Stupid Human Tricks

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I’ve tried to be pretty Orthodox in my investment writing here, to date.

I think that most of what I write about investing could be successfully boiled down to a pretty boring list of 10 plain vanilla commandments.

  1. Save more of your own money and invest it.
  2. Invest your money in low cost passively managed index funds.
  3. When choosing a fund pay particular attention to the expense ratio. Keeping costs down is paramount.
  4. Spend a generous amount of time honestly thinking about your risk tolerance. The less risk tolerance you have the more cash/bonds should be in your portfolio. Better to underestimate your risk tolerance, then overestimate it.
  5. If you want to get creative, then tilt your portfolio towards those factors which have been shown to increase returns: beta, size, value, momentum, and quality.
  6. If you don’t want to be too creative simply buy cap-weighted indexes that mirror your own conception of the market as it currently exists. (lazy portfolios are a very good source of ideas for this sort of thing.)
  7. Diversification is a good thing, and is as close to a free lunch as you will find.
  8. Read a bunch of investment books and come up with a philosophy that is true to yourself as an individual.
  9. Once you have your plan, stick to it.
  10. Come up with an investment policy statement, and write it down.

And that’s really it. And evidence suggests that if we do those 10 simple things, we will outperform the vast majority of investors.

And the reason why I have focused on the simple messages, is that the main risk in investing is overconfidence.

If you think you can beat the broad market, you’re probably wrong.

The market is not perfectly efficient, but it’s efficient enough to make trying to beat it, a fools errand.

And keeping it simple, though it sounds very simple, is actually very hard.

But there are other things that I personally believe about the market.

Warning! These are the sort of things that are probably best ignored!

original(Earmuffs)

One of them that I will mention, (because it is in my own investment policy statement) has to do with valuation.

I’m not talking about evaluating single stocks, I’m talking about valuing the entire stock market.

One historical truth about the stock market, is that investing in it has been more profitable when valuations are low. (This is just a fancy way of saying that it is more profitable to buy into the stock market when stocks are cheap.)

So it doesn’t take a genius to realize that you have a good chance of doing better if you increase your percentage of stocks in your portfolio when stocks are cheap, and decrease it when they are expensive.

But how can you tell when the stock market is cheap or expensive?

The most common method for evaluating American Stocks is the CAPE Shiller index.

This metric essentially averages the price/earnings ratio for the S&P 500 over a 10 year rolling average.

(The price to earnings ratio tells you how much you have to pay for a stock to get 1 dollar of corporate earnings. So it’s essentially a price tag, the higher it is, the more expensive the stock – or in this case the stock market.)

And here is a current snapshot of the CAPE Shiller Index

shiller-pe-0633b7bfdd525c03

And from the snapshot you can deduce the following:

  • The range of values is between 4 and 44.
  • The average value is about 16.5.
  • Bad stuff seems to happen when the value gets above 30 or so (but not always right away.)
  • Our current valuation is well above average (26.48). (so the American stock market is currently relatively expensive.)

So Am I selling out of stocks and buying into bonds right now?

No I am not.

At this point I simply lack the tools to know when is the right time to divest myself from Stocks based on the CAPE Shiller index or any other market valuation tool.

But I have chosen a CAPE Schiller value of 30 to be the point at which I will decrease my allocation to stocks in order to avoid downside risk.

Unfortunately I do not have any convincing data to share with you concerning this strategy.

And it is important to remember how difficult it will be to divest myself from Stocks if and when we get to a CAPE Schiller value of 30. By that time the market will have been on a record run and I will have made a good amount of money in the bull market on the way up. So the last thing I will want to do at that point is to sell stocks and buy low yielding bonds.

But that is what I intend to do.

William Bernstein refers to this strategy as strategic asset allocation. More colloquially, he calls it “over-rebalancing” which is a good description of the psychological toughness it will take to implement it.

So let’s review. The strategy that I am describing is

  • Poorly researched by this author
  • Difficult to implement
  • Overly complex
  • Lacking convincing evidence to suggest future efficacy.

Which is why I have resisted writing about this for such a long time.

Let’s be clear, I am in no way suggesting that my readers follow my lead on this one.

I am explicitly suggesting that it would be smarter to scroll up to this top of the page and read the 10 Commandments again.

Keep it simple, stupid. Don’t be prideful. (You will probably be happy if you do.)

Perhaps I should follow my own advice?

Nah…This time its different.

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19 Responses to “Stupid Human Tricks”

  1. Eric July 3, 2014 at 8:27 am #

    You seem to implicitly acknowledge this in your post, but let’s make it explicit: what you are trying to do is time the market. And it highlights a danger most (all?) investors face: the risk of letting emotion and psychology override logic. If you accept the fact that the market is efficient enough to make trying to beat it a fool’s errand, then don’t be a fool. But I’ll concede that if you’re going to be a fool, it’s better to do it in the way you are suggesting than to let emotions get the better of you in the OTHER direction and start panic selling during a market crash. However, the fact that you still intend to try to time the market even in light of your beliefs about the market and investing demonstrates that it’s a lot easier to talk the talk than to walk the walk. Which means investors shouldn’t overestimate their own ability to show resolve in the face of the next market crash. Because, after all, the next time will be different too.

