I love stocks. But Rob Bennett has eschewed them for some time now. Why? First, let me introduce Rob. He is a passionate investor who loves a good investment debate. Rob Bennett has also developed the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here. Now Rob has been out of the stock market for quite sometime now. Well, let’s see why he’s decided to take this approach and how he’s done so far.
I went to a zero stock allocation in the Summer of 1996. I’ve stayed at zero stocks for the 15 years since.
Am I insane? Don’t I know that stocks are always best for the long run? Don’t I understand that investors need to be willing to take on risk so that they can expect to accumulate the assets needed to finance a middle-class retirement?
I don’t think I’m entirely insane.
For one thing, I’m ahead.
Zero Stocks for 15 Years And Doing Fine!
My money is in Treasury Inflation-Protected Securities (TIPS) and IBonds paying an average return of 3.5 percent real. That’s a bigger return than stocks have been paying for those 15 years. The compounding returns phenomenon will cause my edge to grow larger and larger over the years. And I’ve obtained the higher return while taking on dramatically less risk than I would have taken on by investing in stocks.
So who’s nuts? Could it be that the experts who tell us that we must always be heavily invested in stocks are actually the crazy ones?
Well, I wouldn’t actually say that the experts are crazy. I would say that they are confused. There’s been a lot of exciting academic research published in the past 30 years showing that the conventional understanding of how stock investing works (the Buy-and-Hold Model) gets it mostly wrong. The new model (Valuation-Informed Indexing) is rooted in the research of Yale Economics Professor Robert Shiller rather than in the research of University of Chicago Economics Professor Eugene Fama. I think it makes a lot more sense.
Let’s review Eugene Fama’s buy and hold investment model (aka efficient market theory) vs Robert Shiller’s valuation informed indexing model. Which professor’s investment model do you follow?
Efficient Market Theory vs Valuation Informed Index Investing
The old model presumes that stocks are always priced properly. If this is so, price changes are caused by unforeseeable economic developments. Thus, timing the market can never work. The only way the investor can tap into the strong returns of stocks is to invest in them at all times.
There’s only one problem with this theory. It does not describe how stocks have worked for the 140 years for which we have data available to examine.
Wade Pfau, Associate Professor of Economics at the Graduate Institute for Policy Studies in Tokyo, Japan, recently compared how the two models performed for every 30-year time period in the historical record. He found that Valuation-Informed Indexing beat Buy-and-Hold in 102 of the 110 time-periods. Investors who increased their stock allocations when prices were good and lowered their stock allocations when prices were dangerously high earned higher returns at dramatically less risk. Investor heaven!
But wait. That sounds like stock market timing. Timing doesn’t work! Everyone knows that. Right?
Um — Actually, that’s not right.
There are lots of experts who say that timing doesn’t work. The reality, though, is that there has never been a single study showing that timing doesn’t work. The confusion stems from the fact that there have been many studies showing that one form of timing (short-term timing) doesn’t work. Change your stock allocation with the expectation of seeing stronger performance within a year or two and the odds are great that you are going to end up losing.
But that’s not the only way to practice market timing. What if you were to take stock price into consideration when setting your stock allocation with the understanding that it might take as long as 10 years to see a payoff for doing so? In that case, you would be almost certain to see the payoff. Long-term timing always works. At least it always has (in the past).
It’s not hard to understand why. The U.S. economy has been sufficiently productive to support an average annual stock return of a little more than 6 percent real for as far back as we have records. If you pay fair price for the purchase of an index mutual fund, it’s reasonable to expect a long-term return of something in the neighborhood of 6 percent real.
But what if you pay two times the fair price of the stocks you buy? In that case, you would be paying $200 for every $100 of stocks paying 6 percent real. Your return would likely be something near 3 percent real. If you buy stocks when they were priced at three times fair value (as they were in 2000), you should reasonably expect a long-term return of something in the neighborhood of 2 percent real (you’d be paying $300 for each $6 of annual return).
That’s how things work, according to the academic research of the past 30 years. Stocks are like everything else put up for sale in this consumer wonderland of ours. Buy them at a good price and you’ll obtain an amazing value proposition. Buy them at a fair price and you’ll do fine. Buy them at an insanely inflated price (like the prices that have applied since 1996) and it’s unlikely that you’ll do better than those invested in super-safe asset classes.
The strategic implications are profound. We have learned how to greatly diminish the risks of stock investing. The risks of stock investing are heavily concentrated in those time-periods when prices are high. Never yet in U.S. history has there been a time when stocks performed poorly starting from a time of low or moderate prices. And never yet in U.S. history has there been a time when stocks performed well starting from a time of high prices. Open yourself to the idea of changing your stock allocation in response to big price swings and you will earn far higher returns at dramatically diminished risk.
It turns out that market timing (at least the long-term variety) isn’t such a bad idea after all!
What A No Stock Portfolio Looks Like
Editor’s Observations (aka SVB’s take): Rob owns what is called a “no stock portfolio”. So what does that look like exactly? Rob has stated that his portfolio is mainly in Treasury Inflation-Protected Securities (TIPS) and IBonds, which is quite conservative. I also decided to do a little bit of research to see if I can unearth other flavors of this portfolio. Following is one from Kiplinger’s, and it’s comprised of other asset classes beyond just bonds:
- High Quality Corporate Bonds – 15%
- Real Estate Investment Trusts (REITs) – 15%
- Sector Fund or ETF Invested in the Energy, Oil, Natural Gas Sector – 15% (a commodity play?)
- Tax Exempt or Municipal Bonds – 15%
- Precious Metals such as Gold – 5%
- Junk Bonds – 10%
- TIPs, Short Term Bonds – 15%
- Cash (Certificates of Deposit, High Yield Savings Accounts) – 10%
This is just an example of what you can do. I based it on this portfolio conceived by Jeffrey Kosnett, one of Kiplinger.com’s Senior Editors. It’s actually done well for 2009 (the performance data was calculated here), earning 23% in its totality, while U.S. stocks gained 26.46% in that year. However, moving forward, allocations may need to be reevaluated as prices have shifted dramatically for some of these asset classes. I’d be rebalancing any portfolio that has shifted heavily due to large price swings.
If you’re fairly young, then a “no stock portfolio” may come across to you as fairly unusual, especially when the prevailing wisdom is that we should all carry some stocks in our portfolios, no matter what our age. I personally subscribe to the conventional wisdom of having a portion of my assets in stocks but I also believe that in order to construct a functional investment portfolio, various factors need to be considered. Some things I look at:
- Current valuation of different asset classes — Rob places much emphasis on this item
- Economic climate
- Your age and comfort level with different investments
- Your existing financial goals
- Your cash flow situation
- Your personal psychological makeup – are you naturally risk averse or a nervous nellie?
For instance, given the low inflation environment we’ve come to enjoy for a while now (and yes, we’re spoiled), it seems easy to forget about the threat of inflation eroding our assets. Consequently, this may allow us to be more comfortable about tilting towards a cash heavy portfolio. But who knows how long this environment can last? Shouldn’t we hedge appropriately anyway? So how about you: what do you think of the “no stock portfolio”? Would you opt for one (or not)?
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