A costly mistake made by both investors and advisors

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Tue Aug 02, 2016 8:51 pm

lack_ey wrote:I don't get why you're upset by this. That's how these things work. Of course this stuff isn't all that accurate, and it's not too controversial that new information can improve forecasts.
I'm upset by this because leading financial experts are stating that we should set our AA and withdrawal strategy based on valuations. Valuations are HUGELY important, we are told.

But like you said, this stuff isn't all that accurate, and changes year-to-year. Should we change our AA every year based on valuations?

Who has a list of the expected returns MADE AT THE TIME (not backwards looking) for the past 10-20 years? I'd love to see how accurate they turned to be.

They keep tweaking the model, so it looks better.

The only example I know is Shiller himself forecasting 0% real returns in 1996 and instead we got 6%+ real over the past 20 years.

Yet when I bring this up, experts today state, "Oh no, our latest models forecast 4.4% expected returns in 1996, so we weren't that far off".

But yes they were. The models have been adjusted AFTER the fact, and then the experts gloss over the failure, and continue to state that valuations are great predictors. They'll bring up a list of extenuating circumstances to explain away the failure of the model. But who knows what variables will change next? They'll admit valuations are only 40% effective as a predictor, but then state people should change their AA based on valuations and work 7 years longer to get down to 3%.

But I probably should just let it all go. My apologies to everyone for getting too worked up....
Last edited by HomerJ on Tue Aug 02, 2016 11:52 pm, edited 1 time in total.

User avatar
triceratop
Posts: 5838
Joined: Tue Aug 04, 2015 8:20 pm
Location: la la land

Re: A costly mistake made by both investors and advisors

Post by triceratop » Tue Aug 02, 2016 10:53 pm

Thanks Larry. This has been one of the best articles of yours that I have had the pleasure of reading.

It reaffirms my investing decision to focus ~40-50% of equities internationally and in emerging markets (tilting small / value where possible). Hopefully the next 40 years work well for us all, with proper planning, for which in any case these articles are excellent tools. Thanks again, bookmarking..
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

User avatar
coachz
Posts: 1048
Joined: Wed Apr 04, 2007 7:10 am
Location: Charleston, SC

Re: A costly mistake made by both investors and advisors

Post by coachz » Wed Aug 03, 2016 6:33 am

HomerJ wrote:
lack_ey wrote:I don't get why you're upset by this. That's how these things work. Of course this stuff isn't all that accurate, and it's not too controversial that new information can improve forecasts.
I'm upset by this because leading financial experts are stating that we should set our AA and withdrawal strategy based on valuations. Valuations are HUGELY important, we are told.

But like you said, this stuff isn't all that accurate, and changes year-to-year. Should we change our AA every year based on valuations?

Who has a list of the expected returns MADE AT THE TIME (not backwards looking) for the past 10-20 years? I'd love to see how accurate they turned to be.

They keep tweaking the model, so it looks better.

The only example I know is Shiller himself forecasting 0% real returns in 1996 and instead we got 6%+ real over the past 20 years.

Yet when I bring this up, experts today state, "Oh no, our latest models forecast 4.4% expected returns in 1996, so we weren't that far off".

But yes they were. The models have been adjusted AFTER the fact, and then the experts gloss over the failure, and continue to state that valuations are great predictors. They'll bring up a list of extenuating circumstances to explain away the failure of the model. But who knows what variables will change next? They'll admit valuations are only 40% effective as a predictor, but then state people should change their AA based on valuations and work 7 years longer to get down to 3%.

But I probably should just let it all go. My apologies to everyone for getting too worked up....

I don't think you are getting worked up. I think you have valid points that nobody has been able to explain clearly.
"The single biggest problem in communication is the illusion that it has taken place.”
― George Bernard Shaw

lack_ey
Posts: 6701
Joined: Wed Nov 19, 2014 11:55 pm

Re: A costly mistake made by both investors and advisors

Post by lack_ey » Wed Aug 03, 2016 12:01 pm

HomerJ wrote:
lack_ey wrote:I don't get why you're upset by this. That's how these things work. Of course this stuff isn't all that accurate, and it's not too controversial that new information can improve forecasts.
I'm upset by this because leading financial experts are stating that we should set our AA and withdrawal strategy based on valuations. Valuations are HUGELY important, we are told.

But like you said, this stuff isn't all that accurate, and changes year-to-year. Should we change our AA every year based on valuations?

Who has a list of the expected returns MADE AT THE TIME (not backwards looking) for the past 10-20 years? I'd love to see how accurate they turned to be.

They keep tweaking the model, so it looks better.

The only example I know is Shiller himself forecasting 0% real returns in 1996 and instead we got 6%+ real over the past 20 years.

Yet when I bring this up, experts today state, "Oh no, our latest models forecast 4.4% expected returns in 1996, so we weren't that far off".

But yes they were. The models have been adjusted AFTER the fact, and then the experts gloss over the failure, and continue to state that valuations are great predictors. They'll bring up a list of extenuating circumstances to explain away the failure of the model. But who knows what variables will change next? They'll admit valuations are only 40% effective as a predictor, but then state people should change their AA based on valuations and work 7 years longer to get down to 3%.

But I probably should just let it all go. My apologies to everyone for getting too worked up....
I have a few notes to make in response that don't all address specific points so I'll just enumerate them below.

1. If we have information that is actionably reliable enough, sure, it makes sense to adjust AA or withdrawal rate some from year to year. The discussion should be on how much and how useful the information is. If 30-year TIPS were yielding 3% I'd feel a lot better about a given withdrawal rate than if they were yielding -1%. Based on moderate-to-low changes in stock valuations that we see most of the time, the amount of "signal" available is low enough that there's not enough new or changed information to make any significant changes in AA. But this is not necessarily always the case.

2. With stocks I believe a lot of the academics and financial writers are likely overstating the predictability of returns based on valuations, and here they already admit it's not very high.

3. Evaluating forecasts for accuracy is very important, good. Agreed there.

4. You're right to be suspicious of people changing models used over time (which is different from the same model being updated over time with new data, which I think you might have also criticized? not sure). Of course a newer model is going to be tuned to not do so poorly over the past, so that doesn't really say anything.

But your one anecdote of Shiller in 1995 speaks to an analysis that was objectively aggressive, potentially prone to overfitting the past and being relatively poor in predicting a future. This is not just some canned excuse we can pull out in hindsight; forgetting all the context if you just look at it from a statistical point of view it would be clear at the time in 1995—albeit debatable which technique would turn out best. If today you have a forecast that assumes on average that valuations stay put (which you derided earlier), this would be less aggressive in (over?)fitting the past data, for better or worse. There's a tradeoff between overreacting to noise and underreacting to signal.

5. Sometimes a model can be right and operating properly within the range of expectations, but the world just surprises with an outcome on the fringes. If the weather forecasts gives a chance of rain of 30% and it rains, then the chance of rain the next day as 20% and it rains, and the chance of rain the day after that as 40% and it rains again, maybe the forecast is broken. Or maybe it was right and that 30% probability was hit, the 20% was hit, and the 40% was hit. Over the long haul with a lot of data you can see if a forecast is getting things about right. For example, if it rains about 20% of the time the forecast says that there's a 20% chance of rain then it's working properly.

The problem in finance is relatively slow updating and paucity of data so here we're all basically just guessing a lot with models that are difficult to evaluate. It's possible even Shiller's 0% was right for an average but what happened was really surprising on the upside. I don't think that sounds right but we'll never really know. Going back to the rain example, the difficulty we have is in assessing, if it actually rained three times in a row, the probability that are model is messed up and by how much. Without much data it's just hard to say. Some will suspect the model is bad; others will suspect we just got unlucky with rain. It might actually be something in between.

6. Even though there are problems with the models, you can't avoid using any, implicitly or explicitly. If you want to criticize a certain prediction, you need to offer your own. If you assume historical returns, this is itself a model with certain strong assumptions that is also probably wrong to some degree and can be attacked.

