Wednesday, June 20, 2007

Your 401k is All Wrong!

Sorry I haven't blogged in a while. I've been swamped, between family visits and working on a journal article. Hopefully I'll find more mental energy to blog - that's the key, not time, but just the ability to sit and pen my thoughts.

Meanwhile, I'm quite excited to report about a website that has captured some of my concerns about average Joes and Janes and their saving for retirement. I haven't read the entire Passion Saving website, but have liked a lot of what I read. The website talks about valuations and how they affect future investment returns.

What do I mean? Ok, so if you have a 401k or ever read a financial advice column, they would advice you to follow a certain asset allocation. Maybe you're 30 years old. Maybe you are told to do 80% stocks, 20% bonds (Nowadays, there are more exotic choices than the two, but let's stick with those two) Why? Well, stocks return more than bonds, so as a younger person, you should be willing to load up on riskier stocks.

But wait, that tells you nothing about the value. Think about it this way. Tom Brady is a great football player, but you wouldn't be betting the club on him. An investment is only good when the price is right - buy low, sell high.

"But stocks are cheap" comes the chorus. According to data from Standard and Poor's, the P/E on the S&P is 17 - that's down from over 46 in 2001, just when the market crashed. Two problems with that. One - why look at 2001 as the base year? The median P/E of the S&P since 1936 has been 15.4, so stocks certainly don't look cheap on that basis. But that's only the beginning ...

Unfortunately, the P/E doesn't correct for the cyclical nature of earnings. I have previously pointed to the work of John Hussman, manager of the Hussman Funds (my fav fund) talk about this issue. What's nice about the Passion Saving website is that it uses a much simpler way to bring the valuation issue to focus. By using a 10-year moving average of earnings for the P/E, Prof Robert Shiller of Yale, of "Irrational Exuberance" fame, shows that the P/E10 of the stock market is close to 30, the highest level with the exception of during the dot-com boom. The median value historically has been closer to 14. The value in 1982 at the start of the great bull market in stocks was under 6.

Click on the return predictor, and you'll see that based on historical valuation models, the expected real (i.e. adjusted for inflattion) return over the next 10 years is about 0.5%, which is much less than available on government bonds and inflation securities. What if the P/E10 was at its historical median. Then we could expect a 10-year return of over 6%, a pretty handsome return.

Valuations matter, and in an environment where real estate and stocks and longer-term bonds have been pushed up, the best an investor can do is to select a flexible bond fund or keep money in a short-term bond fund yielding about 5% until better options emerge.

13 comments:

Anonymous said...

I'm quite excited to report about a website that has captured some of my concerns about average Joes and Janes and their saving for retirement.

Thanks for your kind words about The Stock-Return Predictor and The Retirement Risk Evaluator, Karthik. And bless you for focusing on the issue that matters most, the effect that what "experts" say about investing topics has on average middle-class people.

Most people do not study these issues. They are too busy. They put their faith in experts to tell them the straight story. It is my view that the retirement experts have failed us big time. Millions of retirements are at risk of going bust because of the flaws in the methodologies of the Old School studies. Yet it is hard to get many "experts" to speak out in clear and strong and direct terms about the problem.

If you or anyone else has questions about either of the two calculators, I'm glad to try to respond to them.

I very much like your "About Me" description of yourself, by the way. When you're so happy that it pisses people off, you must be doing something right!

Rob Bennett

Anonymous said...

I haven't read the entire Passion Saving website, but have liked a lot of what I read. The website talks about valuations and how they affect future investment returns.

I looked at the site a little. Is Rob suggesting getting entirely out of stocks due to valuation?

Karthik said...

Jason, because your comment is significant, I'm authoring a new post to clarify my thoughts.

Anonymous said...

Is Rob suggesting getting entirely out of stocks due to valuation?

The short answer to this is "no." My advice to the typical investor is to lower his or her stock allocation by about 25 percent from what it was at times of reasonable prices. So, if you were at 60 percent stocks at times of reasonable prices, you should be at about 35 percent stocks today.

Rob

Anonymous said...

So you would switch back and forth an absolute 25% as stocks crossed the reasonable/unreasonable line?

Anonymous said...

So you would switch back and forth an absolute 25% as stocks crossed the reasonable/unreasonable line?

No, that's not what I would recommend.

