Beyond Buy-and-Hold #76

By Rob Bennett

Buy-and-Hold doesn’t work. Look around. it’s obvious.

But wait! The Buy-and-Holders have an explanation.

It’s the Economy! Buy-and-Hold is aces. It’s that darnned economy that is messing everything up. Buy-and-Hold cannot be expected to produce good results in the face of such a bad economy.

Trying to have it both ways

Please think over what is being said here. When Buy-and-Hold produces good results, we credit the investing strategy. When the results are poor, we place the blame elsewhere. As Church Lady might observe, “How convenient for the advocates of Buy-and-Hold!” It’s a “heads I win, tails you lose” approach to investing analysis.

And you know what? This isn’t the first time the Buy-and-Hold advocates have played this little trick on us.

This is the fourth time in U.S. history that The Stock-Selling Industry has been successful in persuading a large percentage of investors to follow a Buy-and-Hold strategy. The first time, Buy-and-Hold produced gangbuster results until an economic crisis ruined all the fun and we didn’t see acceptable stock returns for another 20 years.

The second time, Buy-and-Hold produced gangbuster results until an economic crisis ruined all the fun and we didn’t see acceptable stock returns for another 20 years. The third time, Buy-and-Hold produced gangbuster results until an economic crisis ruined all the fun and we didn’t see acceptable stock returns for another 20 years.

The fourth time (this time), Buy-and-Hold produced gangbuster results until an economic crisis ruined all the fun and we didn’t see acceptable stock returns for another 12 years (and counting).

Are you beginning to see a pattern?

There is a reason why it always plays out the same way. Economic crises always ruin the Buy-and-Hold game because the Buy-and-Hold game always causes an economic crisis. To say that “Buy-and-Hold isn’t working because of the economic crisis” is to say “Buy-and-Hold isn’t working because of what Buy-and-Hold is.

Buy-and-Hold is the investing strategy that says that stocks are worth buying at any price, that it is okay to stay at the same stock allocation no matter how high prices go. That can never, ever, ever work in the long term. It is a logical impossibility.

We often refer to stocks as “risky” without stopping to think about the nature of that risk. The risk is that stocks might some day become so high-priced as to provide poor long-term returns. Stocks never perform poorly when they are low-priced or fairly priced, stocks always perform poorly when they are high-priced. So the proper way to say it is to say that high-priced stocks are risky.

Stock prices are set by investors. If we all were concerned about our retirements, we could pump stock prices up to 10 times what they are today over the course of the next six months. Why don’t we do just that?

We don’t do it because our common sense tells us that it is a silly and dangerous game. Whenever we cause stock prices to increase more than the 6.5 percent gain justified by each year’s economic growth, we are borrowing the extra returns from future years, pumping up our returns in the now in exchange for poor returns a few years down the road. What’s the point?

Do you remember the “New Paradigm” in the economy and the stock market?

Common sense tells us not to play stupid games with our retirement money. Buy-and-Hold encourages us to play such games. Hey! Maybe this will be the first time in history when overpriced stocks provide good long-term returns! No one has a crystal ball. No one can say for certain.

The Buy-and-Holders encouraged us to play this game to the hilt in the 1990s, to pump and pump and pump stock prices and never to apply the brakes by lowering our stock allocations when risk got out of hand. When millions of investors agree to take on far more risk than they could handle, an economic crisis follows. And the Buy-and-Hold advocates then blame the economic crisis for their strategy failing once again.

Yuck!

It’s a dishonest game. It has hurt millions of people in very serious ways. I want no part of it. I am working hard to earn a reputation as the most severe critic of Buy-and-Hold alive on Planet Earth today.

If you are feeling the pain of this economic crisis, or if you know of others who are, I hope you will place the blame where it belongs. It is The Stock-Selling Industry and its reckless and relentless promotion of Buy-and-Hold investing strategies that brought on this crisis.

There’s nothing wrong with our economy. We should be grateful that our economy was strong enough to survive for a good number of years in the face of the relentless promotion of Buy-and-Hold strategies. We should all be doing whatever we can to bring our wonderful economy back to life. By making sure that Buy-and-Hold dies and is never permitted to come to life again.

Rob Bennett has identified the 23 most common and most costly investing mistakes. His bio is here.

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By Kevin M

My friend Jay and I were talking about jobs this past weekend and he pointed out something that I hadn’t thought about: There are no astronauts any more! That may not mean too much if you’re under 30, but when he and I were growing up being an astronaut was the ultimate “hero career”. It was, as the kids say today, “the shit” among careers.

Back then it seemed that all of humanity would eventually be going to space—to find resources, to conquer new worlds or at least to alleviate overpopulation here on earth—and astronauts would lead us there. High minded and exciting, yes, except that it never happened!

If a career as cutting edge as astronauts is no longer secure, what can we say about the far more ordinary fields most of us regular folks work in?

You’ve heard it and read it before, and perhaps you’ve even been a casualty of one of the biggest phenomena of our time–the end of job security.

We have to do something about that, but what? Individually, there’s little any of us can do to create job security, but we can gravitate toward it’s close cousin, income security. If we have income security we might not even notice or care that we no longer have job security.

What is job security? What is income security?

Let’s face it, in order to function everyday and to have some sort of certainty about the future we need some measure of security when it comes to earning a living. For at least the past couple of generations that meant having a stable job, but the times they are a-changin’. Fast.

Job security implies that your job is safe for the foreseeable future and hopefully clean through to retirement. Your job IS your income—as well as your source of health insurance, retirement and other benefits, and even your self esteem and your standing in the community. All is well, and you even have income security, as long as your job is secure.

Most people seek job security because it’s a simpler way to earn a living—your employer has your job and your income “covered” freeing you to go about living your life. The downside is when your job is suddenly in jeopardy, because the entire financial component of your life is also at risk. It’s a classic case of having all of your eggs in one basket.

Income security means your income never comes from a single source. If one source fails, you have others to tap, and you can eventually replace the failed sources with new ones. You’re not overly concerned with any one income source, but with creating and maintaining a portfolio of income streams.

In the economic and employment conditions of our time, I think income security is the logical security to pursue.