    • Miles Dividend M.D. July 3, 2014 at 10:04 pm #

      Eric,

      What can I say.

      I must plead guilty to all of your accusations. I am a foolish market timer.

      The 10 Commandments I stand behind. The 11th one I revealed with embarrassment.

      I had reservations about writing this post for all of the reasons that you stated. Ultimately I thought it would be interesting, so I wrote it.

      My only defense is that my investment policy statement reflects my own deeply felt biases and beliefs about the market. My feeling is that this will make it easier for me to stick to it when the going gets tough, which I honestly think is the most important thing in determining one’s ultimate success.

      It takes great discipline to keep it simple. And from your comments, it seems you are a man of great discipline, which I respect very much.

      Alexi

  2. Robert July 3, 2014 at 11:12 am #

    As you know, I look at P/E also, in the context of expected returns. And like you, I haven’t yet used it to time the market. I’m still studying how best to use this indicator, not being as far along as you as setting an actual threshold (30 in your case).

    This article says that Shiller doesn’t see it as a market timing tool, but does see it as a way to add and decrease equity exposure. http://www.businessinsider.com/robert-shiller-explains-how-to-use-cape-2013-11. The article suggests 26 as the cutoff. Shiller’s comments make me think that one might have a strategy that decreases or increases equities gradually rather than on/off at 30 (or 26). For example, maybe you’d decrease your equity exposure by 5% for each unit increase in Shiller PE above 25.

    One thing that bothers me, however, is that Shiller uses an arbitrary 10 year averaging period. Since the frequency of strong business (earnings) downturns is irregular, that would seem to me to introduce problems into any arbitrary scheme like this. For instance, the business downturn in 2007/08 will introduce a lower average earnings for the next ten years that will disappear from the average in 2019 or 2020. That might have no meaning for the economy in 2019 or 2020, though. Depending on if there was one long continuous slow growth economy for 10 years, or a volatile economy for 10 years with perhaps 2 or 3 significant cyclical downturns, the Shiller PE fluctuations over the subsequent period would be quite different. But does it mean anything in terms of expected returns? That is something I’m still puzzling over. I should read Shiller’s original work, but haven’t gotten around to it yet. I’m concerned that there’s a bit of data-mining going on here. i.e., how did he end up picking 10 years? Was it because it best predicted future returns? But if that is based on past cycles, what if future cycles are longer/shorter?

    Another thing I recently learned offers further food for thought on this subject. Citi’s Levkovich argues that Shiller’s CAPE is flawed because it doesn’t normalize for interest rates, and if one does so, stocks are currently undervalued. It is an interesting argument: http://finance.yahoo.com/blogs/daily-ticker/no–stocks-aren-t-wildly-overvalued–citi-strategist-finds-hole-in-shiller-s-cape-153310694.html. Normalizing for interest rates might also allow one to better avoid “fighting the Fed” which is one of the cardinal sins of equity investing.

    • Miles Dividend M.D. July 3, 2014 at 9:57 pm #

      Robert,

      You kind of drilled down to the heart of the problem.

      I firmly believe that valuations matter, but finding the right metric for judging value is very difficult.

      On the question of the interaction between interest rates and the price to earnings ratio, I recently saw an interview with Robert Shiller, and he pooh-poohed the effects of interest rates on the P/E ratio. I don’t know enough to have an informed opinion about such effects, unfortunately.

      I am choosing 30 as my cape P/E ratio value for decreasing my portfolio to a 50-50 portfolio, because it is so extreme.

      If the market continues rising past 30 for a long time I will make less money, but I will still be alright. I would feel more strongly about this maneuver if I were already retired and could less afford to lose my stash.

      Incidentally do you have a good source for CAPE Shiller type valuations of non-US markets?
      That’s a rare commodity it seems.

      AZ

      • Robert July 4, 2014 at 5:01 am #

        Sorry, but no info on CAPE for non-US markets. It might be tough to get reliable earnings data for developing markets (some questionable accounting in some places). I’ve been pulling back from foreign investments, after digesting that Credit Suisse report. (Did you ever finish reading it? Thoughts?).

        • Miles Dividend M.D. July 4, 2014 at 12:29 pm #

          I finished reading it, and was not at all persuaded that the US will be unique going forward in any meaningful way.

          In my reading of the report, our outperformance relative to other developed nations was almost entirely attributable to our homeland having never been invaded. (a trait which we share with Canada, Australia, and South Africa.) We are also resource rich which is nice.

          In the end I just have more faith in diversification, than I do in American exceptionalism, so that’s where I’ll put my pennies.

          • Robert July 4, 2014 at 1:38 pm #

            That’s an interesting reaction. My own response is to figure that what has occurred in the past is more likely to continue than for the relationships to change (not that they can’t). It seems almost like saying, “I know that value has worked in the past but I don’t believe in value exceptionalism so I’ll be putting my money in growth in the future.” Would you diversify between value and growth if you knew that the long-term edge was to value?

