Solving Puzzles Can Yield Big Investing Insights

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By Rob Bennett

Robert Shiller says that valuations affect long-term returns. That means that the riskiness of stocks varies with price changes. Yet the Buy-and-Holders say that the safe withdrawal rate — a risk assessment tool — is always the same number. It’s a puzzle.

A regression analysis of the historical return data going back to 1870 shows that the most likely 10-year annualized return on stocks when they are priced as they were in January 2000 is a negative 1 percent real. Treasury Inflation-Protected Securities (TIPS) were at the time paying a guaranteed return of 4 percent real. Yet the Buy-and-Holders say that investors are compensated for being willing to take on more risk. It’s a puzzle.

Shiller predicted the 2008 economic crisis in a book that was published in March 2000. He said: “If, over some interval in the first decade or so of the twenty-first Century, the U.S. stock market is going to follow an uneven course down, as well it might – back, let us say, to its levels in the mid-1990s or even lower – then individuals, foundations, college endowments and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.” Yet, when the crisis hit, few of the analyses of it attributed it to the out-of-control irrational exuberance of the day. It’s a puzzle.

Price discipline is the key to smooth functioning of all markets other than the stock market. It is through the exercise of price discipline on the two sides of transactions that markets perform their core function of setting prices properly. Yet the only means of practicing price discipline in the stock market is through market timing and Buy-and-Holders discourage the practice. It’s a puzzle.

There is nothing that can be bought or sold in this world that is not a bad buy at some price point. Yet the Buy-and-Holders say that stocks are worth purchasing at any possible price. It’s a puzzle.

John Bogle often spoke in derisive terms about market timing. But he once advanced a post to the Bogleheads Forum in which he said that he could see how it could work at times of extreme prices. He suggested that market timing could be successful six times in an investor’s investing lifetime, three times when prices were crazy high and three times when prices were crazy low. The hundreds of commentators and investment analysts that on many occasions have quoted Bogle’s investing insights, did not pick up on this one. It’s a puzzle.

Rob Arnott once observed that: ““Returns are for the most part a matter of simple arithmetic…. Much of our industry seems fearful of basic arithmetic of this sort.” That’s a scary statement. Rarely have I seen it quoted. Never have I seen it effectively refuted. It’s a puzzle.

Brett Arends wrote an article titled “The Market Timing Myth” in the Wall Street Journal on October 14, 2010. It stated that: “For years the investment industry has tried to scare clients into staying fully invested in the stock market at all times, no matter how high stocks go. It’s hooey. They’re leaving out more than half the story. Anyone who followed the numbers would have avoided the disaster of the 1929 crash, the 1970s or the past lost decade on Wall Street…. I wonder how many stayed fully invested because their brokers warned them ‘you can’t time the market’.” Again, that’s a highly provocative and scary comment. Again, it’s a statement that I rarely see quoted and that I have never seen effectively refuted. It’s a puzzle.

Wade Pfau told me during the time that we were doing research into Valuation-Informed Indexing that: “I know that there is an extensive literature about the predictability of long-term stock returns dating back to Campbell and Shiller’s work in the mid-1990s. I also know that there is an extensive literature about short-term market timing strategies…. But my question is about LONG-TERM market timing strategies. In other words, using market timing over periods of at least 10 years to obtain better returns than a Buy-and-Hold strategy. The literature seems slim.” He ultimately concluded that: “Yes, Virginia, Valuation-Informed Indexing works!” Yet I have not seen other academic researchers follow up on our research in the years since it was published in a peer-reviewed journal. It’s a puzzle.

My experience is that, when one comes upon a puzzle, one has come upon a learning experience of great potential value. All puzzles can be explained, Sometimes it takes a lot of digging to get to the explanation. But the puzzle is telling the person who comes upon it that there is some way in which his understanding of the subject at issue is deficient. Puzzles are gifts. They point us in the direction of new and valuable knowledge.

Rob’s bio is here.