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One of the most dependable rules of investing is that stocks as a whole revert to their mean price-earnings ratio over time. When stock prices are high compared to company earnings, on a historical basis, you can count on prices to come down in the long run.

But why?

Is the barrier to permanently higher price-earnings ratios a physical or psychological one?

If the barrier is physical, what might it be? During times of stock bubbles I never see stories about a physical limit being hit.

So the limiting factor to upward price-earnings growth, once you are beyond the historical mean, must be purely psychological, right? If everyone bid up the price of stocks and agreed to keep them high, prices could stay there indefinitely.

For this discussion we can’t ignore alternative investment opportunities. It only makes sense to own stocks if the alternatives are worse. So the alternatives exert an invisible hand to keep stocks modestly priced in the long run.

I’ll accept a 3% tax-free return on a safe investment such as a municipal bond, but I want an 8% return on something risky such as stocks. So as long as the risk-reward ratio of bonds stays put, it limits how much the rational investor will be interested in stocks. I would take a medium-sized risk for a potential 8% return but I wouldn’t take a gigantic risk for that kind of potential payoff.

So stocks are anchored by peoples’ risk-reward reflexes and a sense of the alternatives. But in theory, if the risk of owning stocks became lower for any reason, people would perceive a better risk-reward ratio and bid up the price of stocks.

And that means that if we humans can figure out how to remove any risk from stock picking, the value of stocks will increase, and stock owners will become wealthier with no other change to the environment.

So what makes stock investments so risky?


Answer: professional investment advisors


An investment advisor needs to justify his pay, and that means pretending to have stock-picking magical powers that science has never discovered. Every study on the topic shows that the professionals generally don’t beat the market average over time. But they do cause a lot of churn that causes a lot of unnecessary taxpaying on gains. And the professionals charge enough to take perhaps 25% of your potential annual gain in fees.

Meanwhile, wise people such as you buy your market index ETFs and avoid all of the risks injected by the professional investment advisors. But your potential stock gains are suppressed because so many other people are using professional advice and losing money. That makes the category of “investing in stocks” look riskier than it is.

So my suggestion for permanently lifting the value of the stock market to new sustainably high price-earnings ratios is to pass a law making it illegal to offer financial services without disclosing the truth – that they are mostly a waste of your time.

The reason it is legal to open a palm reading shop is that the public understands it to be entertainment and not prediction. Investment advice should be the same situation: You can buy investment advice if you want it, but not until you sign a document acknowledging that science says no one has magical stock-picking skills.

I know you don’t like big government getting involved when it isn’t needed. But the financial industry as it stands now is the world’s biggest scam, and most of us agree that the government is the right agency for rooting out crime, pyramid schemes and the like. And I think most people would agree that putting warning labels on cigarettes, and nutrition information on food, has served us well. It’s time to do the same with investment advice.

I think the government could do for investment advice what it did with the food pyramid. Ignore for the moment that the food pyramid was done wrong because we didn’t understand the science; the idea of the food pyramid was excellent. We don’t have the food pyramid problem with investments because the science of stock picking is settled: It doesn’t work. So I believe the government could produce a simple investment chart for the public that shows most people should own broad market ETFs under a certain set of simple conditions. Or perhaps the government could develop twenty-or-so example portfolios for different family situations and you just need to pick one that is similar to your situation. That would be far better than today’s system in which people either get no investment help or they pay an investment advisor who actively harms them.

Once society gets rid of the risk of professional investment advice, stocks should go to a permanently higher price-earnings ratio. Given the massive dollar amounts in the investment economy, this instant increase in the value of stocks would have an enormous impact on humanity.

Let me boil this down to one question: Do you think the government should require investment advisors to disclose to customers that their services are proven by studies to be harmful to your wealth?

 

UPDATE: By one measure (CAPE) stocks have been historically overpriced for the past 20 years. One could argue that being overpriced for 20 years means stocks have moved to a new and somewhat "permanent" higher value. The past 20 years also correlates with the biggest improvement in small investor knowledge, specifically the knowledge that ETF and index investing is better than hiring stock-pickers. This is merely correlation not causation, but according to my hypothesis in this post one would expect to see permanently higher stock values as investor ignorance -- and the risk that comes with it -- is reduced.