2015
Posts: 2906
Joined: Mon Feb 10, 2014 2:32 pm

Re: A costly mistake made by both investors and advisors

Post by 2015 » Wed Aug 03, 2016 12:55 pm

I have one more important issue to cover: How to address issues surrounding the difficulty of forecasting returns? One of the best ways to address probabilistic forecasts is to use a Monte Carlo (MC) simulator...the MC simulation program generates a sequence of random returns from which one return is used in each year of the simulation. This process is repeated thousands of times to calculate the likelihood of possible outcomes and their potential distributions. This allows you to look at alternative scenarios, including ones where returns will be well below expectations (which Asness showed is quite possible). Being forewarned about the potential for such events allows you to prepare for the various possible outcomes. That includes putting in place a contingency plan of action (a “Plan B") to be implemented if a major unexpected event (a “black swan”) appears. The plan should detail what actions to take if financial assets fall to such a degree that the investor runs an unacceptably high level of risk of failure. For individuals, those actions might include remaining in or returning to the work force, reducing current spending, reducing the financial goal, selling a home and/or moving to a location with a lower cost of living.
I am going to ask what is probably a dumb question, but I am trying to make this actionable. Assuming solely for the sake of argument that returns for the next 30 years are lower than historical averages, would using Fidelity's Retirement Income planner in "underperforming market" mode be a good tool per Larry's discussion of MC simulators?

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Wed Aug 03, 2016 2:25 pm

lack_ey wrote:The problem in finance is relatively slow updating and paucity of data so here we're all basically just guessing a lot with models that are difficult to evaluate.
Excellent point.
It's possible even Shiller's 0% was right for an average but what happened was really surprising on the upside. I don't think that sounds right but we'll never really know.
You are correct. He may indeed have been right, and we just got really lucky.

Going back to the rain example, the difficulty we have is in assessing, if it actually rained three times in a row, the probability that are model is messed up and by how much. Without much data it's just hard to say. Some will suspect the model is bad; others will suspect we just got unlucky with rain. It might actually be something in between.
I agree. Great illustration.
Even though there are problems with the models, you can't avoid using any, implicitly or explicitly. If you want to criticize a certain prediction, you need to offer your own.
I disagree... My point is nobody knows enough to make any actionable predictions at all.
you assume historical returns, this is itself a model with certain strong assumptions that is also probably wrong to some degree and can be attacked.
True enough.

User avatar
coachz
Posts: 1048
Joined: Wed Apr 04, 2007 7:10 am
Location: Charleston, SC

Re: A costly mistake made by both investors and advisors

Post by coachz » Wed Aug 03, 2016 4:27 pm

Since nobody knows, that explains why so many investment books are filled with what not to do instead of what to do.

NMJack
Posts: 836
Joined: Sun Feb 14, 2016 1:22 pm

Re: A costly mistake made by both investors and advisors

Post by NMJack » Wed Aug 03, 2016 8:46 pm

NMJack wrote:Larry: I'm trying to wrap my head around your using E/P as the sole basis for forecasting future returns. Four hypothetical companies:

All have a market cap or $1B, one million shares outstanding (i.e. $1000 per share price), corporate earnings of $50M and thus P/E of 20. Using your model, the E/P would be .05, which you say would project a 5% ROI.

Company A:
Has $200,000,000 of cash on the books doing nothing. They decide to implement a stock buyback plan, and buy back 200,000 shares of stock at the current price of $1000 per share. There are now 800,000 shares of stock outstanding. This increases the earnings per share from $50 to $62.50, reducing the P/E to 16. Now, granted, during the share buyback, the price per share would likely increase, but that would reward the shareholder in a similar manner. Does your model now increase the ROI from 5% to 6.25%?

Company B:
Also has $200,000,000 cash on the books, but decides to aggressively spend on R&D that will have less than a 3 year payback (so will increase earnings by at least 33% of the $200,000,000 spent per year). So, annual earnings go up to $50M + $200M x .33 = $116M. That changes the P/E from 20 to 9. Does your model now increase ROI from 5% to 11%?

Company C:
Has $100 on the books, so just continues along as usual.

Company D:
Highly leveraged. Has outstanding debt of $200,000,000 but is still paying dividends and at times borrowing money to do so.

I'm no accountant (and I can prove it), so I may not understand any of this. If not, I would appreciate more knowledgeable individuals "kindly" educating me. That said, I believe that there are many more variables on a corporate balance sheet that need to be considered beyond P/E ratio.

Thanks.
NMJack wrote:
I will postulate that the above will not occur in the real world. Despite the fact that all mathematically would generate the same P/E (and thus E/P), there are far different inherent values, and thus potential future returns, in each case. The investment world would recognize this and drive up the stock prices of Companies A and B and drive down the stock prices of C and D. A and B might be selling at $1250 per share (P/E = 25) while C might be selling at $750 (P/E = 15) and D might be selling at $500 (P/E = 10).

Is it possible that in the early years cited in Larry's research that companies operated more like company C and company D? I believe that in the decades following the great depression, companies did not accumulate cash and paid large dividends (likely in large part due to the mistrust of institutions in general after the depression). I believe that in today's environment, more companies operate like A and B. We read countless reports of record balance sheets and aggressive stock buy backs. Could this explain much of the high current P/E ratios, and thus shoot holes in using historical vs. current E/P to make forecasts regarding future real earnings? I'm just asking.... :confused
Still hoping for some meaningful feedback to these very basic questions. With a sea of financial experts out there, somebody should be able to at least tell me if my questions are valid or silly? :confused

If they are valid, then I will invite Larry to explain why he is only using P/E as the sole basis for advising the forum as to what stocks will do in the future.

Topic Author
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: A costly mistake made by both investors and advisors

Post by larryswedroe » Wed Aug 03, 2016 9:30 pm

First, as promised I had our team run the MCS and for a total US market portfolio with 60/40 estimated odds of success are now just 74% and with 40/60 it's just 70%. Far from conservative. Using our more heavily tilted to EM and non US developed (40% international) and about .3 loading on size and value raises the odds to 83 and 80, still not conservative.

As to current times and P/E. First I would say that far fewer companies pay dividends today and payout ratios are MUCH lower, that should lead to bit higher EPS growth and justify slightly higher P/E. Slightly. Of course this doesn't have any impact on the bond side.

AS to actionable, with investing we know all we can do is put the odds on our side and we know that higher valuations and lower yields must lead, all else equal to lower future expected returns. Thus ignoring the evidence and logic IMO is imprudent and there is actionable items not only one can make but should. And that includes changes in valuations impacting AA. The reason is simple, the ASSUMPTIONS you made in the original plan no longer hold and if you would NOT have chosen your current AA with these different assumption it makes no sense to adhere to a plan whose assumptions are different. Now that doesn't mean AA should change as there are other levers that can also change, like savings rate, goals, duration of working years, etc. But smart people when they have new information incorporate that new information.

Again I would note that Saint Jack changes his forecast of stock returns as valuations change, as that is what the DDM model does, and if you change your forecast your need to take risk changes.
Hope that helps
Larry

NMJack
Posts: 836
Joined: Sun Feb 14, 2016 1:22 pm

Re: A costly mistake made by both investors and advisors

Post by NMJack » Wed Aug 03, 2016 11:14 pm

larryswedroe wrote: As to current times and P/E. First I would say that far fewer companies pay dividends today and payout ratios are MUCH lower, that should lead to bit higher EPS growth and justify slightly higher P/E. Slightly.
I believe that the investment community has voted, and the results suggest much more than "slightly." This much I know; an earnings dollar that is not paid out in dividends is retained for the future benefit of the shareholders. I don't think shareholders are expecting a "bit higher" or "slightly higher." I think they are expecting a strong return, hence the (justifiable) higher P/E driven by higher expected future earnings. This is 100% contrary to the idea of allowing P/E (E/P) to forecast future returns.

