Index Funds Don’t Work in Bear Markets

This is a guest post from Rob Bennett. In the Carnival of Personal Finance we recently hosted, we included a submission from Mike Piper at The Oblivious Investor that Rob disagreed with. He asked if he could rebut it, and because he largely met the Control Your Cash guest post criteria, we said yes. We then gave Mike the opportunity to rebut the rebuttal. He politely declined, so we’ll consider today’s post to be the terminus of this issue. (So if you want to leave a comment today, you’d better make it count.)

As for Rob, his claim to fame is developing “the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins.” His bio is here.

Some people LOVE a bear market


Mike Piper at The Oblivious Investor blog argues in a recent article that Index Funds Work in Bull and Bear Markets. The argument is that index funds earn the market return and that, if you try to pick good stocks, you might pick wrong and end up earning less than the market return. So index funds are your best choice.

 

I don’t buy it.
If stock investing were not so intensely emotional an endeavor, we would all be able to spot the flaw in this logic chain in 10 seconds.

 

Stocks do not do well in bear markets! Index funds are stocks! You do not want to be invested in index funds in bear markets! D’oh!

 

I have a stock valuation calculator (“The Stock-Return Predictor”) at my web site that performs a regression analysis on the historical stock-return data to reveal the most likely 10-year return for stocks starting from any of the possible starting-point valuation levels. It shows that the most likely annualized 10-year return in 2000 was -1%. Treasury Inflation-Protection Securities (TIPS) were at the time paying a government-guaranteed return of 4% real.

 

That’s a differential of 5 full percentage points of return per year for 10 years running. The investor who chose stocks over TIPS in 2000 was setting himself up to over the course of 10 years lose 50 percent of his accumulated savings of a lifetime. The investor with a $100,000 portfolio was likely to end up $50,000 poorer at the end of 10 years. The investor with a $500,000 portfolio was likely to end up $250,000 poorer at the end of 10 years. The investor with a $1 million portfolio was likely to end up $500,000 poorer at the end of 10 years.

 

Those who appreciate the power of the compounding returns phenomenon will understand why those numbers are only the beginning of the story, not the end of it. Investors who won for themselves a $50,000 differential or a $250,000 differential or a $500,000 differential will be seeing the size of those differentials grow and grow over the course of however many years they will be continuing their walk through the valley of tears.

 

It’s not just crazy Rob Bennett who says that valuations affect long-term returns. Yale Economics Professor Robert Shiller showed this in research published in 1981 and explained why it works this way in his widely praised and best-selling book Irrational Exuberance. There is now 30 years of academic research backing up Shiller’s findings. The latest study making the point is a study by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo. You’ll find that one here.

 

Pfau’s study states: “On a risk-adjusted basis, market-timing strategies provide comparable returns as a 100% stocks buy-and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns…. Valuation-based market timing with P/E10 has the potential to improve risk-adjusted returns for conservative long-term investors.”

 

So we do not need to be invested in stocks via index funds or through any other means during bear markets!

 

Long bear markets are not random events. They only show up following runaway bull markets. And they always show up following runaway bull markets.

 

Pay attention to the price of the stocks you buy, going with a lower stock allocation when stocks are insanely overpriced than you’d go with when stocks are fairly priced or low-priced, and most of the risk associated with buying stocks no longer applies for you. Yet you obtain higher returns! Investor heaven!

 

This approach (Valuation-Informed Indexing) sounds so easy and so rewarding and so rooted in common sense. Why doesn’t Mike Piper follow it? Why doesn’t everybody follow it?
Stock investing is an intensely emotional endeavor. When stocks were priced at three times fair value in 2000, the numbers on the bottom line of the last page of our portfolio statements overstated by a factor of three the amount of lasting wealth we had accumulated up to that time. We all wanted to believe that it was the portfolio statements that had it right and the last 30 years of academic research that had it wrong.

 

We tell ourselves that index funds always work even though there is a voice of common sense within each of us that tells us that it cannot possibly be so. How could there ever be an asset class that is worth buying at any price?

 

Mike uses numbers in his arguments. But it is emotion that drives his analysis of the numbers and it is emotion that makes Mike’s analyses popular with his readers.  Mike and his readers very, very, very much want to believe that index funds work during bear markets. But it is not so, at least not according to the 140 years of historical data available to us today.