Creating income security

Its one thing to know the difference between income security and job security, but ultimately it all comes down to making it happen and that’s not as easy. There are various ways you can begin creating income security and that can include just about any revenue sources you can think of.

Self-employment. This is the obvious first choice for providing an additional (or alternative) income source beyond a job. By its very nature, being self-employed is all about creating new revenue streams. If your business income is derived from several or many clients or customers (which it should), you’ll actually have a portfolio of income streams, and that’s the best income security you can have. Even if your income drops, you can still have at least some income from your business, as opposed to a job where your entire income will cease the day you’re let go.

Fortunately, the internet has made self-employment easier than ever and because it’s here and now and growing, that’s probably the first place you should look. It’s where I’ve decided to camp out and it’s working for me—and I’m not exceptional in any way, believe me.

Investment income. In an era of record low interest rates, this is more about turning small amounts of money into larger ones. There are various ways to do this and you should start investigating them. This is not about plunging into the stock market per se, but about developing the ability to identify under-priced securities that have the potential to grow well beyond conventional rates of return—then having the willingness to wait it out. It has nothing to do with get-rich-quick. It’s a skill, just like business- or job-skills are, and once you master it you’ll have created a whole new way to earn a living.

Forming business partnerships or investing in small businesses. One of the things you can do if you have a business is to partner with other businesses in ways that will enable both entities to grow. There are as many ways to do this as there are small businesses and people who own them. It can also be the middle ground between starting your own business and investing. And you can do this with skills as well as with capital.

Let’s say you have some capital but you’re spooked by the stock market; as an alternative you can invest some money in an existing small business (or several) as a way taking partial ownership of a growing business. Small businesses always need capital, but never more than now when getting a bank loan is harder than ever. Conversely, if you have certain skills needed by a small business, you may be able to join that business as an owner/partner. Marrying capital with management and skills is a time honored way for all parties to make money, and very the foundation of free enterprise.

Lowering your cost of living. Not many people think of this as an income source but it really is. When you lower your living expenses, you’re lowering the amount of income you need to earn—that’s the equivalent of a fresh income source, but it gets even better. The less income you need to live on, the less you need to earn, and the less you’ll need to pay in income taxes. That’s a double benefit. The biggest advantage here will come from lowering your biggest expenses, the ones that represent the biggest drain on your income. Less need for income means more freedom to pursue other income sources.

Jobs. I gotcha on this one, didn’t I? If there’s no job security and we need to pursue income security instead, why discuss jobs? Because jobs are, first and foremost, a source of income! The topic of income security isn’t a self-employment is good/having a job is bad debate—any legal income source is a valid one. That includes jobs. Income from a job is good, it’s the complete reliance on it that creates the problems. If you can keep a job while developing additional revenue streams, you’ll achieve income security in addition to having a job. Your job is then part of the income mix, but not the sole source.

One more point about jobs: if you intend to keep one in an era where there is no job security, it’s important that you emphasize skills over the job itself. Transferability is the key, and only a strong set of skills can give you that.

 
You’re creating income security in your life when you start receiving income from sources other than your employer. That point is important in itself—you shouldn’t quit your job to create income security—you can and should do it while you have a job. In fact it will be easier to do it this way, and your job itself can be part of the security you’re working to build.

At a time where there isn’t much in the way of job security, what steps are you taking to build your income security? Are there any ways I didn’t mention?

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By Kevin M

Last night my wife learned something disturbing—not for herself but for some of her coworkers. She has a part time job with a company that just announced that fulltime employees are losing their benefits and being converted to part time status.

Now the optimist may say, “it could have been worse—at least they didn’t lose their jobs”. And while there may be a grain of truth to that assumption, the bad news outweighs the good here, and I’d say by a wide margin. First of all, part time isn’t full time—it’s part time. That means even if you keep your hourly rate of pay, there’s no guarantee of 40 hours a week, or even of 30 or 20. That looks an awful lot like a pay cut to me.

Second is suddenly going from a job with benefits to one without—that includes health insurance. Charles Hugh Smith has made a strong case that the middle class isn’t middle class without health insurance coverage, and I think that point is beyond debate. What we’re looking at here, in addition to the pay cut, is the loss of socio-economic class status. They’ve been demoted to “the working poor” without ever losing their jobs. That’s pretty radical.

There ain’t no more job security

The example on my wife’s job isn’t isolated either. More employers are moving toward some variation of this all the time. Here’s the bottom line: from day to day, you can never tell what will happen with your job. A full-time job can turn into semi-employment with a single policy decision by people you don’t even know. It isn’t just layoffs anymore; its hours and schedule, pay cuts, job re-classification, job stagnation, loss of benefits—you name it. I’d even argue that the unemployment rate issued by the government is now mostly irrelevant.

Employment Realty #1 is that employers are figuring out ways to eliminate people and payrolls through a relentless shift to cheaper workers offshore, the latest computer technology or a combination of both. Translation: as much as we want to buy into the economy-is-recovering projections, it’s becoming painfully obvious that if that is happening, it’s fully capable of doing so without employees. The stagnant employment picture has less to do with the state of the economy than it does with the progression of options available to employers.

At least since World War II job security and benefits have always been major reasons why most people prefer to work for someone else rather than for themselves. Job security means insulation from the ups and downs of both the economy and the employers business, and benefits provided the safety net protecting against many of life’s uncertainties. Who wouldn’t want that if they could get it?

Now that neither job security nor benefits are guaranteed through employment, has the playing field been leveled, is there now less risk in being self-employed than there has been in the recent past? I think so.

Job security and self-employment

Here’s why I think that the case for self-employment is growing all the time, and why it may be the ultimate solution to the employment meltdown of the 21st Century:

1. As discussed above, jobs no longer carry the promise of stability or benefits
2. Self-employment was the primary income source of most people for thousands of years prior to the 20th Century—it is entirely possible that after nearly 100 years of large scale employment by large organizations, conditions are now returning to the historic norm of the family farm or shop (though it won’t look that way)
3. The same computer technology that’s putting people out of jobs is also making it easier to start your own business—we’ll spend a bit of time on this one in a minute
4. As the number of people who are self-employed expands, so will networking opportunities. The way you used to job network with people at other companies coverts to networking with those in the same or related businesses
5. The same instability that is making the job market less secure also opens up opportunities for part time, seasonal or contract work that can be used to supplement self-employment income—in the start up phase and later on an “as needed” basis
6. Employers who are reducing staff are often subbing out the work once done by employees—that’s an opportunity for a small business
7. Because you’re smaller and have much greater freedom in a small business you may be in a better position to react to changes in the economy, such as the ones we’re seeing now

This really is a “glass half full” situation—if we recognize what’s really happening and learn to use it to our advantage. Reality is going where reality is going; we can either embrace change as an opportunity, or let it roll over us while we look to the past for answers.

