(The following is a guest post by Rob Bennett at Passion Saving. He is known for thinking outside the box on certain financial issues. I asked him to explain his stance on passive investing, so here it is!)
I invite you to take a look at a recent research paper that I believe in days to come will be changing the history of our understanding of how stock investing works. The paper was prepared by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan. The paper can be downloaded here.
The background is that, while many investing experts have asserted in recent years that market timing does not work, there has never been a study showing this to be the case. The idea that timing doesn’t work is rooted in a misunderstanding of research showing that short-term timing doesn’t work. There is a good bit of research showing that, if you change your stock allocation with the thought of seeing benefits for doing so within a year or two, the odds are high that you are going to be disappointed. On seeing such research, many analysts jumped to the conclusion that no form of market timing works.
The reality is that there is much research showing that long-term market timing (changing your stock allocation in response to big price swings with the understanding that you may not see benefits for doing so for as long as 10 years) always works and in fact is required for long-term investing success. See, for example, Pfau’s preliminary research on this point.
Pfau’s most recent paper examines the one study that really did conclude that long-term timing does not work. The new paper states that: Valuation-based market timing demonstrates greater potential to improve risk-adjusted returns for conservative long-term investors than given credit by Fisher and Statman (2006). On a risk-adjusted basis, market-timing strategies provide comparable returns as a 100 percent stocks buy-and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns.â
What if everything you thought you knew about stock investing turned out to be wrong?
Here are some elements of the conventional investing wisdom that need to be changed as we develop a consensus that long-term market timing always works.
1) All asset allocation advice rooted in the Buy-and-Hold Model needs to be revisited. If going with lower stock allocations at times of super-high stock prices (like those experienced from 1996 through 2008) causes greater risk while not increasing returns, there is no reason to encourage investors to take on that added risk. In cases where added risk brings on no increase in return, investors would be better off not taking on the added risk;
2) All retirement planning advice rooted in the Buy-and-Hold Model needs to be revisited. Retirement planners have been telling us for years that the safe withdrawal rate (SWR) is 4 percent regardless of the valuation level that applies on the day the retirement begins. If returns are greater at times of low valuations, the SWR is obviously higher than 4 percent at such times. It is also obviously lower than 4 percent at times of high valuations (meaning that millions of retirees are likely to suffer failed retirements in days to come because of the failure of the SWR studies to take valuations into consideration in their calculations);
3) All risk management advice rooted in the Buy-and-Hold Model needs to be revisited. The Buy-and-Hold Model teaches that we must accept risk to realistically expect good returns. But Pfau’s research shows that there are times (times of high stock valuations) when super-safe asset classes reliably offer better returns than stocks. Perhaps it is not a willingness to take on risk that permits an investor to earn good returns but a willingness to take valuations into consideration when setting his stock allocation; and
4) Our understanding of what caused the economic crisis needs to be revisited. The stock market was overpriced by $12 trillion in January 2000. Vanguard Founder John Bogle has described Reversion to the Mean as an Iron Lawâ of stock investing. It appears that all that we are seeing with the economic crisis is one more instance in which the Iron Law came to asset itself. The loss of the $12 trillion left all middle-class investors far poorer than they expected to be at this stage of their lives, the fears they experienced over having fallen so far behind in their efforts to finance their retirements has made them reluctant to spend, and their reluctance to spend has caused thousands of businesses to collapse and millions of workers to lose their jobs.
The idea of rooting investment advice in academic research was a true breakthrough, in my assessment. But there are responsibilities that come with rooting investing advice in research. We all need to be careful not to get too carried away with tentative findings and to remain open to new findings generated by new research looking at new questions.
We don’t know all there is to know about stock investing today. We need to adopt a more humble stance in all publicly voiced claims. Getting it wrong can cause horrible problems for millions of investors and indeed for our entire economic and political systems.
We’re gradually learning the realities of stock investing through research. That’s good. Let’s not ruin a good thing by failing to note at all times that we don’t know it all yet, that we are all still in the learning stage of this wonderful process of discovery of the realities of stock investing.