best to respond to them, Mark. It may be that there are some who are listening in who will benefit from hearing the responses. If you don't have any further questions, I am of course fine with that. My goal is to help out.

    Rob
  • @Rob & Mark- thanks for having the discussion here. As long as things
    stay civil I think people benefit from the conversation.

    My unoffical comment policy is us all to think of ourselves as invited
    guests at a dinner party.

    Good, opinionated discussion: good. Name calling: bad.

    Thnaks for your contribution.
  • Thanks for your contribution.

    Thanks for hosting the blog, Carl.

    I can tell you that there have been people who have gotten emotional about Valuation-Informed Indexing at other blogs and at a number of discussion boards. It is the strangest phenomena that I have ever come across in 52 years of walking the planet. Good investing ideas help every single person alive and hurt absolutely no one. But there is something about the investing realm that makes some people view new ideas as a threat. My best attempt at a take on this is that we are all afraid to put our money at risk and yet we all need to choose some investing approach despite our imperfect knowledge, and, once we do, we become emotionally attached to it and have a hard time letting in other possibilities.

    There are of course also lots of people who have responded to the new ideas with a great deal of excitement and interest. I like to think that I've learned something from both groups. But it is certainly fair to say that I enjoy my interactions with the positive group more.

    My policy is to do the best that I can to answer whatever questions people have while tuning out to the greatest extent possible the negativity. There is one exception to this rule that I believe needs to apply in a limited set of circumstances. There are times when we need to take into consideration the emotional reactions because the emotional reactions are part of the story. If we are not able to have civil discussions of the realities of stock investing, we obviously are limited in what we can learn about this subject in a way that we are not limited when trying to learn about any other area of human endeavor. I can say from experience that there are particular difficulties that apply when trying to learn new things about how stock investing works.

    In any event, you can count on me to do the best job that I am able to do to respond to as many questions as possible while keeping things on a positive track to the greatest extent possible. That's the combination that helps us all learn and it is learning together that makes this all worthwhile and fun.

    Rob
  • Rob, you continue to represent all the tricks of the person who cannot defend a position. Answer a few questions please:

    1) Why do ignore my questions and instead substitute answers to 'questions' that were not asked? Please reply directly to this question

    2) You have played the 'emotion' card before. It's your favorite. I tried to get a response to from you and you ignored me. I presented my questions in the simplest language I could, albeit using improper terms. You ignore it one again. So how about you stop being emotional and respond to questions? Is that going to happen?

    3) I challenged you on using 10 years worth of data and you simply ignore that fact. Question/Comment: My position is that 'valuation-informed' indexing is not viable when you use data that covers 10- years. Your response to that challenge is to ignore it and continue to state your case. That is not productive. So why is 10 years worth of data NOT a ridiculous idea in our rapidly changing world?

    4) I agree 'good ideas' are very helpful. What I don't agree with is that your ideas are 'good.' You claim they are good. That is not proof they a e good. the fact that you refuse to answer direct questions tells me you have something to hide.

    5) You repeat your thoughts often, but you ignore challenges. You ignore disagreement. You refer to people who disagree with you as emotional. How does any of that contribute to a discussion? How does that suggest that your ideas are still workable in TODAY's market. Please respond as to why those ideas work in TODAY's rapidly changing world?

    6) I am going to go out on a limb here: If you once again refuse to reply, I will assume you have nothing to say on the matter and that is an admission that you are just a salesman with a pitch - and nothing worthwhile to sell.

    Carl: I put it to YOU. Get you get him to reply? Isn't that the purpose of a back and forth discussion. Question and answer, not question and refusal to reply?

    Thanks for hosting the discussion.

    I claim the world is changing so quickly that making investment decisions based on 10 years worth of data is a bad idea. How about a comment directed to that specific sentence? Is that asking to much?
  • I will assume you have nothing to say on the matter and that is an admission that you are just a salesman with a pitch - and nothing worthwhile to sell.

    It's okay for you to come to that conclusion for yourself, Mark. It's not okay for you to come to that conclusion on behalf of everyone else who visits here. They get to make up their own minds.