How the internet helps the self-employed

Many might curse computers and the internet for the negative affect they’re having on employment, but that’s the wrong approach.

In #3 above we touched on how computers are making it easier to be self-employed and that’s absolutely true. I’m an example of this. Earlier this week, in How Blogging Solved My Mid-Life Career Crisis, I spilled my guts about being disenfranchised at the age of 50. I was a textbook case of an economic casualty. But I chose to embrace the change rather than fight it.

Here’s the thing…people are making money working from home on their computers, and I decided that I needed to join them. Difficult? Most certainly. Impossible? No way!

Yes, there is more than enough get-rich-quick-on-the-internet snake oil being peddled out there, but beneath the phony claims, thousands of people are making a living (or better) on the internet.

I’m not saying that everyone could or should blog like I and many others are doing. But at a minimum you can use the internet to grow a local “bricks and mortar” business, in a way that wasn’t available even ten years ago. One of my best friends is running a very successful trash hauling business here in my neck of the woods and gets nearly all his business from the web. I believe that’s increasingly possible for most businesses.

If you have any idea for a business, fully investigate how you can use the internet to make it work. And if you don’t have any, look closely into ways you can make money on the web. Some ideas include blogging (my favorite!), freelance blog writing for other sites, and providing marketing, technical and administrative support to the many commercial websites and blogs that are out there on the web.

Because of the internet, nearly any skill you have or can acquire can be converted into some form of self-employment, if only as a side business. And these days, that’s looking a lot more secure than the average job.

Have you considered starting some sort of internet business? If not, what’s stopping you?

Monday’s post: Self-employment in the Internet Age

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Beyond Buy-and-Hold #68

By Rob Bennett

One of my critics makes a great point in a recent Bogleheads Forum discussion of the Valuation-Informed Indexing concept. A poster going by the name “nisiprius” says: “I just don’t believe that a few simple rules based on numbers that are easily available to everyone will substantially improve your risk-adjusted returns.”

I say that the typical middle-class investor could retire five to ten years sooner if he were willing to switch from Buy-and-Hold to Valuation-Informed Indexing. I say that the heavy promotion of Buy-and-Hold was the primary cause of the economic crisis. I say that we would eliminate 80 percent of the risk of stock investing by letting investors know about the 30 years of academic research supporting this approach.

Yet the only difference between Buy-and-Hold and Valuation-Informed Indexing is that Buy-and-Holders choose a single stock-allocation percentage that makes sense for them at all times while Valuation-Informed Indexers change their stock allocations in response to big valuation shifts. Could this one strategic change really make such a big difference? That’s more than a little hard to believe, isn’t it?

It’s hard to believe.

The power of addiction

But let me tell you a story about my coffee addiction. I drink ten cups of coffee each day. I wish I didn’t. If I am busy doing something in the morning and don’t get to coffee for a few hours, I get a massive headache. I am certain that this coffee addiction is not good for my health. Until I went to college, I didn’t drink any coffee whatsoever. I sometimes wonder how it is that I got on this road that led over time to a situation where I am drinking ten cups of coffee every day.

It wasn’t a conscious choice. There was never a thought in my head that I really should increase my coffee consumption from one cup per day to ten cups per day.

It happened gradually and without me taking much notice of it. Once I had a habit of drinking one cup per day, going to two cups per day did not seem like a big deal. Once I had a habit of drinking two cups per day, going to three cups per day did not seem like a big deal. You get the idea.

This is how it works with stock valuations. Stocks were priced insanely low in 1982. Then valuations went up a bit. But it didn’t matter because prices were so low. Then valuations went up a bit more. But it still didn’t matter because prices were at fair value. Then valuations went up a bit more. But it still didn’t matter because stocks offer a strong value proposition even when they are selling at prices a bit above fair value.

Then there came a day when stocks were priced at three times fair value. At that point, the most likely annualized 10-year return on stocks was a negative 1 percent real. IBonds were at the time offering a guaranteed return of 4 percent real. So middle-class investors who stuck with stocks lost 5 percentage points of return for 10 years running. Do the math and you see that Buy-and-Holders ended up losing 50 percent of their accumulated wealth of a lifetime as a result of their addiction to Buy-and-Hold strategies.

Buy-and-Hold and the economic crisis

We lost so much wealth in so short a time-period that we are now scared to death to spend money. So tens of thousands of companies are going out of business and millions of workers are being laid off. Lots of people are losing confidence in a political system that permits such massive wealth destruction to take place. We are likely within a few years of going into the Second Great Depression.

No one knew this was going to happen when we first began thinking it might be a cool idea to follow Buy-and-Hold strategies any more than I knew that someday I would be suffering from a terrible coffee addiction on the day I drank my first cup of coffee following my Political Science 101 class back at old Temple University. These things catch up with you over time.

Some people think it can never change. Buy-and-Hold investing strategies have been causing stock crashes and economic crises ever since the first stock market opened for business. So some people think we can never do better. Some people think we are doomed to repeating the fatal mistake of ignoring valuations over and over and over again.

I don’t buy it.

Change may be hard, but it’s never impossible

It’s true, though, that it is awfully difficult to persuade people that valuations make a huge difference after they have been ignoring them for so many years. If we are going to become effective investors, we are going to need to start watching valuations even at times when we are not living through an economic crisis. We need to make watching valuations as important a priority as we make looking at the price of things we buy before we put money down on the table. If our free market system is to survive, we need to begin buying stocks in the same way we buy all other goods and services in this Consumer Wonderland we have created for ourselves.

How is it that one number — the P/E10 value — matters so much?

