Sunday, June 24, 2007

Reader Question: Leave the Stock Market?

In response to a previous post on 401k allocations, one of my readers, Jason asked if the author of a website I mentioned was suggesting avoiding stock allocation altogether. I do not know if that was Rob Bennett's point - in my reading, I didn't necessarily get that impression. But I do know a few things I'd consider.

The first is Benjamin Graham's counsel. Graham is the father of value investing, whose followers include a laundry list of super-investors including Warren Buffett (the world's third richest man), the Schlosses, the folks and Tweedy Browne, Seth Klarman and many others. Graham, in his book The Intelligent Investor, a classic investing text, ranted against paying too much for stocks and poor performance that ensued. And yet, Graham acknowledged that there was a significant element of performance that may not be captured purely by valuations, and that because of market action, it might not be desirable for an investor to stay out of markets until the next bear market. His preference was instead to reflect those inflated prices in an adjustment in equity allocation, with a 50-50 stock-bond mix in normal times, and going down as low as 25% in either asset when it was inflated.

This is precisely the tactical asset allocation many institutional investors pursue. The best, in my mind, is Jeremy Grantham of GMO. Grantham's commentaries, available for free with registration, are a must-read. In his latest piece, he points to a global bubble in every kind of asset, and GMO's own 7-year forecasts predict that based on average conditions, we can expect poor returns from our stocks, bonds, real estate, whatever. And yet there's enough variability that you wouldn't want to sit on cash. While that risk profile would justify increasing allocations to near-cash instruments, (i.e. money-market funds) yielding over 5%, a 100% allocation would be a mistake!

Also, even within the stock market, there might be reasonable investments. The one promising asset Grantham finds is "high quality" stocks. This is consistent with the opinion of others like John Hussman, who points out that quality stocks are cheap relative to garbage. He points out that the median P/E of the largest 50 stocks in the S&P 500 is 17, down from 35 in 2000, while that of the smallest 50 stocks in that index is 20, up from 10 in 2000. So people are paying more for riskiest assets than stable giants. By the way, the median P/E on the small cap universe is somewhere around 35, if I remember correctly (source forgotten).

So what's an investor to do? Well, if you're an active investor, you could reduce your stock allocation, keep your bond durations relatively short (the US bond market is going to see some blood), and focus on a bottoms-up stock picking. If you're a passive investor, focus on cutting your stock allocations, increase your short-term allocations, and hoard some cash. Sprinkle in TIPS or I-bonds. Rebalance if you haven't been doing it!

Oh, and either way, maybe pay off your debt - that can give you a guaranteed "rate of return" of anywhere from 6-9% for your mortgage, to 10-20% for credit card debt.

UPDATE: COMMENTING CLOSED This is a first for me, but as I've followed this debate, and glanced at other forums where this debate has continued, I've decided that most of the quality information has been revealed in the post and comments so far, and we're getting a combination of regurgitation of the same facts and personal attacks. So I've decided to close comments on this post. This isn't intended as censorship or bias - simply a decision to prevent this blog from getting hijacked by a rather vitriolic battle I've seen at other forums. Thank you all for your participation - heaven knows I haven't had 11 comments on too many other posts before!


Anonymous said...

Before you take advice from Bennett, you should become more familiar with him.

Great advice about debt, by the way. Some investors get so interested in their portfolios they totally overlook that simple step.

Karthik Narayanaswamy said...


I wasn't endorsing Rob Bennett or criticizing him. I think his website's information on valuations are correct. I haven't read all his writings, but a stock-free portfolio seems inappropriate for almost anyone - indeed, even the figures on the Passion Saving website that I pointed to suggest poor average returns, the dispersion in returns is enough to justify some exposure.

If the facts are right, one of the bigger issues is that Mr Bennett only had $400,000 in retirement assets. That simply isn't enough ...

Rob Bennett said...

His preference was instead to reflect those inflated prices in an adjustment in equity allocation, with a 50-50 stock-bond mix in normal times, and going down as low as 25% in either asset when it was inflated.

Graham had it exactly right, in my view. We are not able to tell with enough precision the effect of overvaluations to justify dramatic changes. But we know with "mathematical certainty" (this is a phrase used by William Bernstein) that valuations affect long-term returns. So the advice you often hear today to stick with the same stock allocation regardless of valuations makes no sense.

The very fact that these sorts of views have become popular is itself evidence of the extent of the overvaluation problem we are facing. It's a bad sign when common sense becomes "controversial."


Rob Bennett said...

if the facts are right, one of the bigger issues is that Mr Bennett only had $400,000 in retirement assets. That simply isn't enough

The "facts" stated in the links above are of course nowhere even remotely in the right neighborhood.