Ari
Posts: 538
Joined: Sat May 23, 2015 6:59 am

Re: A costly mistake made by both investors and advisors

Post by Ari » Thu Aug 04, 2016 12:31 am

I think it makes a lot of sense to say that the best prediction of future returns depends on P/E (or CAPE10) and is independent of term, but the reliability of the prediction might be better at intermediate terms. I.e. our best guess for 30-year returns is the same as our best guess for 10-year returns, but the guess is "better" for the 10-year returns. Is that an accurate summary? I'm trying to reword the argument to make sure I understand it correctly.
All in, all the time.

NMJack
Posts: 836
Joined: Sun Feb 14, 2016 1:22 pm

Re: A costly mistake made by both investors and advisors

Post by NMJack » Thu Aug 04, 2016 1:53 am

Ari wrote:I think it makes a lot of sense to say that the best prediction of future returns depends on P/E (or CAPE10) and is independent of term, but the reliability of the prediction might be better at intermediate terms. I.e. our best guess for 30-year returns is the same as our best guess for 10-year returns, but the guess is "better" for the 10-year returns. Is that an accurate summary? I'm trying to reword the argument to make sure I understand it correctly.
So you don't care about anything else on the corporate balance sheets? (i.e. buckets of cash on hand vs. debt, etc.)

Ari
Posts: 538
Joined: Sat May 23, 2015 6:59 am

Re: A costly mistake made by both investors and advisors

Post by Ari » Thu Aug 04, 2016 1:56 am

NMJack wrote:So you don't care about anything else on the corporate balance sheets? (i.e. buckets of cash on hand vs. debt, etc.)
I didn't say that. I'm not sure if Swedroe has said it, but all I said was that it depends on the P/E or CAPE10. I didn't say it SOLELY depends on that.

I'm not trying to make a model or predictions, I'm just trying to understand this variable and how to look at it.
All in, all the time.

inbox788
Posts: 6696
Joined: Thu Mar 15, 2012 5:24 pm

Re: A costly mistake made by both investors and advisors

Post by inbox788 » Thu Aug 04, 2016 2:54 am

trueblueky wrote:Thank you. The negative correlation with historical was unexpected.
What goes up must come down?

inbox788
Posts: 6696
Joined: Thu Mar 15, 2012 5:24 pm

Re: A costly mistake made by both investors and advisors

Post by inbox788 » Thu Aug 04, 2016 3:06 am

NMJack wrote:Larry: I'm trying to wrap my head around your using E/P as the sole basis for forecasting future returns. Four hypothetical companies:

All have a market cap or $1B, one million shares outstanding (i.e. $1000 per share price), corporate earnings of $50M and thus P/E of 20. Using your model, the E/P would be .05, which you say would project a 5% ROI.

Company A:
Has $200,000,000 of cash on the books doing nothing. They decide to implement a stock buyback plan, and buy back 200,000 shares of stock at the current price of $1000 per share. There are now 800,000 shares of stock outstanding. This increases the earnings per share from $50 to $62.50, reducing the P/E to 16. Now, granted, during the share buyback, the price per share would likely increase, but that would reward the shareholder in a similar manner. Does your model now increase the ROI from 5% to 6.25%?

Company B:
Also has $200,000,000 cash on the books, but decides to aggressively spend on R&D that will have less than a 3 year payback (so will increase earnings by at least 33% of the $200,000,000 spent per year). So, annual earnings go up to $50M + $200M x .33 = $116M. That changes the P/E from 20 to 9. Does your model now increase ROI from 5% to 11%?

Company C:
Has $100 on the books, so just continues along as usual.

Company D:
Highly leveraged. Has outstanding debt of $200,000,000 but is still paying dividends and at times borrowing money to do so.

I'm no accountant (and I can prove it), so I may not understand any of this. If not, I would appreciate more knowledgeable individuals "kindly" educating me. That said, I believe that there are many more variables on a corporate balance sheet that need to be considered beyond P/E ratio.

Thanks.
If you want to consider cash and debt, a better measure may be P / EBITDA vs EV / EBITDA :

http://www.wikinvest.com/metric/Price_to_EBITDA

bigred77
Posts: 2028
Joined: Sat Jun 11, 2011 4:53 pm

Re: A costly mistake made by both investors and advisors

Post by bigred77 » Thu Aug 04, 2016 8:02 am

Ari wrote:I think it makes a lot of sense to say that the best prediction of future returns depends on P/E (or CAPE10) and is independent of term, but the reliability of the prediction might be better at intermediate terms. I.e. our best guess for 30-year returns is the same as our best guess for 10-year returns, but the guess is "better" for the 10-year returns. Is that an accurate summary? I'm trying to reword the argument to make sure I understand it correctly.
I think you nailed it.

That's the argument I was trying to make anyway.

bigred77
Posts: 2028
Joined: Sat Jun 11, 2011 4:53 pm

Re: A costly mistake made by both investors and advisors

Post by bigred77 » Thu Aug 04, 2016 8:15 am

NMJack wrote:
larryswedroe wrote: As to current times and P/E. First I would say that far fewer companies pay dividends today and payout ratios are MUCH lower, that should lead to bit higher EPS growth and justify slightly higher P/E. Slightly.
I believe that the investment community has voted, and the results suggest much more than "slightly." This much I know; an earnings dollar that is not paid out in dividends is retained for the future benefit of the shareholders. I don't think shareholders are expecting a "bit higher" or "slightly higher." I think they are expecting a strong return, hence the (justifiable) higher P/E driven by higher expected future earnings. This is 100% contrary to the idea of allowing P/E (E/P) to forecast future returns.
NMJack,

I agree with Larry on this one. When companies choose to reinvest profits into the business instead of returning those profits directly to shareholders via dividends or stock buybacks investors would expect higher earnings growth, which would justify higher valuations (at least valuations where one is comparing current prices to past earnings) but not to the extent that we have seen.

I think the higher P/E valuations we see currently are better explained by lower interest rates, an increased supply of capital, and the US market being seen as safer right now than international markets.

User avatar
coachz
Posts: 1048
Joined: Wed Apr 04, 2007 7:10 am
Location: Charleston, SC

Re: A costly mistake made by both investors and advisors

Post by coachz » Thu Aug 04, 2016 8:21 am

larryswedroe wrote:First, as promised I had our team run the MCS and for a total US market portfolio with 60/40 estimated odds of success are now just 74% and with 40/60 it's just 70%. Far from conservative. Using our more heavily tilted to EM and non US developed (40% international) and about .3 loading on size and value raises the odds to 83 and 80, still not conservative.

As to current times and P/E. First I would say that far fewer companies pay dividends today and payout ratios are MUCH lower, that should lead to bit higher EPS growth and justify slightly higher P/E. Slightly. Of course this doesn't have any impact on the bond side.

AS to actionable, with investing we know all we can do is put the odds on our side and we know that higher valuations and lower yields must lead, all else equal to lower future expected returns. Thus ignoring the evidence and logic IMO is imprudent and there is actionable items not only one can make but should. And that includes changes in valuations impacting AA. The reason is simple, the ASSUMPTIONS you made in the original plan no longer hold and if you would NOT have chosen your current AA with these different assumption it makes no sense to adhere to a plan whose assumptions are different. Now that doesn't mean AA should change as there are other levers that can also change, like savings rate, goals, duration of working years, etc. But smart people when they have new information incorporate that new information.

Again I would note that Saint Jack changes his forecast of stock returns as valuations change, as that is what the DDM model does, and if you change your forecast your need to take risk changes.
Hope that helps
Larry
Larry, Thanks for running the MCS. Even the JQB book mentions that we have not seen high valuations and low interest rates before to know what to expect.
I see 2 headlines here: "4% SWR IS DEAD WRONG NOW" and "CHANGE THE COURSE"
I look forward to the book !

carolinaman
Posts: 3939
Joined: Wed Dec 28, 2011 9:56 am
Location: North Carolina

Re: A costly mistake made by both investors and advisors

Post by carolinaman » Thu Aug 04, 2016 12:04 pm

Thanks Larry. I thought your article was excellent.