People say that the P/E10 value reveals the level of overvaluation present in the stock market at any given time. That’s so. But there’s a different way of looking at it. Stocks can never become overpriced so long as investors are acting rationally. The sensible thing to do would be to price stocks properly. So what P/E10 is really telling us is how emotional investors are being at any given point in time.

P/E10 protects us from ourselves!

If we made it a practice to use P/E10 to set our stock allocations even when prices had not yet reached insanely dangerous levels, prices could never get to insanely dangerous levels. Using P/E10 takes the emotion out of stock investing.

It’s one thing we are talking about here. It really is hard to accept that making one change could make such a huge difference. But the one thing we are changing is whether investors act emotionally or not. Change that and you really do change the nature of the stock investing game in a fundamental way.

Rob Bennett has written extensively on what causes stock price changes. His bio is here.

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By Kevin M

Everybody knows that too much debt is bad; the financial universe is filled with blogs, experts, and gurus who tell us as much and even how to get out. So why are people still unable to get out from under? Is it because debtors behave badly, that they fail to adequately confront their credit problems—or are they just plain lazy?

Maybe, possibly in some cases, but I think there’s a lot more to it, and by the time you’re finished reading this list, you may have a better understanding as to why—if you’re deep in debt—you’re having such a tough time getting out of it. Knowing what you’re up against is the first step to solving a problem, and only when you do can you make any real progress.

1. Lack of sufficient income to do so

A lot of people are making less money than they were just a few years ago. They were making more money when they incurred their debt, but now the lower income level has them in a trap where they have barely enough money to pay living expenses, let alone pay off debt.

2. A rate of inflation that’s substantially higher than what is publicly reported

Over time, expenses are growing faster than income, especially since raises are usually tied to the understated inflation rate (CPI). Does anyone really believe inflation is running at the 1-2% rate that’s claimed by the CPI? A 2% raise (again based on the CPI) will cause a drop in real wages in an economy where prices are rising by something closer to 5-7%. This is a very carefully hidden obstacle that requires either steadily lowering living expenses or being on a perpetual quest to find additional income sources. Many households are using credit to cover the difference, which is a strategy that’s destined to have an unhappy ending.

3. Conforming to a “standardized” idea of middle class life

When I was younger, if a family couldn’t afford a new car they bought a used one, and if they couldn’t afford that they bought a beater. If they couldn’t afford to keep their house, they sold it and moved to a rental or in with family. But in the past 20-30 years there’s been a kind of standardization of middle class life—how one must live and what one must own to live in it. Call it the “TV version” of middle class life. Many people can no longer afford to live this lifestyle, but they’re emotionally rooted in it and cannot abandon it. Once again, credit is often used to bridge the gap.

4. A benign view of debt

Culturally, debt is seen merely as a way to get from where you are to where you want to be. Want a house—take a mortgage. Need an education? Student loans can help. Can’t afford a car? Bring us your trade in and we’ll finance the rest. All of these require little or no money up front and make the process easy. Credit cards are just an extension of other forms of debt and a natural outgrowth. If debt is what “moves us forward” then how can it be a bad thing? Once you start thinking that way, you’re licked.

5. A culture that encourages debt at all levels

Credit is what moves the economy isn’t it? At least that’s what we’re told by those who are supposed to know. I’ve never agreed with this thinking. Money is what moves the economy–how it comes into being is the real issue. We can either earn it or save it—historically the preferred methods—or we can borrow it. The System—for lack of a better term—encourages us to borrow it since that’s the quickest way to make it happen. Once we have money—what ever the source—we can buy, buy, buy, and that’s what moves the economy. But when we use debt we’re also creating liabilities and they don’t go away once a paycheck shrinks or disappears.

6. A lack of orientation toward savings

Americans have a terrible track record when it comes to building savings, and we’re paying a huge price for it. Savings are the most fundamental antidote to debt—when we have plenty of savings we’re “self-financing” and don’t need debt. Building up savings is the first step to getting debt out of your life, and that requires a fundamental shift in financial thinking.

7. Too much structural debt

Over the past 20-30 years people have taken on too much structural debt. Mortgages and student loans are widely thought to be “good debt” but represent the foundation of even more debt. They’re long term debt, which creates the need for ever more cash later, and if it worked when you bought your house or your education it can work with anything else you buy, right? Mortgages and student loans can work if you don’t overbuy, then commit yourself to paying them off. For many people, however, mortgages and student loans set the stage for a lifetime of indebtedness.

8. An economic system that has a vested interest in keeping consumers in debt

Merchants have a symbiotic relationship to consumer debt—more credit equals more consumers, equals more sales, equals more profit. They’ll often provide the credit for you, all you need to do is come in and buy. This situation exists at nearly every level of the economy and, along with the media, it works to lower our resistance to consuming—and to going deeper into debt.

9. Habit

OK, this one is comes closest to being a pure personal fault by a debtor. Like smoking, drinking and over eating—people get into debt, learn to live with it and just continue on. If you want to break this cycle, it will require an effort comparable to a crash diet. Even though there’s long term benefit to doing it, the short term is uncomfortable and easy to avoid.

10. Debt has become a massive pyramid scheme

There was a time not long ago when lending was considered to be a fringe function in society; the old saw was “before you can get a loan you first have to prove that you don’t need it”. No longer. Credit is very easy to get and has been for a few decades. Because of that ease, lending has grown into a trillion dollar industry, with many layers. You can borrow with the swipe of a credit card, and when your revolving debt reaches the point where you can’t manage it, you can consolidate it with a home equity line of credit (HELOC). When the HELOC gets stressful, you can consolidate it with a new first mortgage on your home. See the trend? If it weren’t so legitimized in our culture and economy, we might be able to identify it as the pyramid scheme that it truly is. Nothing in that system is set up to encourage us to get out of debt, but just to roll it over to more tolerable loans.

 
As you can see, the obstacles to getting out of debt are enormous. It’s not just your bad habits and lack of discipline that are keeping you in debt, you’re getting a lot of help from a culture that’s keeping you in that ditch. This isn’t an attempt to give debtors a pass or to deflect responsibility, but rather to paint a full picture of the true obstacles.