In college? Switch majors. TODAY.

 

Did she major in a) philosophy, b) drama, or c) applied mathematics?

Problem: a college’s engineering students have futuristic ideas, but no clue how to monetize them. That same college’s business students have grand capitalistic designs, but nothing to market.

You can probably figure out the solution.

We’ve said repeatedly at Control Your Cash that formal higher “education” isn’t an absolute good. And we’ll continue to put the word “education” in quotes if people are going to classify Montclair State’s “How to Watch Television” as no less worthwhile than MIT’s Atomistic Modeling and Simulation of Materials and Structures. (No dismissive quotes required for that course description.)

State legislators and impressionable parents throughout the country transfer far too much taxpayer money into the pockets of directionless adolescents looking for a place to drink, protest and sleep late while deferring productivity. The tangibly beneficial college and university courses continue to get outnumbered by dross like everything listed here.

And then there’s the Cambridge of the Mojave, the University of Nevada-Las Vegas.
Indulge us with some time for a little local content.

To most people who think about this kind of thing, UNLV is a punchline – a basketball factory, a commuter school for unambitious commuters, the kind of institution that’s emblematic of the same faux learning that we’ve spent the last few paragraphs deriding and whose only redeeming feature is its world-renowned hotel management school.

Not quite. UNLV is also home to a groundbreaking program that should revolutionize post-secondary education: a partnership between the two most crucial schools at the college, engineering and business. (UNLV doesn’t teach medicine.)

(Note: Control Your Cash co-founder Betty is also a co-founder of UNLV’s Center for Entrepreneurship, known colloquially as the “E-Center”. Betty attended Northern Arizona University for one semester, realized her fortune lay elsewhere, and sought and achieved it. With no student loans to worry about paying off. Years later, she realized that the common financial sense she implemented in her own life barely existed in academia. But rather than dismiss the typical university education as largely pointless, she committed resources to finding a way to make it meaningful.)

The UNLV engineering/business partnership began as the fusion of two separate but easily unifiable ideas. Since 2000, the curriculum requires senior engineering students to form small teams and enter a design competition. Simply put, the teams have to invent something practical. And their brainchildren have been not just feasible, but inspiring: a cane that uses sonar (for blind people), motorcycle headlights that see around corners, etc.

A few hundred yards away, business students were doing something similar: creating plans and projections for potential businesses. The last couple of years your humble bloggers have had the pleasure of serving as judges for the business students’ contest, and we’ve seen some impressive proposals. They include the group that was going to import and distribute a revolutionary weatherproofing compound from South Korea, and the “micro-farmer” team who wanted to grow vegetables on abandoned urban lots. Some of the other ideas were less marketable than they were creative, still others were quite the opposite. But the very act of conceiving and developing these ideas did and will do far more good for the world than the nearby English class looking for meaning in the short stories of Jack Kerouac.

The trouble was that none of the engineering projects ever got off the ground. (Figuratively speaking, particularly in the case of the dolly that lifts 300-pound payloads 3 feet in the air.) Meanwhile the business projects, while some of them had potential, weren’t exactly recalibrating the boundaries of human endeavor.

So the deans of the departments got together and meted out a little interdiscipline. For full credit, the engineering students had to partner with the business students (and vice versa) to develop a viable plan. For the engineers, it meant developing an appreciation for normally mundane tasks like securing warehouses, filing paperwork, and learning how to market. For the aspiring MBAs, it meant gathering the requisite technical knowledge about how moneymaking gadgets make money. (Dr. Andrew Hardin, director of the Center for Entrepreneurship, got the inspiration for this from a similar program at Washington State University.)

You need both the yin and the yang. This is just one of countless examples, but there’s a $500 Universal Corporation all-in-one remote control at Control Your Cash headquarters that contains 43 buttons and 6 screens, most of which never get used. The device is supposed to control the TV, the DVD player, the satellite radio, the AM/FM, the CD players, the iPod and probably one or two other things. Three years in we still haven’t mastered this leviathan of overengineering, because we can’t be bothered to spend the necessary couple of days decoding its indecipherable user’s manual. Seriously, we don’t need 80 equalization pre-settings (“Classical”, “Bass Reducer”, “Sports”) for the tuner. We’re not Jimmy Iovine.