The links go to a site owned by John Greaney. Greaney published a study of safe withdrawal rates (SWRs) at his web site ( which got an important number wrong. I am the founder and leader of the New School of SWR analysis, and I pointed out the error. The majority of board members responded with great enthusiasm to our discoveries of the flaws of the old methodology and to our development of analytically valid methodologies. Greaney and his supporters responded in a very different way.

Those interested in more background on the SWR topic should take a look at the "Risk Assessor" tab at the left side of each page at my site. At the bottom of that page is a link to an article setting forth snippets of posts from over 40 Retire Early community members who have been able to put together more effective Retire Early plans as a result of what they have learned about SWRs from our community discussions.


Rob Bennett said...

a stock-free portfolio seems inappropriate for almost anyone - indeed, even the figures on the Passion Saving website that I pointed to suggest poor average returns, the dispersion in returns is enough to justify some exposure.

I strongly agree with the second point you make here, Karthik. I think you go too far with the first.

You are getting at something important when you make reference to the "dispersion in returns." The historical data shows that the most likely annualized return over the next 10 years is about 1 percent real. But the possibilities range all the way down to a negative 5 percent and up to a positive 7 percent. So while it is false to say that the historical data does not argue strongly in favor of lowering our stock allocations when prices get to where they are today, it is also a mistake to respond in extreme ways to the message of the historical data. Given the upside potential of stocks over the next 10 years, I think it is a bit on the extreme side to go to a zero stock allocation.

That said, personal circumstances always need to be taken into account. My personal circumstances are unusual. I did go to a zero stock allocation in 1996, and I think that I did the right thing in doing so.

One thing that makes my circumstances unusual is that I am taking on risk in other areas of my life. I left my corporate employment in late 2000 to begin a career as a freelance writer of non-fiction books. This is an area where I could make a lot of money if my books are wildly successful. It is also an area where I cannot count on a regular paycheck. I have two small children and a stay-at-home mom counting on me to be bringing in a small amount of money each year to cover "nice-to-have" expenses like vacations and new cars (our essential expenses are covered by our investments). In these circumstances, it simply does not make sense for me to be putting the nest egg at unnecessary risk by investing in stocks at the sorts of valuation levels that apply today.

The low-end possibility is an annualized return over 10 years of a negative 5 percent. The typical investor can take that hit so long as he limits his investment in stocks to 25 percent or 30 percent. I cannot. That sort of loss would be devastating to me. Why should I take on the possibility of facing that sort of loss when there is no need for me to do so?

I have my money in TIPS and IBonds paying a return of 3.5 percent real. That's a return far in excess of what can be realistically expected from stocks today. Given that I can get a higher return outside of stocks and given that I cannot afford the risks of stock investing, it would be irresponsible for me to take on those risks today. If prices returned to reasonable levels, then, yes, I could see putting a good portion of my portfolio in stocks. Given the realities that prevail today, I think it would be a highly irresponsible move for me to make.

I am financially ahead on my decision to get out of stocks in 1996, by the way. I am a little bit down on the small amount of money that I took out in 1996. But I am ahead by more than I am down because I have done better with my TIPS investments than I would have in stocks from 1998 forward. The fact that someone could be ahead after being out of stocks for ten years shows just how poor the value proposition for stocks becomes when prices get to where they traveled in the mid- to late 1990s. When stock prices fall hard (the data tells us to expect a 40 percent drop in real value [including dividends] for money in stocks today), I will of course be much farther ahead financially than I am today.

Stocks were greatly oversold during the out-of-control bull market of the late 1990s. Stocks are a wondeful asset classs; they are my personal favorite. But stocks have been greatly oversold. Lots of people are going to suffer great pain as a result of the tall tales that have been told in recent years about how stocks perform in the long run.

The best way to learn about the realities is to study the historical data in an analytically valid way. That's the reason why I put in the work developing The Stock-Return Predictor. It's an easy way of learning at a glance the true value proposition of stocks purchased at various price levels.


Rob Bennett said...

This is precisely the tactical asset allocation many institutional investors pursue.

This one is a question, Karthik.

You describe the sort of portfolio change made in response to overvaluations as "tactical." I have seen it described as such elsewhere. You are certainly not doing anything unusual in referring to it as such here.

Personally, I view it as not a tactical move but as a strategic move.

The reason why I think stock allocations should be changed as valuations change is that the long-term value proposition of owning stocks is so much less when prices are high.

To me this is a strategic question. My entire strategy turns on looking for a good value proposition and then presuming that over the long term that will work out.

I've seen this approach referred to as "tactical" so many times that I sometimes wonder if I am wrong to think of it as "strategic." If you are able to shed light on what so many think of this as a "tactical" approach, I'd be grateful.


Jason said...