I have not read the entire thread, but some people have major issues with the valuation model. I understand that it is far from perfect but IMO it seems to be the least bad model. Also, it is not a set it and forget it model. It should be revisited frequently, perhaps every year, to adjust based upon changes in valuation.

What model would the critics use instead? If you are going to project how long your assets will last using some withdrawal or you are going to project how much savings will be needed to fund your retirement, you need to use some type of model and a discount rate based upon investment returns.

I have always been troubled when people use 90 or 100 years of historical data for planning or to prove some investment strategy. There have been so many changes over the years that make it questionable to rely very much on that much historical data and, as Larry said, valuations matter... a lot.

MIretired
Posts: 760
Joined: Fri Sep 06, 2013 12:35 pm

Re: A costly mistake made by both investors and advisors

Post by MIretired » Thu Aug 04, 2016 12:52 pm

I wish I, myself, had never used the phrase "set-it-and-forget-it" on these boards. I think there might still be a broken Veg-a-matic lying around here somewhere.

Day9
Posts: 825
Joined: Mon Jun 11, 2012 6:22 pm

Re: A costly mistake made by both investors and advisors

Post by Day9 » Thu Aug 04, 2016 1:41 pm

The example about current yields being a better indicator of expected bond returns than historical returns is the most easily graspable, common sense example of this point. If yields fall then historical bond returns go up but it is easy to see that expected returns going forward must be lower. So if you just looked at historical returns to estimate expected return you would overstate it.

It is less obvious for stocks and I appreciate this article and the points of clarification in this discussion. Thank you Mr Swedroe.
I'm just a fan of the person I got my user name from

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 1:57 pm

larryswedroe wrote:First, as promised I had our team run the MCS and for a total US market portfolio with 60/40 estimated odds of success are now just 74% and with 40/60 it's just 70%. Far from conservative. Using our more heavily tilted to EM and non US developed (40% international) and about .3 loading on size and value raises the odds to 83 and 80, still not conservative.
I had my team run the numbers and we came up with 99.7%, totally conservative.
As to actionable, with investing we know all we can do is put the odds on our side and we know that higher valuations and lower yields must lead, all else equal to lower future expected returns.
All else is never equal. The CAPE model created in 1988 failed to predict returns accurately since then because other variables changed

From one of your own posts:
larryswedroe wrote:There are also good reasons some times for valuations to move higher than historical levels.

Regulations have strengthened making investing more transparent and less risky
Trading costs have come down.
Expense ratios have come down
Accounting rules have changed lowering earning as have to write off at once what once could have been amortized.
Country has become wealthier and capital is less scarce and thus should be less expensive
What other variables are we not accounting for? Will you be posting in ten years about how X and Y and Z are the good reasons the CAPE model failed again, but everyone should totally believe the new improved model of 2026?

Declaring that valuations is the most important variable and investing decisions should be made around that one number seems imprudent to me.

But that's just my opinion.
Last edited by HomerJ on Thu Aug 04, 2016 2:05 pm, edited 2 times in total.

Topic Author
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: A costly mistake made by both investors and advisors

Post by larryswedroe » Thu Aug 04, 2016 2:00 pm

NMJack
If you do the math it works out to about 1 in PE ratio, that doesn't change the forecasted mean return much. Take 26 and 27 E/P and you get 3.85 and 3.7.

For all
I would add this, that returns have proven to be somewhat higher than models forecasted as the MEAN, but well within expected normal distributions around that. Why did that happen? Because earnings growth was faster than historical average. Why did that happen? Mainly because profit margins widened to beyond their highest level of the long time range of 6-10%. Logically you see tug and war between labor and capital and that is why you see ranges. We have had very long period of high UE and underemployment allowing capital to improve margins. Unless you think that capital can continue to expand margins faster, earnings growth not likely to grow faster any longer, and seems more likely that margins will fall back into range, which would mean likely slower growth in earnings than historical. And in fact we are seeing that already. Now I don't predict such things so don't know what will happen but it does seem more likely that margins will revert back to within historical ranges and valuations more likely to fall than rise, which would mean even lower future returns than the models forecast. At least that is a risk.

What some like Homer seem to want is a model that gives 100% accuracy which of course is impossible because then there would be no risks. And no one can clearly see the future. So the best we can do is to put the odds in our favor using the best tools we have and understand that wide dispersion around the mean forecast are likely.

Again I'll note that using these type models and making unconditional forecasts (the kind Homer has criticized greatly) is EXACTLY how Saint Jack forecasts. And so does the rest of the great majority of professionals/academics in the field. And others use the same model but then make a forecast that relies on some RTM (such as Hussman and Grantham).

The models IMO provide very valuable, though not perfect, information and those that ignore them (likely because it doesn't fit their plans and they don't like the answers) do so at their own peril.

Larry
Last edited by larryswedroe on Thu Aug 04, 2016 2:08 pm, edited 1 time in total.

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 2:04 pm

carolinaman wrote:I have not read the entire thread, but some people have major issues with the valuation model. I understand that it is far from perfect but IMO it seems to be the least bad model. Also, it is not a set it and forget it model. It should be revisited frequently, perhaps every year, to adjust based upon changes in valuation.
Why would you change your allocation every year because of a model that weakly predicts 7-10 year returns?

That's my problem with these threads. What happened to stay the course?
What model would the critics use instead? If you are going to project how long your assets will last using some withdrawal or you are going to project how much savings will be needed to fund your retirement, you need to use some type of model and a discount rate based upon investment returns.
Roughly Age-in-bonds for your Asset Allocation, and 25x expenses for retirement (4%).

It really isn't as difficult as some people are making it.

soboggled
Posts: 901
Joined: Mon Jun 27, 2016 10:26 am

Re: A costly mistake made by both investors and advisors

Post by soboggled » Thu Aug 04, 2016 2:23 pm

HomerJ wrote:
carolinaman wrote:I have not read the entire thread, but some people have major issues with the valuation model. I understand that it is far from perfect but IMO it seems to be the least bad model. Also, it is not a set it and forget it model. It should be revisited frequently, perhaps every year, to adjust based upon changes in valuation.
Why would you change your allocation every year because of a model that weakly predicts 7-10 year returns?

That's my problem with these threads. What happened to stay the course?
What model would the critics use instead? If you are going to project how long your assets will last using some withdrawal or you are going to project how much savings will be needed to fund your retirement, you need to use some type of model and a discount rate based upon investment returns.
Roughly Age-in-bonds for your Asset Allocation, and 25x expenses for retirement (4%).

It really isn't as difficult as some people are making it.
The rules-of-thumb are fine but they are just a starting point. They assume an average return and current valuations provide much reason to believe returns on both stocks and bonds will be below historical average in the short to intermediate term. So if you have a very long horizon, you can ignore valuations; otherwise, maybe not so much. In particular, the 25x expenses rule seems a tad optimistic to me - it assumes an equity exposure too rich for some, so maybe more then ever one should allow a lot of room for error or consider annuities rather than depending on sheer return.

lack_ey
Posts: 6701
Joined: Wed Nov 19, 2014 11:55 pm

Re: A costly mistake made by both investors and advisors

Post by lack_ey » Thu Aug 04, 2016 2:24 pm

NMJack wrote:
NMJack wrote:Larry: I'm trying to wrap my head around your using E/P as the sole basis for forecasting future returns. Four hypothetical companies:

All have a market cap or $1B, one million shares outstanding (i.e. $1000 per share price), corporate earnings of $50M and thus P/E of 20. Using your model, the E/P would be .05, which you say would project a 5% ROI.

Company A:
Has $200,000,000 of cash on the books doing nothing. They decide to implement a stock buyback plan, and buy back 200,000 shares of stock at the current price of $1000 per share. There are now 800,000 shares of stock outstanding. This increases the earnings per share from $50 to $62.50, reducing the P/E to 16. Now, granted, during the share buyback, the price per share would likely increase, but that would reward the shareholder in a similar manner. Does your model now increase the ROI from 5% to 6.25%?