A competent business management team would have simplified the remote while maintaining its primary selling feature – the ability to control every electronic component in the house. The team would have hired an erudite technical writer to translate the instructions into something a layperson will want to comprehend, and packaged the remote as something more necessity than luxury. We can only wonder what engineering breakthroughs never make it to market, for lack of marketing.

When teachers’ unions in your state complain that you need to fork over more tax money for education, ask them if and how they’re prepping kids for crucial programs like UNLV’s engineering/business partnership. And making a legitimate difference in the world, not a theoretical one.

TONIGHT, the winners of the 2011 competition do a dress rehearsal for the forthcoming tri-state competition. If you’re in the neighborhood, swing by and see how the future doesn’t merely appear.

**This article is featured in the Totally Money Carnival #21-Memorial Day Edition**

**This popular post is also featured in The Carnival of Wealth #42**

Sometimes, an education is the worst thing you can have.

Professors Snider and Cooper were right. Be chrool (sic) to your scuel (sic).

DISCLAIMER: (And we disclaim things so infrequently, you know this is big.) This post references and links to a story that originally appeared in the Las Vegas Review-Journal, a paper that treats even hints of copyright violation the way Genghis Khan treated Central Asia. The R-J and reporter Richard Lake provided much of the raw material for this post, as did the unfortunate MySpace page of the post’s protagonist.

Time for a painfully simple exercise. We’re going to give you a series of words – concepts, really. Then say whether each is good, or bad. Look at each one irrespective of anything else. Here’s an example:

Clean air – good or bad?

Don’t overthink it. It’s not “clean air, but what about all the manufacturing jobs that will be lost if the parts of particulate matter per million rises a tiny fraction?” It’s simply, “clean air”.

Understand? Answered it? Then let’s go.

Puppies – good or bad?
Ending terrorism – good or bad?
Education – good or bad?

Slow down there, Ace.

After years of real-world examples, there’s no getting around it – all levels of government spend far too much taxpayer money to put people in classrooms where they’ll neither do anything productive nor develop the capacity for doing anything productive.

(People are going to misinterpret this post, and they’re going to start by misinterpreting that line. We’re not saying elementary schools shouldn’t teach basic math and grammar. We’re saying college is more often than not a waste of time.)

In the last century, college/university has gone from a place where you learn a profession, to a mandatory rite of passage for kids with good grades who come from white-collar families, to a mandatory rite of passage for everyone, to a necessity no less fundamental than food and water.

That’s wrong on several fronts. Amassing debt before entering the real world isn’t necessarily bad, but the debt has to have a purpose. Seeing as this post is about education, let’s use a SAT analogy:

Borrowing money to buy a house : borrowing money to buy lottery tickets :: borrowing money to study engineering : borrowing money to study sociology.

No matter how hard we hammer the opposite point, some commenters are still going to miss it, and lament that we’re downplaying the importance of education. Again, we’re not. But the unalloyed word “education” isn’t always an absolute good.

Meet J.T. Creedon, student government president at the College of Southern Nevada. Guess how many years he’s been going there.

No, higher.
10. That is not a typo.
He’s 28 years old.

(We can only speculate as to how many of the people who voted for him wouldn’t have voted for John McCain for president because he was “too old.”)

Education, ideally, is a financial investment for the educatee: make little money for 4 years, so you can make a lot more money for 4 decades. Sure, there are purists who don’t concern themselves with such philistine values, and who argue that the trivium and quadrivium are ends in themselves – and that education for its own sake is our very purpose here on Earth. This argument will be valid the moment classrooms build themselves and professors forgo salaries.

The economic argument occasionally carries weight among the purists, if they can use it to serve their own ends. Money becomes suddenly important to some people when the possibility of losing it presents itself.

The legislators and executive officeholders in Nevada, like those in a lot of states, spent far too much taxpayer money during the good years and now face a budget crisis. In Nevada, education makes up 28% of the state budget.

To hear the pro-“education” forces, if you want to deny unlimited funds for students, teachers and administrators; or even get the percentage down to 26 or so, that means you want children to be illiterate and innumerate.