If you have a serious amount of debt to payoff you need to…

• Understand the big picture obstacles you face in trying to get out of debt
• Make a concentrated effort to resist those obstacles by setting and living by your own standards and preferences
• Be fully prepared to lower your standard of living as low and for as long as it will take—separate wants from true needs
• Stop using credit going forward
• Be ready to increase your income—if you’re paycheck doesn’t increase to cover the true cost of living or paying off debt, then be ready to do what you need to find additional sources
• Make savings—and not borrowing—the standard of your financial success
• Once you’re out of debt, vow never to get back in.

You may not have the entire blame getting into debt, but rest assured you’re 100% responsible for getting yourself out.

What are your thoughts on why people can’t get out of debt?

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Beyond Buy-and-Hold #66

By Rob Bennett

I believe that the case against Buy-and-Hold is rock solid. Common sense tells us that it cannot possibly work. There is now 30 years of academic research confirming what common sense tells us. That research is based on 140 years of historical stock-return data. What more could you ask?

Lots of people are asking for more. Buy-and-Hold remains popular. My articles stating the case against it remain unpopular.

I have exchanged a number of e-mails with a fellow who is a big believer in Buy-and-Hold but also not entirely unsympathetic to my case for Valuation-Informed Indexing in an effort to better understand what is going on in people’s minds. This fellow has looked at the research and acknowledges that is appears generally solid. Still, he is not a convert. Buy-and-Hold seems right to him.

He was fair-minded enough to tell me that, following one of our recent e-mail conversations, he laid in bed for a time asking himself what it would take to persuade him that Buy-and-Hold does not work. That’s the question I most need answered. So I listened carefully to what he told me.

The “this time it’s different” philosophy

He told me that he does not really trust much of the historical stock-return data used in the research that shows that Buy-and-Hold cannot work. Why? That data is old. In recent decades, Buy-and-Hold has done well. It’s the recent data (from 1980 forward) that has the greatest influence on his thinking. To the extent that the data from 1870 through 1980 tells a different story, he discounts it.

I don’t think it is just this one guy. I think this may be the most important reason why so many people have a hard time understanding how stock investing really works. We are all most heavily influenced by what we see going on around us today and in recent days. Stuff that happened 40 years ago or 80 years ago or 120 years ago is old news. It doesn’t seem relevant to our current-day concerns.

I agree to a point. The economy obviously has an effect on stock market developments. And the economy of 2011 is not the economy of 1870. It makes sense to give developments taking place in recent decades more weight in trying to figure out how to invest for your retirement.

The flaw in that thinking

However, there is also a serious problem with this line of thinking.

Buy-and-Hold is rooted in the idea that it is economic developments that determine short-term stock returns. The economy improves, and stock prices go up. The economy gets worse, and stock prices go down. Since the economy is changing every day, it is possible to test the validity of the premise of the Buy-and-Hold model on a daily basis.

Given that the model is either being confirmed or discredited on a daily basis, one could argue that it is possible to gain a good sense of whether Buy-and-Hold works based on three decades of experience. Since recent data is indeed more relevant than data from long ago, it makes a certain amount of sense to permit recent stock-market history to be your guide in deciding whether to go with a Buy-and-Hold strategy or not.

The trouble is that Valuation-Informed Indexing is rooted in a different premise. Valuation-Informed Indexers believe that it is investor emotions that determine stock prices in the short term. This is why long-term returns can be predicted. Long-term returns are determined by the economic realities. So, all that you need to know to be able to predict returns effectively is how far returns have strayed from what they would be if it were the economic realities that were the dominant influence in the short term. That lets you know in which direction returns are headed and how big the move in that direction is likely to be.

The complete bull/bear cycle

Valuation-Informed Indexing cannot be tested on a daily basis. It cannot be tested on a weekly, monthly or yearly basis either. It takes 10 years for the return predictions that make this strategy work to become statistically significant. It takes 35 years or so for an entire bull/bear cycle to play out.

So there is no way to gain a sense of whether Valuation-Informed Indexing is a good model or not without taking into consideration at least 35 years of data. And it’s hard to have much confidence in conclusions based on viewing of only a single cycle. One cycle could of course be a fluke. I am convinced because the cycle that should always apply if Valuation-Informed Indexing is a valid model has repeated over and over again throughout the entire history of the U.S. market. But even I would like to see more cycles (there are three complete cycles now in the record and a fourth cycle that will be complete after the next stock crash).

From the Buy-and-Hold perspective, there is lots of evidence supporting the belief in the dominant model. Stocks have done well from 1980 forward. They obviously have not done as well from 2000 forward as they did from 1980 through 2000. But the overall record is not a bad one. Buy-and-Holders don’t like what they have seen from 2000 forward but don’t feel that 12 years of bad returns is enough to discredit a model that was supported by 20 years of good returns before the 12-year run of bad returns kicked in.

The deciding years will likely be the next five. If the Valuation-Informed Indexing model is valid, we will be seeing another price drop of about 60 percent from where we stand today. A stock crash of that magnitude would be a fourth confirmation of the Valuation-Informed Indexing model. It’s hard to dismiss a model that has been able to predict stock returns far in advance for 140 years and for four complete bull/bear cycles.

If stocks perform well for the next five years, the shaken confidence of the Buy-and-Holders will be restored and the Valuation-Informed Indexers may need to go back to the drawing board.

We’ll see what happens. You know what I am expecting to see. But the full truth is of course that none of us knows for sure.

Rob Bennett has written about what he likes and doesn’t like about Robert Kiyosaki. His bio is here.

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By Kevin M

Does a day go by when it doesn’t seem as if the towers of financial and political power seem to be shaking some where in the world? Iceland, Ireland, Spain, Greece, Portugal and now Italy. Will the Euro implode? Will the dollar implode? I personally don’t think either will, but given the perpetual avalanche of news that no one seems to be able to pay their bills, this is not a time for idle speculation.

And here’s what we do know…interest bearing investments (CDs, money markets and treasury bills) have gone negative against inflation…bond yields are at all time lows and since bond prices run in inverse proportion to rates, when rates do begin to rise, bonds are poised to take a big hit…stocks are swinging wildly in a way that suggests that a tumble of epic proportions may be in the offing…and real estate is already down for the count.