          • Miles Dividend M.D. July 6, 2014 at 4:42 pm #

            Robert.

            On one level you are of course right. But on another perhaps wrong?

            As of 2012, an investor would have outperformed the total US market with an international allocation of up to 40% due to the diversification benefit. Perhaps that’s not still the case given the recent run of US stocks. (But if you believe higher valuations predict lower future returns, the recent run up in US valuations is hardly reassuring.)

            The value factor has been reproduced in multiple markets and market types. The US (or Australian, or South African) markets outperformance has not.

            By definition in a collection of countries a few countries will outperform over long time horizons. Whether that finding is a random or non random result is the unanswered question.

          • Robert July 6, 2014 at 7:22 pm #

            Over what period are you making that claim (the outperformance of a 40% allocation)? I don’t see it in the Credit Suisse numbers.

          • Miles Dividend M.D. July 6, 2014 at 7:47 pm #

            I believe I remembered that from larry Swedroe’s book, “the only Guide to a winning investment strategy you’ll ever need.”

            And I believe the period was 1970-2012. (The length of time with reliable MSCI data ?)

            Here’s a similar point he makes with a 60/40 portfolio.

            http://www.cbsnews.com/news/how-much-should-you-put-in-international-stocks/

            AZ

          • Robert July 6, 2014 at 7:53 pm #

            This deserves a better answer than I can give now. I’ll try to get back to it, but am leaving in the morning for a two week trip. Part of the answer is that I believe the correlation has strengthened over the years so that the diversification benefit is less, while there still remains some of the other risks of foreign investing.

          • Miles Dividend M.D. July 6, 2014 at 8:04 pm #

            Robert,

            Enjoy your trip!

            We are certainly in an increasingly multinational world.

            And unfortunately, because of this I think the downside risk is quite correlated.

            But to me, the recent dramatic outperformance of the US relative to the rest of the world reaffirms my belief in the diversification benefit of an international portfolio.

            This is my bias. And in the end the difference on our biases is probably hair splitting.

            AZ

  3. Miles Dividend M.D. July 4, 2014 at 12:33 pm #

    Oh, and here is the Shiller interview that I mentioned above vis a vis the predictive value of interest rates.

    http://finance.yahoo.com/blogs/daily-ticker/-it-looks-like-a-peak—robert-shiller-s-cape-is-waving-the-caution-flag-004753218.html?.tsrc=applewf

    • Robert July 4, 2014 at 1:35 pm #

      Thanks for the link. So, who knows when it comes to applying these tools?! What does seem clear to me is that CAPE (or any form of P/E) is well-documented to be an indicator of expected returns, but as for precise market-timing, not so much. If this were/is a bubble, it can inflate beyond anyone’s expectations. P/E on NASDAQ stocks reached well beyond anyone’s expectations in 1999/2000. If you’d bailed based on PE, you’d have saved a lot of angst but missed a lot of the bubble gains. I suspect that in the long run, bailing when PE gets high will probably mean getting out “too early” which will be psychologically difficult as everyone else keeps raking it in, but in the long-run more profitable. Unless you give up and jump back in, which would probably be at the peak. The mirror image of those who give up at the bottom.
      Incidentally, I forwarded the Levkovich comment to Ed Easterling of Crestmont Research (whose books and website I think I recommended some time ago as helpful to me in thinking about PE). He responded that his position has been that PE is driven by inflation (extremes of inflation or deflation result in lower PEs, while low inflationary environments lead to PE expansion), and since that inflation and interest rates are related, normalizing for interest rates would effectively be creating an index of relative value rather than a comparison to historical norms, which is more useful for prediction. So he thinks Levkovich’s analysis is flawed as well.

  4. G-dog July 5, 2014 at 6:19 pm #

    So, after the CAPE >= 30 trigger, when do you move back into more stocks than bonds in your portfolio? CAPE < x….

    • Miles Dividend M.D. July 6, 2014 at 4:22 pm #

      My method. (Which I honestly recommend to noone else.)

      I move back to my base 75/25 portfolio at CAPE < 20. I move to 95/5 when CAPE< 10. (And back to 75/25 when CAPE > 20 again.)

      • Robert July 6, 2014 at 7:22 pm #

        huh?

        • Robert July 6, 2014 at 7:23 pm #

          oh, never mind. You must have edited that since the version that landed in my email box.

  5. Grant July 7, 2014 at 4:00 pm #

    I struggle with this, too. As you may know Larry Swedroe (also my favourite guru, followed very closely by Bill Bernstein), has made two market timing trades in his life. One in 1998, when he sold all his large cap when the CAPE was 25, and bought all small value. He was a couple of years early, but right in the long term. Then a couple of years ago he sold all his REITS, as expected returns were quite low, around 1%. A bit early to judge that one. He strongly advises anyone else not to do this, because of behavioural risks – after 2 years from 1998, what if you had a change if heart and bought back in? So, I have made the decision to stay the course no matter what, but if the CAPE hits 30, I’m sure it will feel like walking off a cliff with my eyes wide open!

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