The GMO forecasts are pretty grim. I am willing to buy individual “quality” stocks and find that I owned quite a few even before hearing the term.

Rob- you are the founder of the New School? I couldn’t confirm that on the web site
and I could't find a "Swr Analysis"

The links provided by anonymous demonstrate that you have really touched a nerve on some discussion forums. Challenging assumptions is generally a good thing in my view. Were you really banned from Morningstar?

Rob Bennett said...

The GMO forecasts are pretty grim.

They're not "grim" if you are prepared for them, Jason. They're indeed very "grim" for those who have been buying into the idea that there is no need to adjust stock allocations downward when prices get out of hand.

I am willing to buy individual “quality” stocks and find that I owned quite a few even before hearing the term.

Those who have the skill and time needed to pick individual stocks effectively can find good buys even at times of extremely high valuations. It's not easy, though. I don't see this approach as being appropriate for the typical investor but it's fine for those who really can pull it off.


Rob Bennett said...

Rob- you are the founder of the New School?

I am the founder and leader of the New School of SWR analysis (the term "New School" comes from a Scott Burns column that was written at my urging -- he coined the phrase, not me). The New School argues that, since the historical data shows that the single most important factor in determining the SWR is the valuation level that applies at the start date of a retirement, an adjustment for the valuation level that applies for a particular retirement must be included in the calculation. Incredibly enough, the Old School SWR methodology contains no adjustment whatsoever. Those numbers are of course as a result wildly off the mark from what you get by using an analytically valid methodology.

The first New School SWR calculator is available at my site. Click on the "Risk Evaluator" tab at the left side of each page. There are links to a number of articles at the bottom of the calculator page that give background on what experts say and what Retire Early community members say and so on.

I am leading an effort that I call the "Save the Retirements!" initiative to get publicity about the New School findings. The Old School findings served as the source of thousands of articles on retirement published over the past 10 or 15 years. All of these articles of course get the numbers wrong. So there are now millions of retirements at grave risk of going bust. My hope is that we will be able to reach people before prices drop and even worse damage is done.


Rob Bennett said...

Were you really banned from Morningstar?

Yes. I've been banned at numerous places. I've also been banned at Motley Fool, at the Early Retirement Forum, at, and at a site that is no longer around,

There were hundreds of posters who expressed a desire to hear about our findings at all of these places. I of course oppose the bans. The bans tell a disturbing story both about how many site administrators fail to take their site administration responsibilities seriously and about how investors become so emotional at times of high stock prices as to be unable even to bear to hear what the historical data says about the probabilities of various long-term returns.

The primary cause of the bans is the abusive posting of posters who post in support of John Greaney, an individual who posted an Old School SWR study at his web site ( The links you see above are from a board owned by Greaney. He uses this board as the base of operations for his goons, who travel from one site to another as posters indicate an interest in discussing SWRs and valuations in general. It is of course Greaney and his supporters who should be banned. That's not what happened.

The question that investors should be asking themselves when they see something like this take place is -- Why would the entire community not speak up in opposition to these sorts of posting tactics? If investing were primarily a rational endeavor (as is presumed by the Efficient Market Theory, today's dominant model for understanding how stocks work), all would of course demand that the rules prohibiting abusive posting be enforced. The fact that so many did nothing, and that a good number either encouraged the abusive posting or actually joined in on it, tells us that investing is primarily an emotional endeavor and only secondarily a rational endeavor.

I am writing a book exploring this theme in great depth. It will be entitled Investing for Humans: How to Get What Works on Paper to Work in Real Life. I expect to finish the book near the end of 2008. I write articles on this theme on a regular basis and post them to the investing sections of my site.

It's critical to get the fundamentals right. Charlie Munger has described the Efficient Market Theory as "asinine." He is right. It really is asinine. And because the model we use to understand how stocks work is asinine, the vast majority of the books and articles and research papers available today get important aspects of the question wrong.

I don't think it is possible to overstate how important it is that we abandon this model for a more realistic one. Stock investing is not primarily a rational endeavor. There is of course some reasoning that goes into it. However, at times of high prices it is rationalization and not reasoning that dominates. That's a big problem.


Phoenix said...

For a good look at what Rob does to a discussion forum where he holds the whip, try the SeWeR, an archive of the board he moderated at NFB.

Ignore the commentary. Simply read the unvarnished Rob Bennett, involved in debates and simultaneously in control of what gets discussed and what arguments will survive his censor's pen. Make your own judgments about abuse of authority. A look at half a dozen of the final threads will open your eyes.

Rob burned down NFB single handed but the record has been preserved at the SeWeR. He came close to burning down Morningstar's VGDH forum. It may yet die as most of its posters fled Rob's abuse of good manners when Morningstar was slow to act.