Company B:
Also has $200,000,000 cash on the books, but decides to aggressively spend on R&D that will have less than a 3 year payback (so will increase earnings by at least 33% of the $200,000,000 spent per year). So, annual earnings go up to $50M + $200M x .33 = $116M. That changes the P/E from 20 to 9. Does your model now increase ROI from 5% to 11%?

Company C:
Has $100 on the books, so just continues along as usual.

Company D:
Highly leveraged. Has outstanding debt of $200,000,000 but is still paying dividends and at times borrowing money to do so.

I'm no accountant (and I can prove it), so I may not understand any of this. If not, I would appreciate more knowledgeable individuals "kindly" educating me. That said, I believe that there are many more variables on a corporate balance sheet that need to be considered beyond P/E ratio.

Thanks.
NMJack wrote:
I will postulate that the above will not occur in the real world. Despite the fact that all mathematically would generate the same P/E (and thus E/P), there are far different inherent values, and thus potential future returns, in each case. The investment world would recognize this and drive up the stock prices of Companies A and B and drive down the stock prices of C and D. A and B might be selling at $1250 per share (P/E = 25) while C might be selling at $750 (P/E = 15) and D might be selling at $500 (P/E = 10).

Is it possible that in the early years cited in Larry's research that companies operated more like company C and company D? I believe that in the decades following the great depression, companies did not accumulate cash and paid large dividends (likely in large part due to the mistrust of institutions in general after the depression). I believe that in today's environment, more companies operate like A and B. We read countless reports of record balance sheets and aggressive stock buy backs. Could this explain much of the high current P/E ratios, and thus shoot holes in using historical vs. current E/P to make forecasts regarding future real earnings? I'm just asking.... :confused
Still hoping for some meaningful feedback to these very basic questions. With a sea of financial experts out there, somebody should be able to at least tell me if my questions are valid or silly? :confused

If they are valid, then I will invite Larry to explain why he is only using P/E as the sole basis for advising the forum as to what stocks will do in the future.
This is in part explored here to an extent:
http://www.philosophicaleconomics.com/2013/12/shiller/

All in all, there are a lot of ways that these statistics could be adjusted and just using Shiller PE is a start. As suggested above there are many variants on P/E. Of course, a more complicated model may be overfit and worse.

For these discussions people tend to use the simpler Shiller PE probably because we have more data on that. But as you suggest, the data may not be all that good or consistent across regimes. It's possible that using a lower amount of higher-quality data trumps a higher amount of lower-quality data.

Ultimately nothing fits very cleanly and stocks are a whole lot less predictable than bonds.

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 2:43 pm

lack_ey wrote:This is in part explored here to an extent:
http://www.philosophicaleconomics.com/2013/12/shiller/
That is a great article by the way
For most of history, the Shiller Cyclically-Adjusted Price-Earnings ratio (CAPE) oscillated in a pseudo sine wave around a long-term (130 year) average of 15.30. It spent 55% percent of the time above the average, and 45% of the time below–a reasonable result for a metric that allegedly mean reverts. Since 1990, however, the metric has only spent 2% of the time below its historical average–98% of the time above.

The metric’s failure to mean-revert over the last 23 years hasn’t been for a lack of reasons. The period covered three recessions, two stock market crashes, and one bonafide financial panic–the likes of which hadn’t been seen since the Great Depression. Even in the worst parts of the 2008-2009 crash–at levels that we now look back on with nostalgia as the “buying opportunity” of our generation–the metric failed to provide an accurate valuation signal. In an inexcusable blunder, it basically called the market “slightly below fair value” (see the black circle).

If we’re being honest, there are only two possibilities. Either the “normal” levels of the metric have shifted significantly upwards over the last few decades, or the metric is broken. There is no other way to coherently explain why the metric has consistently failed to migrate towards its long-term average, or spend any amount of time below it, as it should do every so often in bear markets.
This especially:
There is no external, divinely-imposed valuation level that the stock market has to take on. Rather, the stock market takes on whatever valuation level achieves the required equilibrium between those that want to get in it, and those that want to get out of it. At all times, every investor that wants to get in the market needs to connect with an investor that wants to get out of it. If there are too many that want to get in, and not enough that want to get out, the price will rise until the imbalance is relieved. If there are too many that went to get out, and not enough that want to get in, the price will fall until the same. The process is reflexive–investors want to get in or out based on where the price is and what it is doing, but they also make the price be where it is and do what it is doing, through their efforts.

For this reason, context–the set of environmental variables that shape investor outlook and risk appetite, and that influence the preference to be in or out, given the price–is crucial to normative claims about valuation. A valuation level that is “appropriate” in one context–adequate to achieve the required equilibrium–may not be “appropriate” in another.
It closes with:
Shiller bears are making a blind bet on the mean reversion of a poorly constructed metric, without paying attention to context–the set of variables that drive the preferences of market participants to be in or out, and that determine the valuation that the market naturally gravitates towards. The outcome they are calling for requires the market’s context to return to the low points–war, tight money inflation, financial crisis–of prior eras.
Last edited by HomerJ on Thu Aug 04, 2016 2:51 pm, edited 1 time in total.

User avatar
Riley15
Posts: 198
Joined: Wed May 11, 2016 9:21 pm

Re: A costly mistake made by both investors and advisors

Post by Riley15 » Thu Aug 04, 2016 2:49 pm

HomerJ wrote:
Why would you change your allocation every year because of a model that weakly predicts 7-10 year returns?

That's my problem with these threads. What happened to stay the course?

Roughly Age-in-bonds for your Asset Allocation, and 25x expenses for retirement (4%).

It really isn't as difficult as some people are making it.
I can really see why HomerJ is critical of this valuation model and it does sound very un-bogleheadish and defies our notion of simple investing. I also like to look at it from a perspective of adding another variable to determining your asset allocation and investing approach.

Yes the valuation model may change year to year but so does your age when allocating your age in bonds. It's just another variable to consider when determining your asset allocation. We can also go back to a even simpler model by stripping away age in bonds (nothing precise about that, just a rough estimate to reduce volatility).

The goal has always been to obtain average market returns and not optimum returns. Looking at valuation may well be a valuable tool to add to our approach once it's fully understood and we can make it actionable and add it to wiki. It's definitely a step to towards the active side and away from the passive side.

User avatar
investorguy1
Posts: 543
Joined: Mon Nov 24, 2014 7:13 pm

Re: A costly mistake made by both investors and advisors

Post by investorguy1 » Thu Aug 04, 2016 3:07 pm

Can someone help elaborate on this quote from the article?

"The best tool we have for forecasting equity returns are current valuations. With that in mind, the Shiller CAPE 10 earnings yields as of June 30, 2016 are 4.1% for the United States, 6.6% for developed markets and 8.2% for emerging markets."

^How is the above calculated? Where do you get the data from?

"To forecast expected returns, we need to make an adjustment to account for the fact that the Shiller CAPE 10 uses a 10-year average of earnings (adjusted for inflation) and real earnings grow about 2% a year."

^Where does the above 2% number come from? Why do we assume it will continue? For how long?

" Thus, we need to multiply the earnings yield by 1.1 [1 + (5 x .02)]."

^Could you explain the above this please?

That results in expected real returns to U.S. stocks of 4.5%, to developed market stocks of 7.3% and to emerging market stocks of 9.0%. To get an estimate of nominal returns, you can add the current spread between the 10-year nominal bond and the 10-year TIPS, which is currently about 1.5%.
Last edited by investorguy1 on Thu Aug 04, 2016 4:07 pm, edited 1 time in total.

User avatar
coachz
Posts: 1048
Joined: Wed Apr 04, 2007 7:10 am
Location: Charleston, SC

Re: A costly mistake made by both investors and advisors

Post by coachz » Thu Aug 04, 2016 3:13 pm

freyj6 wrote:Coachz, it depends on the sequence of returns.