Say that you identify a P/E10 value of 20 as the danger zone (I think that's a reasonable place to put it). Say that your aim is to be at 60 percent stocks when the P/E10 value is less than 20 and at 35 percent stocks when the P/E10 value is greater than 20. It's possible that the P/E10 value could go back and forth over that line a number of times on its way down to lower values. You don't want to be buying and selling numerous times. So you make the shift once and then wait for a significant change in prices before making another change in your asset allocation.

We are now at a P/E10 of 30. Say that you go to a stock allocation of 35 percent as a result. When we go below a P/E10 of 20, you might up your stock allocation to 60 percent. But then you don't lower it again just because for a brief time we go above 20. You stay at 35 percent stocks until the P/E10 value is a good bit lower (when we are at 20, which is a very high P/E10 value, we are on the way to lower P/E10 values in the long term).

Would you get a bit nervous if the P/E10 value went to 21? You shouldn't. There's not that much difference between a P/E10 value of 20 and 21. You don't want to be making moves as the result of insignificant changes.

What if we go back to a P/E10 of 25? That's not at all likely. A P/E10 of 20 is so high that the odds of going below 20 and then back above 25 are very low. But it could happen. If we went back above 25 again, I would lower my allocation again. At that point, we've just gone so high that you've been put in an intolerable risk situation.

You need to apply some common-sense judgment in deciding on your precise moves. The thing to always keep in mind is that the risk of stocks is dramatically higher when we get to sky-high valuation levels. You certainly do not want to be staying at the same allocation level that made sense when prices were reasonable. Our tools are not precise enough to permit sharp turns to work effectively, however. Informed common-sense judgment calls are what have always worked through the historical record.

Rob

Anonymous said...

Mr. Bennett,

for someone who says he is neither a market timer, nor a bear, you would appear to be both. What is the harm in owning up to what you are? Surely there is no downside to being forthright? Let's do it by close of business today.


Here are more of Bennett's writing, where he goes by screen name "hocus":
http://www.s152957355.onlinehome.us/cgi-bin/yabb2/YaBB.pl?board=HOCO

Anonymous said...

Oh my, Rob Bennett strikes again. Before you put **ANY** credence in anything he has to say, I suggest you google "Rob Bennett financial adviser". You'll find that he has absolutely no credentials in finances, his personal finances are a disaster, he's been debunked repeatedly, and he has been banned from at least 16 discussion boards for serious abuse, including abusive posting and deception.

CAVEAT EMPTOR!

Karthik said...

Anon,

I'm a little tired at the personal attacks at Rob Bennett. I'm no advocate for him or his books - I was simply pointing readers to his website where he reports what I consider an uncontroversial matter - valuations matter!! Not in the short term, but long term returns are highly correlated with normalized valuations.

Question: What are the S&P 500 returns over the last 10 yrs?
Answer: 2.16% per annum.

So all those deniers in 1998 who talked about how valuations don't matter were wrong in the long term!

BTW this isn't Bennet's theory - it was originally espoused by Ben Graham, and has been the motto of value investors for decades!

Anonymous said...

I consider an uncontroversial matter - valuations matter!!

...


BTW this isn't Bennet's theory - it was originally espoused by Ben Graham, and has been the motto of value investors for decades!



Exactly. So Bennett has found nothing new under the sun, and every step he takes to extend or do something new from the 1950's truths that he has just now discovered, exposes his lack of knowledge and fundamental logical thinking. This single voluntary post (link) by Mr. Bennett richly displays his muddled thinking. He is, not to put too fine a point on it, a crank and a liar.

http://bookofhook.com/phpBB/viewtopic.php?t=6

Karthik said...

Anon,

I personally don't understand why there is so much of an obsession with Mr. Bennett's character, personality or originality. I am not interested in any of those. What I care is what can help me seek positive returns while avoiding risk, and I think there is useful information on his website (whether his own or reporting on the work of the others).

Anonymous said...

What I care is what can help me seek positive returns while avoiding risk, and I think there is useful information on his website (whether his own or reporting on the work of the others).

I don't think I would hang around listening to a madman in an insane asylum on the off-chance he may randomly from time to time utter (or refer to) some piece of information that is not insane in and of itself.

I feel there are just far too many sources of quality, reputable, researched, supported, sane information out there, to deal with made up death threats, "reigns of Terror", potty references, song lyrics, etc.

But then, that's just me...

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