    If you go to the home page of my blog and look down the left-hand side, you will see a widget marked "People Are Talking." There are 45 comments there (with links) from many people, some with well-known names, that find great value in the work we have done in the Retire Early and Indexing communities over the past seven years. Those people have every bit as much a right to comment here as do those who have other viewpoints. They add something important to the discussions and I want to do everything I can to encourage them to participate.

    I claim the world is changing so quickly that making investment decisions based on 10 years worth of data is a bad idea. How about a comment directed to that specific sentence?

    It's not only for 10 years that we have seen that valuations have always affected long-term returns, Mark. That's been so over the entire historical record, dating back to 1870. The purpose of looking at 10 years of earnings is to mix in both good economic times and poor economic times. It is not the case that Valuation-Informed Indexing has only worked for 10 years. It has been working for 140 years. And there has been lots of change over that time-period.There's been change since the first market opened for business and taking valuations into consideration in setting one's allocation have always been a plus.

    Rob
  • <<If you have further questions...>> <<My goal is to help>>

    You misunderstand. I have NO questions for you. Only criticisms (that masquerade as questions) that you choose to ignore.
    You cannot be helpful by making your own agenda and refusing to reply to those questions.

    I would try to help you understand better, but that's beyond an impossibility. If you are here to help others benefit from the conversation, then stop lecturing me, stop being condescending, and offer reasons why old earnings results matter. And I mean in TODAY"S rapidly changing world, not in the world of your dreams, in which you ignore reality.

    Yes stock returns come from earnings. I never said otherwise.
    Yes, earnings come from sales. I never said otherwise.

    You make up these replies as a smoke screen to escape responding my my criticism. I hate to have it come down to this, but I am forced to state my opinion plain English, to help you understand what I am trying to tell you:

    In my opinion, using 10-year history to evaluate a stock TODAY is stupid. If that is unclear, let me try this: Your ideas are ABSURD.

    I do not want to be rude, but I don't see any other way to get through to you.

    The world is changing rapidly. We seem to agree on that. My point in stating that fact is to make it clear that data that is 5,6,7,8,9,and 10 years old is essentially WORTHLESS in determining a stock's earning power in the future - FOR MOST STOCKS. Especially for stocks whose very industries are changing rapidly - such as those mentioned earlier. I could not care less how much GM made 9 years ago. The world is different now.

    Bottom line: Your declaration that stocks are not absurdly overpriced right now is based on the fact that we are in a recession and thus, earnings are 'low.' You are taking advantage of those low earnings by investing in equities. That's your right. But YOU DO NOT KNOW which businesses are going to survive the recession and become much stronger and healthier (buy those) vs. which will go OUT OF BUSINESS (don't buy those).

    Consumers spend differently during recessions, and if this does not end quickly, many more businesses will not survive. It does not matter one iota how well they did 8 years ago. Circuit City used to be profitable. How did that help them in today's world? Don't you get that?
  • But YOU DO NOT KNOW which businesses are going to survive the recession and become much stronger and healthier (buy those) vs. which will go OUT OF BUSINESS (don't buy those).

    The strategy that I recommend is Valuation-Informed Indexing, Mark. Those who buy broad indexes do not need to worry about how particular companies do. So long as the U.S. economy as a whole remains roughly as productive as it has been in the past, we are covered.

    Rob
  • Well, now that might not have been something I would have said as an invited
    guest at a dinner party....might be time to shut this one down boys.
  • I apologize
  • To Rob:

    With PE well over 100 these days (for the S&P 500), I assume you have been short this market for many months.

    "How could it not work?" Easily. Markets can stay irrational for very long periods of time. Right now, for example.

    If you choose to go short when PE is 25, you could easily be broke by the time the markets decide that PE is too high and reverse direction. The famous quote is" Markets can stay irrational longer than you can stay solvent."

    Your statements are terribly naive. "Timing always works" is utter nonsense. What you mean is "Timing that actually sells near tops and buys near bottoms always works." It's fairly obvious that you are unable to do that. If you could - you'd be a billionaire several times over.
  • "Timing always works" is utter nonsense.