If you had a stead 1% a year all the way through, or bigger gains in the first half of retirement, you could easily fund a retirement like that.

However, if you had negative returns early and positive returns late, you'd likely run out of money.
How does the math work where if you had a 1% steady yearly gain that it could support 4% safe withdrawal rate?

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 3:24 pm

coachz wrote:
freyj6 wrote:Coachz, it depends on the sequence of returns.

If you had a stead 1% a year all the way through, or bigger gains in the first half of retirement, you could easily fund a retirement like that.

However, if you had negative returns early and positive returns late, you'd likely run out of money.
How does the math work where if you had a 1% steady yearly gain that it could support 4% safe withdrawal rate?
They are assuming a retirement of 30 years and your money not going to zero.

Think about it. Even if you only got 0% real return every year, 4% withdraw would last 25 years of expenses. So even a measly STEADY (which never happens) 1% return will get you enough to fund 5 more years at the end.

Then you better hope you die, because you are going to be pretty close to zero at that point.

Edit:

Actually it looks like you hit zero in Year 29... I would probably use Plan B and buy an annuity in Year 15 with my remaining $517,000 (or start cutting back expenses in year 2!)

970
939
909
878
846
815
783
751
719
686 - 10
653
620
585
551
517 - 15
482
447
411
375
338 - 20
302
265
227
190
151
113
74
35
0 - 29

Edit 2:

If you got a steady 3% real return, and withdrew 4% a year, you'd still have half a million left (in real dollars) even after 30 years.

990
979
969
958
946
935
923
911
898
885 - 10
871
858
843
828
813
797
781
764
747
730 - 20
712
693
674
654
634
613
591
569
546
522 -30
Last edited by HomerJ on Thu Aug 04, 2016 3:54 pm, edited 3 times in total.

NMJack
Posts: 836
Joined: Sun Feb 14, 2016 1:22 pm

Re: A costly mistake made by both investors and advisors

Post by NMJack » Thu Aug 04, 2016 3:35 pm

lack_ey wrote: This is in part explored here to an extent:
http://www.philosophicaleconomics.com/2013/12/shiller/

All in all, there are a lot of ways that these statistics could be adjusted and just using Shiller PE is a start. As suggested above there are many variants on P/E. Of course, a more complicated model may be overfit and worse.

For these discussions people tend to use the simpler Shiller PE probably because we have more data on that. But as you suggest, the data may not be all that good or consistent across regimes. It's possible that using a lower amount of higher-quality data trumps a higher amount of lower-quality data.

Ultimately nothing fits very cleanly and stocks are a whole lot less predictable than bonds.
Thank you for that link. That article does a great job of putting this into perspective. It looks like I wasn't too far off (conceptually) in my earlier posts. The change in accounting rules also throw a huge twist into everything.

I'm still struggling with the fact that the current CAPE 10 includes the anomalous years of 2008 and 2009. Larry himself touched upon this in the following article he wrote in April:

http://www.etf.com/sections/index-inves ... nopaging=1

Not sure if his new writings conflict with his earlier thoughts or complement them. I'll look to him to weigh in on that topic.

It seems that if we look to the CAPE 5 or CAPE 6 now, or simply wait four years to "grow out" of 2008/2009, things won't look so dismal. :sharebeer

NMJack
Posts: 836
Joined: Sun Feb 14, 2016 1:22 pm

Re: A costly mistake made by both investors and advisors

Post by NMJack » Thu Aug 04, 2016 3:50 pm

investorguy1 wrote:
Could you explain this please?

That results in expected real returns to U.S. stocks of 4.5%, to developed market stocks of 7.3% and to emerging market stocks of 9.0%. To get an estimate of nominal returns, you can add the current spread between the 10-year nominal bond and the 10-year TIPS, which is currently about 1.5%.
Not sure which part you're asking about.

Subtracting the current yield of a 10 year TIPS from the current yield of a 10 year treasury note provides an estimate of the inflation rate over the next ten years. This is determined entirely by the treasury markets, so it is considered to represent what treasury buyers/sellers are expecting inflation to be. At today's close, the 10 year was yielding 1.51% and the 10 year TIPS was yielding .04%, so the market today feels that inflation will run 1.47% over the next 10 years. Note that this is below the Fed's 2% "target," meaning the markets aren't expecting the FED to achieve their goal over that time period.

Topic Author
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: A costly mistake made by both investors and advisors

Post by larryswedroe » Thu Aug 04, 2016 4:08 pm

NMJACK
Yes there are many logical reasons as I pointed out for the P/E to have reason, but that still means the ERP is now lower for the same reasons, and expected returns are lower. Doesn't mean that the 130 mean is the right one. I wrote why I thought it was the wrong one to use.

On other subject, this statement
if you only got 0% real return every year, 4% withdraw would last 25 years of expenses
is correct ONLY if the order of returns is favorable. For simplicity I'll use an all equity portfolio to make the point. Start in 1973. You start with 1000. At end of year the market has fallen about 15% and you withdraw 4% PLUS the inflation rate of 9 (rounding) so you have to take out 44 from the 850 portfolio. So now you have just 806. Now the market goes down 27% and you have just 588, and inflation is cumulative about 17%. So you have to take out 47 to maintain the purchasing power of the 40. So now you have just 541. You can see the problem, even if market recovers and you end up earning 0 real on average the money won't last 25 years. Reason is your portfolio cannot fully recover because it has spent down funds that don't benefit from the market recover, if it happens.

Kevin K
Posts: 119
Joined: Sun Aug 26, 2007 7:47 pm

Re: A costly mistake made by both investors and advisors

Post by Kevin K » Thu Aug 04, 2016 4:11 pm

Perhaps he'll see fit to weigh in on this topic here, but Tyler from the excellent Portfolio Charts website posted really good comment on Mr. Swedroe's article over on the Permanent Portfolio forums:

http://www.gyroscopicinvesting.com/foru ... 15#p152423

In particular I'd direct your attention to the Start Date Sensitivity calculator linked to in the body of the comment.

Fascinating stuff.

NMJack
Posts: 836
Joined: Sun Feb 14, 2016 1:22 pm

Re: A costly mistake made by both investors and advisors

Post by NMJack » Thu Aug 04, 2016 4:17 pm

larryswedroe wrote:NMJACK
Yes there are many logical reasons as I pointed out for the P/E to have reason, but that still means the ERP is now lower for the same reasons, and expected returns are lower. Doesn't mean that the 130 mean is the right one. I wrote why I thought it was the wrong one to use.

On other subject, this statement
if you only got 0% real return every year, 4% withdraw would last 25 years of expenses
is correct ONLY if the order of returns is favorable. For simplicity I'll use an all equity portfolio to make the point. Start in 1973. You start with 1000. At end of year the market has fallen about 15% and you withdraw 4% PLUS the inflation rate of 9 (rounding) so you have to take out 44 from the 850 portfolio. So now you have just 806. Now the market goes down 27% and you have just 588, and inflation is cumulative about 17%. So you have to take out 47 to maintain the purchasing power of the 40. So now you have just 541. You can see the problem, even if market recovers and you end up earning 0 real on average the money won't last 25 years. Reason is your portfolio cannot fully recover because it has spent down funds that don't benefit from the market recover, if it happens.
Just to clarify, that second part wasn't a post of mine. That said, whoever suggested that 0% real return would last 25 years is 100% correct in the scenario that they just bought TIPS at an average 0% return (easily done today for a 25 year period).

Topic Author
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: A costly mistake made by both investors and advisors

Post by larryswedroe » Thu Aug 04, 2016 5:06 pm

NMJACK
Yes I know was not you, and of course if buy TIPS that's also correct
Which is why I used example of stocks
Larry

Topic Author
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: A costly mistake made by both investors and advisors

Post by larryswedroe » Thu Aug 04, 2016 5:13 pm

BTW-FWIW the post about Tyler's comment on another site, is correct in saying the 4% is based on the historical returns and the order of them. But that doesn't change anything. What the historical data showed is that IF you had 7% real stock returns and IF you had about 2.5% real bond returns and the order played out the way it did, 4% was safe. Or worked about 95% of time if had moderate equity allocation.