Against this backdrop the most reliable investment of the past ten years has been gold. Even with the correction since August, the price of gold has risen on the order of 500% during a decade when nearly all other investment classes have either tanked or gyrated wildly to no advantage.

Gold—after a 500% run up? That looks like it could be a bubble. Or it could be a sign of the times. A bubble is caused when buckets of money flow into an investment regardless of fundamentals. What has to be considered in the case of gold is that it’s an asset that performs best in a dysfunctional environment. I think that about sums up where we’ve been at for a few years now. Because of gold’s unique relationship to the rest of the economy and financial spectrum, we have to say that gold’s price is in line with its “fundamentals”. It’s an asset unlike any other.

If you think now is a good time to buy gold, there are different ways to buy and hold it.
Each has its own advantages and drawbacks. How you decide to hold your gold then will have more to do with personal preference than anything else.

Gold exchanges and ETFs

One easy and low cost option is to invest through a gold bullion exchange, such as BullionVault that stores your gold remotely. Not only is this a more liquid way to own gold (easy buying and selling) but it also solves the storage problem and does so with a high degree of safety.

Exchange traded funds, or ETFs, of which SPDR Gold Shares (GLD) is the largest, are another way to go. Like bullion exchanges you don’t have to take custody of your gold, and you can easily buy and sell positions as you like, though the fees tend to be somewhat higher than bullion exchanges.

Gold coins

The most direct way to own gold is with gold bullion coins. There are advantages and disadvantages to holding gold in coin form, and these should figure into any decision to own it.

Advantages:

• It’s close to the only investment you can hold in your hand
• You always know exactly what you own
• You never have to concern yourself with the financial health of the custodian—you are the custodian
• In the event things get REALLY ugly, it could be the safest of all assets
• Though one ounce coins (Maple Leafs, Krugerrands, Eagles, etc) are the most common, there are also smaller denomination coins available

Disadvantages:

• Gold bullion pays no interest or dividends
• Transaction costs, on both the buy and sell side, are high
• Holding the coins places the risk of loss squarely on you; you can have them insured, usually through homeowners insurance, but that will add to the cost
• They aren’t terribly liquid–you can’t cash them at a bank or use them to buy gasoline or groceries
• Because of their high value they are probably unsuitable for barter in a complete economic meltdown

Gold stocks

One of the problems with most forms of gold ownership is that it’s not an investment in the true sense—it doesn’t represent the means of production (future cash flow) and, as mentioned above, it doesn’t pay interest or dividends. What gold is mostly is a store of value, a safe haven in uncertain times.

Not so with gold stocks however. Gold stocks are a play on the present and future cash flow of gold mining companies, and they DO often pay dividends. They can be a spectacular way to play a rising gold market.

Or not.

Gold stocks aren’t a perfect hybrid between the store of value of physical gold and the investment potential common to stocks. They’re mostly a speculation of the highest order! Not only are they subject to all the economic and financial constraints of every other operating business out there, but they tend to operate in remote and dangerous parts of the world and/or in highly uncertain regulatory environments.

If you plan to take a position in gold by buying gold stocks, it should be only the smallest sliver of your overall portfolio. The upside potential is meteoric, but the downside risk is there in equal measure.

Watch your allocation!

We have to remember that gold is not a play on economic growth, which is the more common (but never guaranteed) state of affairs. Gold has a place as a store of value, but it isn’t an investment (with the speculative possible exception of gold stocks). It shouldn’t be seen as a get-rich-quick play, but rather as part of a capital preservation plan.

All of that argues for a relatively small position to invest in gold.

Right now I’m of the opinion that most of our money should be in cash type investments, to be positioned to take advantage of market downswings. But a 10-20% position in gold can make that cash position even stronger, which means that gold merits some investigation—and maybe even a buy.

OK, the price of gold is high, at least in nominal terms—do you think now is a good time to get into gold? Why or why not?

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Beyond Buy-and-Hold #63

By Rob Bennett

If stock prices continue their 12-year march downward, we are going to end up in the Second Great Depression. So we would all like to see a turnaround. The thing with which there is a difference of opinion is the question of what we need to see to bring on this happy event.

Buy-and-Holders believe that it is economic developments that cause stock price changes. If that is so, what we need is an economic recovery. That’s obviously a good thing. So, from a Buy-and-Hold perspective, we all just have to wait for and hope for an economic recovery.

Stock prices are the root of economic crises

Valuation-Informed Indexers have a very different understanding of how stock investing works. We don’t believe that it is economic developments that determine stock prices but that it is stock prices that determine economic developments. Once stocks become insanely overpriced, a crash becomes inevitable and, once a crash becomes inevitable, an economic crisis becomes inevitable because the price crash subtracts so much spending power from the economy.

It makes no sense for Valuation-Informed Indexers to wish for an economic recovery. We cannot realistically expect to see that until stock prices stabilize. We need to be rooting for a stabilization in stock prices.

What could bring that about?

Emotion and stock prices

Overvaluation and undervaluation are the product of investor emotion. Rational investors would price stocks properly. So the market can become stabilized only when investor emotionalism is diminished.

Now –

What would be the effect of a price increase? Would a price increase make investors more or less emotional?

A price increase would make investors more emotional. It’s only when stocks are priced properly that investors can assess stocks rationally. From the standpoint of Valuation-Informed Indexers, we need a price drop.

The trouble is that investors have already suffered years of poor stock performance. Another price drop is going to bring on investor depression. Once prices have fallen to fair-value levels, conditions will be in place to cause prices to fall to levels far below fair value.

How far can the stock market fall?

It’s no accident that prices have fallen to one-half fair value in the wake of every major bull market in U.S. history. That’s roughly a 65 percent price drop from where we stand today.

How many Buy-and-Holders do you think will be sticking with their high stock allocations in the wake of another 65 percent price drop?

Perhaps three? Perhaps two? Perhaps one?

Perhaps zero?

Has there ever been a Buy-and-Holder who stuck with his high stock allocation through an entire bull/bear cycle? If there has been, I’d be grateful if someone would pass along his name. I have certainly never heard of one being identified. The fact that none of the advocates of Buy-and-Hold has ever been able to identify a single investor who stuck with the strategy for the long term has always made me skeptical of whether this Buy-and-Hold business is as realistic as its proponents make it out to be.