    Rational timing strategies always work, Mark. We have historical data going back to 1870 that shows this. There has never been one time in history when rational timing strategies (lowering your stock allocation when stocks are priced to provide a poor long-term value proposition) did not work.

    I agree with you when you say that shorting the market is dangerous. It's hard for me to imagine anything more dangerous.

    Say that you were looking to buy a car that has a fair market value of $20,000 and the dealer you are talking to is asking $60,000. Would you buy? I would not. I would look for someone offering the car at fair value or something close to it.

    That's what I do when I buy stocks. When the price is three times fair value (as it was in January 2000), I move my retirement money out of stocks because I like the idea of being able to hold onto some of it.

    You are saying that it is a bad idea to short the market when prices are insane because they might stay insane for several years. You are 100 percent right. I would no more short the market when price went insane than I would short the $20,000 car that the dealer was asking $60,000 for.

    That's not your only option. The more reasonable option is to pay attention to the price being charged for stocks and adjust your stock allocation accordingly. That is what always works. It's not Rob Bennett who says that. It's the historical stock-return data that says that.

    Rob
  • pro2pronetwork
    I think you make a good point. As you've said, this understanding should be obvious but some many of us make this mistake. It's natural for us to do what we think is reasonable, which is usaully based on previous experiences. It's always a gamble.
  • Of course, this is just one more reason why so many investors simply cannot out-perform the markets on a consistent basis.
    Risk management is essential, and I'm sure that's coming soon in this series.

    Note to Rob:
    It's nice for you to note that 'high prices' precede disaster. Who can disagree with that?
    The problem is knowing - at the time - that prices are high. Was today's 9500 DJIA too high? What if someone assumed 8000 was too high? Only history will tell us what was too high.

    Your statements are true, but do they serve any value? How can someone know - at the time - when stock prices are too high or too low?
  • [i]How can someone know - at the time - when stock prices are too high or too low?[/i]

    It's the P/E10 value that tells you this, Mark. P/E10 is the price of a broad index over the average of the past 10 years of earnings. The P/E10 value is telling you how much you are paying for each dollar of earnings you obtain by buying a share in a broad index fund.

    The fair-value P/E10 is 14. Stocks provide a long-term return roughly equal to their average long-term return of 6.5 percent real when they are priced at fair value.

    A P/E10 of 7 is insanely low. That's half of fair value. The average annual long-term return for purchases of an index made when the P/E10 is 7 is 14 percent real. Your retirement account goes up in value quickly when you buy stocks being offered at half price!

    A P/E10 above 25 is insane. We've been above 25 four times in U.S. history. The average price drop on those four occasions is 68 percent. We were above 25 for just about the entire time-period from 1996 through 2008.

    It's not at all hard to figure out how to invest in stocks successfully. The key thing to keep in mind is that stocks are just like anything else that can be bought or sold for money -- there are some prices at which stocks represent an amazing deal and other prices at which investing heavily in stocks will wipe you out in the long run. The source of the confusion on this point is the marketing campaigns funded by The Stock-Selling Industry, which tell us that "timing never works." The reality of course is that timing always works. Timing is paying attention to price and adjusting your stock allocation in response to big price changes. How could that not always work?

    Rob
  • The problem that you are pointing to here is the central problem of stock investing -- the realities are counter-intuitive. When a restaurant or a movie is popular, that's usually a good sign. When stocks are popular, that's always a bad sign. Popularity translates into high prices and high prices translate into low long-term returns.

    I believe that we need tools to reshape our thinking about investing. I use the historical stock-return data. When you look at how stocks have always performed in the past, you see that high prices always</> signal disaster for those heavily invested in stocks. I think that the key is to always time the market, to get into a habit of thinking that reminds you regularly that high prices equal poor returns.

    I think that the cause of the economic crisis is the unfortunate idea that has caught on that long-term investors can get away with not timing the market. Common sense says that price must matter and failing to time means failing to take price into consideration.

    Rob
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