But one should not forecast 7% real returns now (there is simply no logical way to get there under any model) from today's valuations and certainly not with bonds at today's valuations.

Bogle using DDM gets about 4% real and using CAPE 10 you get similar figures.
Those who would rather live in fantasy world that is fine. And 4% still is LIKELY to work, but IMO cannot be viewed as conservative. In the original studies 5% was also likely to work, but was not viewed as conservative. And one should be conservative because it's a Pascal's Wager where the consequences of being wrong are unthinkable.

Larry

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 5:22 pm

larryswedroe wrote:BTW-FWIW the post about Tyler's comment on another site, is correct in saying the 4% is based on the historical returns and the order of them. But that doesn't change anything. What the historical data showed is that IF you had 7% real stock returns and IF you had about 2.5% real bond returns and the order played out the way it did, 4% was safe. Or worked about 95% of time if had moderate equity allocation.

But one should not forecast 7% real returns now (there is simply no logical way to get there under any model) from today's valuations and certainly not with bonds at today's valuations.
Stating it this way makes it very easy to misrepresent the study. You don't need 7% real stock returns for the 4% withdrawal to work.

7% real for stocks and 2.5% for bonds was the AVERAGE. If you got those numbers, you could pull 6% a year.

4% worked during the years where we got poor returns. So you forecasting poor returns going forward doesn't invalidate 4%.
Last edited by HomerJ on Thu Aug 04, 2016 5:45 pm, edited 1 time in total.

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 5:30 pm

larryswedroe wrote:But one should not forecast 7% real returns now (there is simply no logical way to get there under any model) from today's valuations and certainly not with bonds at today's valuations.
Larry... look at this chart

Image

We got 7% real over the long run investing at high valuations AND low valuations. Sure, if you could invest at the troughs and cash out at the peaks, you could have more, but that requires market timing. Just investing at the peaks still paid off over the long run which is why we advocate buy and hold (And of course most of us invest every year, so we have some invested at the peaks and some at the troughs)

The market goes through cycles. You may be right that the next 10 years may have low returns... but then, if history is any guide, that bear market will be followed by a bull, and we'll average out at a higher number again... maybe even 7% real.

When you say there is no logical way to get 7% real returns under any model, what time period are you talking about? 5 years? 10 years? 30 years? 50 years?

Edit: Maybe I just realized what you have been trying to say all along. Are you saying that you expect returns to be permanently lower FOREVER? Just because today's valuations are high?

lack_ey
Posts: 6701
Joined: Wed Nov 19, 2014 11:55 pm

Re: A costly mistake made by both investors and advisors

Post by lack_ey » Thu Aug 04, 2016 5:50 pm

larryswedroe wrote:And 4% still is LIKELY to work, but IMO cannot be viewed as conservative. In the original studies 5% was also likely to work, but was not viewed as conservative.
I think this point gets lost by many people.

With higher valuations (particularly on the bond side where the relationship between yield and return is more predictable and much less in question, and I hope nobody seriously suggests using historical bond return as a best estimate for future bond returns), this shifts the dispersion of possible outcomes unfavorably. This means that 4% is conservative under "standard" (historical average) conditions, too conservative under a regime of high yields, and not as conservative when yields are low like now.

Of course this is just for modeling purposes. The constant inflation-adjusted withdrawal with a rate set at the start is alarmingly stupid and nobody should be doing that.

HomerJ wrote:
larryswedroe wrote:But one should not forecast 7% real returns now (there is simply no logical way to get there under any model) from today's valuations and certainly not with bonds at today's valuations.
Larry... look at this chart

https://s31.postimg.org/l6k9t48rv/7real.png

We got 7% real over the long run investing at high valuations AND low valuations. Sure, if you could invest at the troughs and cash out at the peaks, you could have more, but investing at the peaks still paid off over the long run (And of course most of us invest every year, so we have some at the peaks and some at the troughs)

The market goes through cycles. You may be right that the next 10 years may have low returns... but then, if history is any guide, that bear market will be followed by a bull, and we'll average out at 7% real again.

When you say there is no logical way to get 7% real returns under any model, what time period are you talking about? 5 years? 10 years? 30 years?
I'm not Larry but US returns have been unusually consistent and higher than the global average, which I think gives a misleading impression using the above graph. I think if you take a look at markets as a whole, and through periods in the US prior to that graph, you get a more complete picture.

Larry mentioned models based of CAPE and the dividend discount model as those that would predict in the ballpark of ~4% real for the foreseeable future. In the future, when these models update with new data, they may produce results lower than 4% or higher than 4%, but 4% would be around the central tendency today given these assumptions when looking at any period. These models will only climb back up to ~7% real if earnings growth is unusually high relative to history or stock prices fall. In the latter case you probably wouldn't get back up to 7% for a long time starting today seeing as the fall itself (to get down to lower valuations, higher dividend yields and such) would reduce returns.

Stock returns don't appear out of thin air and thus a bet on the historical average for returns is a bet on other things (earnings growth etc.) being well over the historical average in those respects. That's entirely possible but you need to own this as your modeling assumption for what's going to happen on average (could be even higher say half the time, or worse the other half of the time).

As a related question, if you use the historical average as an estimate, how do you estimate the returns for other country stock markets? Their historical averages? The US market's average?

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 6:00 pm

lack_ey wrote:These models will only climb back up to ~7% real if earnings growth is unusually high relative to history or stock prices fall.
This doesn't make any sense to me. Historically, we've gotten 7% real over the long term. Why would earnings growth have to be "unusually high relative to history" if the average historical earnings growth got us 7% real in the past? Or are you just talking about the next couple of years? I mean, are you saying for us to get 7% real for the next couple of years, we would need unusually high earnings, since we are already at a fairly high point?

But if you are talking long-term, aren't you guys actually forecasting that earnings growth will be unusually LOW relative to history in order to make a case that returns going forward forever will be lower than the past?

Stock returns don't appear out of thin air and thus a bet on the historical average for returns is a bet on other things (earnings growth etc.) being well over the historical average in those respects.
Again, that doesn't make any sense. To get the historical average, why would I need stuff to be well over the historical average?

Look, I'm fine with a prediction that we're in for a crash or 10 years of sideways where prices remain the same and earnings slowly catch up (both would lower valuations). And then I'd expect another big bull market, with outsize double-digit returns, and in 30 years we end up with a decent "average". So I'm not saying I expect 7% a year every year. I'm asking why would the long-term average be different?

Today's valuations don't say anything about the long-term average. They MAY tell us something about the short-term, but most of us are investing for longer than that.
As a related question, if you use the historical average as an estimate, how do you estimate the returns for other country stock markets? Their historical averages? The US market's average?
It's a good question. A case could be made that we had outsize returns during the past century, and we are going to fall back to the global average, or a case could be made that the other countries were held down by wars, and different economic conditions, and maybe they'll come up to our average. Or something In between.

But I don't see high valuations TODAY as an indication that returns will be far lower FOREVER.
Last edited by HomerJ on Thu Aug 04, 2016 6:05 pm, edited 1 time in total.

Topic Author
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: A costly mistake made by both investors and advisors

Post by larryswedroe » Thu Aug 04, 2016 6:04 pm

Today's valuations don't say anything about the long-term average
This statement is completely false as demonstrated by people like NYU's professor Damodaran. Anyone reading his work or those of others on the subject would know better. And that's the problem with these type statements. And why it's fruitless to respond to such comments.
Best wishes
Larry

User avatar
coachz
Posts: 1048
Joined: Wed Apr 04, 2007 7:10 am
Location: Charleston, SC

Re: A costly mistake made by both investors and advisors

Post by coachz » Thu Aug 04, 2016 6:10 pm

larryswedroe wrote:
Today's valuations don't say anything about the long-term average
This statement is completely false as demonstrated by people like NYU's professor Damodaran. Anyone reading his work or those of others on the subject would know better. And that's the problem with these type statements. And why it's fruitless to respond to such comments.
Best wishes
Larry
By saying its fruitless to respond to such comments you are really bailing on this civil discussion. If you want to educate then you really need to be even more patient.