The best of times for stock market investors

There’s a word in the investing literature used to describe the state of play that arrives when the last Buy-and-Holder gives up the ghost and sells his stocks at huge losses: Capitulation.

There’s a reason why the market can turn up again only after capitulation has been achieved. The thing that sends prices wildly up in bull markets is investor emotion. The purpose of a bear market is to wash the emotion out of the market. So long as there are still people claiming that Buy-and-Hold can work, capitulation has not been achieved. For our economy to recover, losses must first get bad enough to persuade the last Buy-and-Holder to give up the ghost.

The idea that Buy-and-Hold can work is a logical impossibility. Wishing for a world in which all Buy-and-Holders do not suffer financial wipeouts is like wishing for the discovery of a perpetual motion machine. We can all easily see the appeal of the concept. It is not possible for any of us to imagine an alternative universe in which the fantastic dream could be made concrete and practical and real.

I am hoping for the Buy-and-Holders to sell soon. Not because I don’t like them. Not because I intend to laugh at them. Not because I long to say “I told you so.”

I am hoping for the Buy-and-Holders to sell soon because it is when the last Buy-and-Holder sells that we can begin rebuilding our economic system after the damage done to it during the worst of all bull markets we have ever endured as a nation. I am sick of the human misery we see all about us as a consequence of the temporary triumph of Get RIch Quick thinking. I want to stop waiting for more inevitable bad scenes to play out and resume enjoying economic growth extending its bounty far and wide.

I don’t wish for an economic recovery. Because I view that as a vain wish.

I wish for a collapse of belief in Buy-and-Hold. Because I believe that’s what we need to see for the conditions to fall in place that will permit the greatest economic recovery ever seen in our history.

Rob Bennett believes that by studying the historical return data we can advance our understanding of how stock investing really works. His bio is here.

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By Kevin M

After the briefest of pauses, the stock market is back to swinging back and forth and showing no clear direction either way–Europe-itis is to blame once more. On Friday the European Union was assuring the world that it had matters well in hand—by Monday the world was back to not believing any of it. The global markets responded accordingly by whipsawing back and forth.

As much as we might wish otherwise, the signs are screaming out for of more of the same. Rising stock markets are based on calm and predictability, and both are in short supply—hence the volatility. And volatile markets typically settle in unhappy places. Consider the large stock slides in 2000-2002 and again in 2007-2009; I believe we’re at just such a point again today. Where this run ends is anyone’s guess, but there’s enough uncertainty out there to support an argument for just about any scenario we can imagine—and most of them are bad for our finances.

DISCLAIMER: I’m not an investment expert, nor do I write often about specific investment strategies. As a “certified outsider”—I don’t work in an investment related capacity, don’t stand to gain from a bear market and am not out to sell you anything—this is just the opinion of a peon. But sometimes peon status gives you the ability to see what insiders don’t, won’t or can’t. As a peon, I have no agenda!

That said, I offer my opinions on the current state of the investment universe, and steps we can take that might minimize the damage that I think is coming.

Cash and cash equivalents

The equity markets have been largely supported by historically low interest rates. After all, why put money in interest bearing investments when the rate of return on them is less than 1%? If these were normal times, that thinking would make abundant sense but the times are anything but normal.

Now is the time to ignore the low interest rate issue, and load up on cash investments. We’re not looking for return with cash, we’re looking to use it to 1) lower our exposure to risk investments and 2) to have funds available to buy up stocks at bargain basement prices once the market hits bottom. Think of holding cash as “keeping your powder dry”—when you put it in those terms it sounds a lot more on the edge.

Cash represents liquidity, and the time to build it is when investment prices are relatively high. Liquidity will only be harder to come by once stocks start to fall in earnest.

Bonds

Investors often use bonds as either a way to achieve higher rates of return in a low rate environment, or—because of the inverse relationship between interest rates and bond prices—as a way to capitalize on still lower rates in the future.

On the first point—looking for higher returns—the only way to get higher returns in a low rate environment is either by extending the term of the securities, or by accepting those of lower quality. Both strategies add risk to your portfolio at a time of increased overall volatility.

As to the second point—capitalizing on still lower rates–since interest rates are now at record lows, the likelihood of them going still lower looks like a sucker’s bet. If anything, volatility will magnify those risks causing you to lose money on your bonds.

In the current economic climate and interest rate environment, bonds may be only slightly less risky than stocks (maybe). This includes not only corporate bonds, but also municipals and foreign government bonds. All carry increased risk, and as we’re now seeing in Europe, many governments are at risk of outright default. That’s not a diversification from stocks in any sense of the term.

If you’re looking for longer maturities with complete safety, consider US Treasury securities. You can purchase Treasury Notes (terms from two to ten years) or Treasury Bonds (terms up to 30 years). Both offer rates higher than short term securities, but the notes carry far less risk in the event of an increase in interest rates (a bond trader once told me that a bond with a term of 20 years or more is no better than owning a stock!). Corporations and states can default on their bonds, but since the U.S. Government has the power of the printing press, one way or another you’ll always get paid!

You can buy U.S. Treasury Securities through brokerage firms or through Treasury Direct in denominations as little as $100. This is probably the only safe “bond play” in a volatile market.

Dividend stocks

I’m personally of the opinion that high price markets accompanied by high volatility are prime candidates for a quick exit, but I’m also aware that many people don’t agree with that thinking. So for the benefits of those who believe that stocks hold a place in any investment environment, here are a few thoughts.

Rob Bennett has written on this site that he’s been out of the stock market since 1996 and I completely agree with him. I’ve been out for most of that time as well. The same ultra low interest rates that have driven the equity markets to insane levels are also the prime force behind the worldwide explosion of debt since about the same time—hence the debt crisis.

Now that interest rates have hit bottom, a major re-alignment is playing out. Yet stocks remain at the upper end of their all time trading range! There’s a disconnect here, but I think it’s about to be resolved in a way that will make most investors quite uncomfortable. I think the only reasonable plays in the market will be special situations, one of which is dividend stocks.

Dividends can not only provide a cash flow that helps you to survive a major market decline, but they also can put a floor on the price of a stock. Even if the price of the stock falls in a market slide, dividend paying stocks will be prime candidates to be scooped up by bottom feeders looking for bargains and thus more likely to recover quickly.

