Six Dangerous Investing Myths

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Investing Strategy

INVESTING SOLUTIONS (part 2) 

Welcome to Investing Solutions Week at Barbara Friedberg Personal Finance. This week there are three educational and enjoyable investing articles here. Stick around all week and become a smarter investor. 

This is a guest post by Rob Bennett who created the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here. 

Valuation Informed Indexing Approach

Mr. Bennett advocates Valuation-Informed Indexing. This strategy calls for the investor to increase his stock allocation when prices are low and to decrease his allocation when prices are high. The concept is rooted in the research of Yale Economics Professor Robert Shiller, who found that, contrary to the widespread belief that market timing doesn’t work, long-term returns are predictably poor starting from times of high valuations. 

Fact or Fiction? 

Set forth below are six items of investing wisdom viewed as truths by Buy-and-Holders but as dangerous myths by those who root their strategies in Shiller’s research findings: 

1) Market Timing Doesn’t Work. Buy-and-Holders believe that the market is efficient; that is, all information known to affect the market price is incorporated into it at all times. It follows that market timing cannot work; no one can effectively guess how unforeseeable events are going to play out. 

Valuation-Informed Indexers believe that investor emotions are the primary influence on prices in the short term and that economic realities become dominant only after the passage of 10 years or so. If this is so, long-term returns are highly predictable (prices move in the direction of fair value). Under the new understanding of how stock investing works, timing is not only possible but required; investors who fail to change their stock allocations in response to big price shifts thereby permit their risk levels to get wildly out of whack. 

Barb’s comment: Actually, maintaining a constant asset allocation will do this for you. When one asset class becomes overvalued, you will rebalance by either selling the overvalued asset class or putting future cash into lower valued assets.  

2) Economic Developments Cause Stock Price Changes. Did you know that Shiller predicted the economic crisis? So did Robert Arnott. So did Andew Smithers. So did every stock analyst who takes Shiller’s findings seriously. How did they perform this magic feat? Valuation-Informed Indexers don’t believe that it is economic developments that cause stock price changes but that it is stock price changes that cause economic developments. The market was overpriced by $12 trillion in 2000. The inevitable return to fair value was going to cause a loss of that amount of buying power from our consumer economy. The crisis became unavoidable once we permitted the bull market to get so out of control. 

3) The Safe Withdrawal Rate Is a Constant Number. Financial planners use the concept of the “safe withdrawal rate” to tell us how to structure our retirement plans. The idea is to use the historical return data to determine what withdrawal rate would work even in a worst-case scenario. The conventional studies are rooted in the pre-Shiller research and thus do not consider the effect of the valuation level that applies on the day the retirement begins. Studies that do consider valuations come to wildly different conclusions as to what is safe. In the event that Shiller is right, millions of middle-class people will be experiencing failed retirements in days to come. 

4) Stocks Are More Risky Than Bonds.This has been the conventional wisdom for a long, long time. But risk is uncertainty. If Shiller is right that long-term returns are highly predictable, stocks are not nearly as risky as we have long believed them to be. If Shiller is right, stocks are a high-risk asset class only for those who don’t take valuations into consideration when setting their stock allocations — that is, Buy-and-Holders. 

Barb’s comment: Modern Portfolio research defines risk as VOLATILITY. In other words, how much your asset value moves  up and down. In general, stocks are more volatile than bonds, although over the long term they have offered much higher returns than bonds. 

5) Super-Safe Asset Classes Are a Poor Choice for Long-Term Investors. The conventional wisdom is that stocks are always best for the long -term investor and super-safe asset classes never provide returns high enough to finance a comfortable middle-class retirement. But a regression analysis of the historical return data showed that at the prices they were selling at in 2000 stocks were likely to provide an annualized return of something in the neighborhood of a negative 1 percent real. In contrast, Treasury Inflation-Protected Securities (TIPS) were at the time paying 4 percent real. That’s a return differential of 5 percentage points per year for 10 years running — a total shortfall for the stock investor of 50 percent of his initial portfolio value. 

6) Stocks Have Become a Good Buy in the Wake of the Price Crash. There were three times prior to the late 1990s when stock prices reached insanely dangerous (high) levels. On each of those three occasions, the damage done to the economy as a result of the inevitable crash ultimately caused stock prices to fall to one-half of fair value. That’s a price drop of 65 percent from where we stand today. 

The information contained in this article is the opinion of the guest author and does not necessarily represent that of Barbara Friedberg. Do not construe this information as a recommendation to buy or sell particular securities or asset classes. 

For a quick overview of Investing Strategies, pick up my FREE eBook; 20 Minute Guide to Investing (top right of the page). If you like what you’re reading, sign up for my RSS feed and follow me on twitter so you get the word immediately.   

Barb’s question: Do you consider valuations when making investment decisions? 

•  Visit Investing Solutions (part 1); Why You Must Start Saving Now!
•  Stop back for Investing Solutions (part 3); MBA Class; Use Net Present Value to Make Investment Decisions.

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