First, tens of millions of kids already are illiterate and innumerate, with no incentive for them to read, write, add, divide and calculate square roots. Read Facebook, Twitter, MySpace (especially MySpace, where we’re pretty sure you need to be convicted of a felony to open an account) or the comments on any site other than Deadspin if you don’t believe us. Most of these kids’ parents aren’t exactly qualifying for Rhodes scholarships themselves.

Creedon is exactly the kind of person that a blanket funding policy attracts, and helps render financially impotent. Creedon had only moved to Nevada when – well, when he was an age at which most community college students are a year from graduating. Now at 28, he’s not close to done. From the Review-Journal:

(H)e’s probably going to leave for an out-of-state university.
“I really want to go to a place where it’s a little more stable for the next two years,” he says.
He’s applied to universities across the country, from New York to Texas to Washington state. He’s received one acceptance letter and waits to hear from the rest. He also applied to UNLV, but that’s just his safety net in case he doesn’t get in anywhere else.

Again, 28. An age at which:

  • Steve Jobs had already sold millions of computers, taken Apple public, and ceded operational control of it to a professional CEO;
  • George Harrison had embarked on a solo career, because the Beatles had already broken up;
  • Steven Spielberg had directed Jaws, then the biggest-grossing movie in history;
  • Theo Epstein was responsible for the day-to-day operations of the Boston Red Sox;
  • Thousands of other people were doing something productive.

But hey, Creedon’s getting an education. Given that there’s a positive correlation between duration of post-secondary study and real-world success, those eventual 12 years in the classroom will certainly make Creedon a bigger star than Jobs, Harrison, Epstein and Spielberg combined.

We don’t mean to use an outlier as indicative of an entire group. Instead we mean to show that Creedon’s no outlier. His eventual diploma, should be ever earn one, will be in history and/or political science. That puts him square in the majority of unproductive, barely employable college graduates, but 95% of students at his college never graduate (necessitating the rare bold/italics/underlining hat trick.) Our educational system doesn’t merely turn these dropouts out by the myriad, it does so for obscene prices – both in terms of taxpayer wealth confiscated and of student loans incurred.

The president of Creedon’s actual college – not merely that of the student government – has that analytical flair that academics are famous for (again, from the Review-Journal):

Already, the college had to turn away 5,300 students in the fall.
“Had we been able to accommodate those students, our enrollment would have been much higher,” (Michael) Richards says.

They should phrase Richards’ statement as a true/false question in one of the community college’s introductory math tests.

What makes J.T. Creedon reprehensible is…well, several things and they’re difficult to rank, but what struck us hardest was his insistence on taking the moral high ground of concerning himself with the nebulous well-being of others, rather than looking at the financial necrotizing fasciitis case in the mirror. He publicly advocates securing ever more funding for students such as himself – oblivious to the reality that his own example is as strong an argument as any for gargantuan financial cuts.

This world would be a far better place if people took care of their own business first. J.T. Creedon is welcome to save the world from a shortage of overlearned, underexperienced waiters and retail clerks. That he feels an obligation to do so while taxpayers continue to wean him, well into adulthood, is his problem, and ultimately society’s.
—————
If your kid says he wants to go to college, or even merely thinks that that’s what you’re supposed to do when you get out of high school, part of being a parent is assessment and counsel. J.T. Creedon could have spent $3000 to enroll in truck driving school a decade ago, graduated with a commercial license a month later, and at the absolute minimum made $600,000 since then.

Heck, J.B. Hunt would have paid for his schooling, requiring only a one-year apprenticeship and allowing Creedon 9 years of freedom. But truck drivers never get on TV, nor do they have the luxury of organizing protests. They’re too busy delivering the food and drink that parasites require to survive.

Creedon could have learned to deal blackjack in even less time than it takes to learn to drive a truck. He could have done so for far less money, but with similar earning potential. (Albeit without ever seeing daylight nor breathing clean air. We live in a world of tradeoffs.)

Society can’t function without physicians and pharmacists. Nor without contractors and carpenters. But it’ll do just fine without directionless leeches.

This was Part I of a two-part series on higher education and how it pertains to the financial life of either you or the 20-something in your life. Part II, which is a lot less depressing than Part II, goes live Monday.

**This article is featured in the Yakezie Carnival on Judgement Day 2011**

and

**The Carnival of Wealth #40-Memorial Day Edition**