Dividend stocks are some of the best investments in any market, but especially in volatile ones. Dividend Stocks Online specializes in high yield dividend stocks and is a good place to start looking for high paying stocks.

Value stocks

Another special situation in stocks is value stocks. These are stocks that for one reason or another have fallen out of favor with the markets, and so their prices trade at low levels relative to earnings, book value or even companies in the same industry. Sometimes entire sectors fall out of favor. In bull markets, value stocks don’t hold much appeal, but in bear markets they begin to stand out. This is often because bear markets bring a changing of the guard—a new “Nifty Fifty” if you will.

Value stocks are often prime candidates for bottom feeders. In bull markets, everyone is looking for high performers; in bear markets when few stocks are performing, underperformers with good fundamentals suddenly come back in demand.

Still whether we move into dividend paying stocks or value stocks, now is the time to lower our equity holdings, preferably to minority positions. The less we have in stocks, the less we have to lose.

Be ready to “bottom feed”

I’ve mentioned “bottom feeders” a couple of times in this post and for good reason: that’s precisely what I think we need to be preparing ourselves to be in the coming months!

The whole point of moving into cash and treasuries and lower risk stocks is to be ready with the cash AFTER stocks drop substantially in price. It’s a matter of positioning ourselves as bear market beneficiaries—able to buy stocks at bargain prices. And when we do, dividend and value stocks should be high on the “buy list”.

Where do you think the financial markets are heading, and what are you doing to prepare for it?

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Beyond Buy-and-Hold #62

By Rob Bennett

I often observe that Buy-and-Hold can never work. I get the feeling that a lot of people think I am exaggerating. No. I really mean that. This article sets forth nine reasons why it is so.

1) Buy-and-Holders don’t know when they are doing well or doing poorly.

The key to success in many types of life endeavor is learning from feedback. Because Buy-and-Holders don’t adjust their portfolio values to show the effect of valuations, the feedback they receive is often misleading.

I was warning people back in 2002 that going with a high stock allocation at the price levels that applied at the time was a terrible mistake. The usual response I received from Buy-and-Holders was “I’m doing just fine.” Huh? Buy-and-Hold was a disaster in the late 1990s. It took stock prices to the most insanely high levels ever seen in history. Yet Buy-and-Holders were not aware of the problem because they were viewing the numbers on their portfolio statements as legitimate.

2) Buy-and-Holders often go with wildly improper stock allocations.

The most important choice a stock investor makes is his choice of a stock allocation. It’s an easy one to get right for non-Buy-and-Holders. You look at the P/E10 level that applies. That tells you whether you should be going with a high stock allocation, a moderate stock allocation or a low stock allocation.

Buy-and-Holders get it wrong two-thirds of the time. They choose a stock allocation that makes sense for times when stocks are priced at moderate levels. So they go with wildly improper stock allocations both at times when valuations are low and at times when valuations are high.

Follow a strategy that causes you to get the most important factor wrong two thirds of the time and you are not going to see good long-term results.

3) Buy-and-Holders are the most emotional investors.

Stock prices follow a pattern that takes about 35 years to play out. They start out low, rise for many years, eventually reach insanely high levels, crash, and then remain low for a good number of years. Every investor experiences every stage of the bull/bear cycle at some point in his investing lifetime.

The years that cause the most stress are the years in which there is a crash followed by a good number of years of super-low prices. All investors get worried about their financial futures during this time-period. But Buy-and-Holders get the most worried. Why? Because they are the most stubborn about admitting their mistake of going with too high a stock allocation at times of insanely high prices.

A bear market cannot come to an end until capitulation is achieved. For there to be capitulation, the Buy-and-Holders must sell. But the anxiety must reach truly scary levels before the Buy-and-Holders become willing to break their vows never, ever to sell no matter what.

4) Buy-and-Holders cannot plan their financial futures.

Stocks were priced at three times fair value at the top of the bull. That means that portfolios that showed a nominal value of $600,000 possessed a true and lasting value of $200,000. How can any middle-class person who is working with accumulated wealth numbers that are $400,000 off the mark have any hope of knowing whether he can afford to buy a new house or a new car or to go on a special vacation?

5) Buy-and-Holders suffer double and triple hits when stock prices crash.

Buy-and-Hold causes economic crises. There has never in U.S. history been a time when Buy-and-Hold strategies became popular and we did not see an economic collapse. Nor has there ever been a time when we saw an economic collapse that was not preceded by a time when Buy-and-Hold became popular.

Just at the time when Buy-and-Holders are seeing a huge loss of their accumulated wealth of a lifetime, they are also seeing a spike in unemployment and the prospect of a prolonged recession or even a depression, adding greatly to their stress.

6) Buy-and-Holders never know what to expect from the stock market.

Robert Shiller saw the economic crisis coming years before it hit. So did Arnott. So did Asness. So did Russell. So did Smithers. So did all Valuation-Informed Indexers.

Buy-and-Holders were shocked to see history repeat yet one more time.

7) Buy-and-Holders sell at precisely the worst time to do so.

In theory, Buy-and-Holders never sell. In reality, they sell at precisely the worst possible time for doing so. Stock prices rose to three times fair value at the top of the bull. They always fall to one-half of fair value by the end of the secular bear market that inevitably follows an out-of-control bull. That’s a loss for Buy-and-Holders of five-sixths of their accumulated wealth of a lifetime. How many do you think stick to their vows to never sell?

8 ) The losses suffered by Buy-and-Holders multiply over the years.

The nominal losses suffered by Buy-and-Holders grow much larger over the decades as the power of compounding returns causes those losses to multiply.

9) Bulls last long enough to cause Buy-and-Holders to up their spending in irresponsible ways.

I know many Buy-and-Holders who began early retirements at the top of the bull because they believed the books and articles and calculators telling them that stocks could continue producing positive returns even starting from such insanely high price levels. Millions of others let their temporarily inflated portfolio values persuade them to spend far more than they would have dared to spend had they known the true value of their portfolios. It’s too late now for them to make up for the years or decades of lost saving opportunities.

Rob Bennett writes about getting over your fear of money. His bio is here.

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