User avatar
HomerJ
Posts: 13568
Joined: Fri Jun 06, 2008 12:50 pm

Re: A costly mistake made by both investors and advisors

Post by HomerJ » Thu Aug 04, 2016 6:14 pm

larryswedroe wrote:
Today's valuations don't say anything about the long-term average
This statement is completely false as demonstrated by people like NYU's professor Damodaran. Anyone reading his work or those of others on the subject would know better. And that's the problem with these type statements. And why it's fruitless to respond to such comments.
Best wishes
Larry
What were valuations in 1929? What was the long-term average 30-40 years later?

What were valuations in 1933? What was the long-term average 30-40 years later?

The long-term average INCLUDES both bear and bull markets.

I'm sorry we are communicating past each other. I agree with you that money invested in 1933 had better long-term returns than money invested in 1929. But the long-term average is the long-term average, including both years.

You seem to saying that valuations are high and that the long-term average (of money invested this year and next year and year after that, and the year after that) will be low forever. But 5-10 years from now, valuations may be lower, and that money will grow more than the money invested today.

The long-term average is not dependent on ONLY today's valuations, but the valuations from 5 years ago, and 5 years ahead, and 10 years ahead, etc.

Just because today's valuations are high, why can't valuations be low 10 years from now? Why can't the average be higher than the returns from just THIS year?

User avatar
Riley15
Posts: 198
Joined: Wed May 11, 2016 9:21 pm

Re: A costly mistake made by both investors and advisors

Post by Riley15 » Thu Aug 04, 2016 6:29 pm

That is a excellent point and I agree. Valuation is directly related to price, if the prices come down valuations will be lower (corrections, recession , etc.).

But it's a very real question about what you define as "long term returns". I can understand high valuations will make returns for the next 20-30 years subdued by historical averages. But over 50-75 years I think the low and high valuations will average out.

Other factors might reduce returns for the very long term but I don't think it would have anything to do with valuations. Even then it would average out by even a longer time frame. 100 years is a very short time on a larger scale where societies/countries collapse and emerge.

lack_ey
Posts: 6701
Joined: Wed Nov 19, 2014 11:55 pm

Re: A costly mistake made by both investors and advisors

Post by lack_ey » Thu Aug 04, 2016 6:34 pm

HomerJ wrote:
lack_ey wrote:These models will only climb back up to ~7% real if earnings growth is unusually high relative to history or stock prices fall.
This doesn't make any sense to me. Historically, we've gotten 7% real over the long term. Why would earnings growth have to be "unusually high relative to history" if the average historical earnings growth got us 7% real in the past? Or are you just talking about the next couple of years? I mean, are you saying for us to get 7% real for the next couple of years, we would need unusually high earnings, since we are already at a fairly high point?

But if you are talking long-term, aren't you guys actually forecasting that earnings growth will be unusually LOW relative to history in order to make a case that returns going forward forever will be lower than the past?

Stock returns don't appear out of thin air and thus a bet on the historical average for returns is a bet on other things (earnings growth etc.) being well over the historical average in those respects.
Again, that doesn't make any sense. To get the historical average, why would I need stuff to be well over the historical average?

Look, I'm fine with a prediction that we're in for a crash or 10 years of sideways where prices remain the same and earnings slowly catch up (both would lower valuations). And then I'd expect another big bull market, with outsize double-digit returns, and in 30 years we end up with a decent "average". So I'm not saying I expect 7% a year every year. I'm asking why would the long-term average be different?

Today's valuations don't say anything about the long-term average. They MAY tell us something about the short-term, but most of us are investing for longer than that.
I think this explains a lot. No, I meant what I said.

Real stock returns are just dividends + earnings growth + change in valuations. The last two terms put together determine the real price return. One assumption you can make is that valuations don't change on average (not necessarily a good one but if you have a better suggestion then let me know; some would argue for mean reversion in valuations but I wouldn't really). So that means there are two terms left for determining the expected future return: dividends and earnings growth. All else equal—that is, assuming equal earnings growth—when dividends are lower then expected returns are lower. And they won't get higher again until dividends get higher again. When dividends are low and you expect the same return, you are predicting higher earnings growth (or a positive change in valuations, which would further reduce dividend yield and so on).

When valuations are high, for every dollar invested in stocks you're getting a lower "payout" of dividends, net buybacks (which have the same effect for our purposes here as dividends), and retained earnings to grow future earnings with. Those are the cards we're dealt.

The argument you should be making is that the dividend payout rate (as percentage of earnings) is lower than historical, which should mean higher earnings growth all else equal. But by how much, and does this compensate for everything else? You can make a case.

But no, you can't say that you're not predicting higher-than-average earnings growth.

To get from here to 7% sustained long term, something's got to give. Recently, we have gotten around 7% despite high starting valuations because corporate profit margins went up to historically fairly high levels, pushing up earnings growth above historical levels. Again, no particular reason earnings growth has to hover around historical reasons either, but you've got to give a reason why that might be.

HomerJ wrote:
As a related question, if you use the historical average as an estimate, how do you estimate the returns for other country stock markets? Their historical averages? The US market's average?
It's a good question. A case could be made that we had outsize returns during the past century, and we are going to fall back to the global average, or a case could be made that the other countries were held down by wars, and different economic conditions, and maybe they'll come up to our average. Or something In between.

But I don't see high valuations TODAY as an indication that returns will be far lower FOREVER.
See above. Also, a "best" estimate (if you believe it) of future returns for the long term is just an average. It could be that future returns will be even lower than that for the long term. Or maybe they'll be higher than that for the long term.

But IMHO over the very long time, there are too many uncertainties to have any confidence in any estimate.

Topic Author
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: A costly mistake made by both investors and advisors

Post by larryswedroe » Thu Aug 04, 2016 6:40 pm

Coach
I would be happy to contribute more but fruitless when people deny facts that don't fit their narrative. And it's most often in my experience from people who don't have the technical background, In other words, it's not what a person doesn't know that gets them in trouble, it's what they know for sure but aint so, as Mark Twain and others have said. There are just limits to how much time one can spend. If I thought it would be fruitful I would continue. But I've learned in some cases it's not. This is one of them. You have someone who is not knowledgeable in the area saying the entire financial profession (note including the Boglehead's hero Bogle) is wrong. Sorry
Best wishes
Larry

User avatar
coachz
Posts: 1048
Joined: Wed Apr 04, 2007 7:10 am
Location: Charleston, SC

Re: A costly mistake made by both investors and advisors

Post by coachz » Thu Aug 04, 2016 6:43 pm

larryswedroe wrote:Coach
I would be happy to contribute more but fruitless when people deny facts that don't fit their narrative. And it's most often in my experience from people who don't have the technical background, In other words, it's not what a person doesn't know that gets them in trouble, it's what they know for sure but aint so, as Mark Twain and others have said. There are just limits to how much time one can spend. If I thought it would be fruitful I would continue. But I've learned in some cases it's not. This is one of them. You have someone who is not knowledgeable in the area saying the entire financial profession (note including the Boglehead's hero Bogle) is wrong. Sorry
Best wishes
Larry
I noticed you have conveniently skipped a number of his very GOOD and valid questions. Thats not a conversation. Your book came in today. More to read!

User avatar
Riley15
Posts: 198
Joined: Wed May 11, 2016 9:21 pm

Re: A costly mistake made by both investors and advisors

Post by Riley15 » Thu Aug 04, 2016 6:55 pm

I think all Homer J is asking is what is meant by long-term returns and what is that timeframe? Seems like a perfectly appropriate question that should have a straight answer. :?
Last edited by Riley15 on Thu Aug 04, 2016 6:59 pm, edited 1 time in total.

Post Reply