-------------------------

Scott Adams

Co-founder of CalendarTree.com

Author of this book

 

 P.S. Sorry about the formatting of the post. Technical problems today.

 
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Aug 10, 2014
You first need to make a distinction between brokers and investment advisors. They are two different breeds, with extremely different fiduciary responsibilities.

A broker is, at heart, a salesperson. They have a fiduciary responsibility to their company, not to the investor. The only requirement that a broker has to an investor is to ensure that the product he or she is selling is "suitable and appropriate" for the client. Yes, I know; that definition leaves a lot to be desired. Brokers are paid by commission on what they are selling.

Compare that with an independent financial advisor. Their fiduciary (legal) responsibility is much different. An IFA's responsibility is to their client, not to their firm. Their advice legally has to be in the best interest of their clients. They are paid a fee based on their clients' assets under management; they don't sell you anything. They manage your portfolio, building it based on your goals and risk tolerance, rebalancing it based on formula they use.

Some people can handle volatility better than others. What Scott seems to want is an investment advisor who would give him a constant, 8% return that never drops below 8%. Then, he'd figure the system isn't rigged. But hit a rough patch, and voila! There has to be market manipulation. As my financial advisor says, there's no complaining when you have upward volatility; only when you have downward.

But over time, the stock market (and other investments) go up. There has never been a ten-year period where the stock market hasn't increased in value. But there have been a lot of two or three year periods where it has. So if you look at investment as a two-to three year window in which you, like Scott, need well above-average returns with no risk, then you're going to try to gamble on a particular mutual fund, or even individual stock, and over time you're going to lose.

As Scott correctly points out, although misconstruing the reason, if a person whose profession is managing stock funds can't pick them correctly, then what chance does a casual investor have?
So how do people react? They set themselves up for a sales pitch, and go to a broker. They want to believe that they can beat the odds, just like they do when they go to Las Vegas.

Now, to Scott's question. I am not big on government regulations, and think that the financial industry is overregulated right now. That stifles the economy because financial institutions are so hog-tied that they are afraid to lend money unless a person or company doesn't really need it. Moreover, government generally causes more problems than they solve. Just look at the impact the Community Reinvestment Act had on the housing bubble.

At the same time, consumers need to educate themselves on something as basic as the different fiduciary responsibilities of a broker versus an IFA, but in the end it's still an individual choice.

There has been a move to change the broker responsibility to match that of an IFA. Of course, the big brokerage houses have fought that move tooth and nail. A lot of that comes from their obvious desire to drive profits, but some of it makes sense. If you work for company 'A' and you think that company 'B's investment options are better than yours are for a particular client's risk tolerance and goals, is it then your responsibility to say, "Hey, we suck. You ought to go over there?"

But I come down on the side of disclosure and responsibility to the client. I have no problem with sales; my civilian career has been in sales. But when you're dealing with someone's financial future, and have as your first responsibility selling your product whether or not it fits the client's needs, there's something wrong. Take a look at what a broker gets in commission for selling you an annuity. If you invest $100,000 in an annuity, your broker may take home $20K.

That kind of thing needs to be disclosed. I would support a change to the rules that would require brokers to disclose their fees and commissions up front, and change their financial responsibility to include the client. There's a world of difference between "suitable and appropriate for" and "in the best interests of" the client.

At the same time, individuals have the responsibility to educate themselves, at least basically, in finance and investing. Personal responsibility requires it, and you can only make informed decisions if you understand the basics.

Here are three books I'd recommend everybody read: "The Millionaire Next Door" by Dr's. Stanley and Danko; "Smart Couples Finish Rich" by David Bach (another in the series is "Smart Women Finish Rich" for our lady readers); and "The Truth About Money" by Ric Edelman. Read these three and you'll have a good idea of how to start planning your financial future.

 
 
+3 Rank Up Rank Down
Aug 10, 2014
I think the case is not as clear-cut as you present it here:
- P/E rations are neither "physical" nor purely psychological - most often they are simply a stand-in for the risk/reward ratio. So, let's go from there, since you seem to have that mixed in too.
- Equity and bonds have different risk/reward ratio. This is by their nature and enforced by law. In case of problems, equity pays debt. In order to make it attractive nevertheless, there's no limit on the profits and no maturity either, so that equity investors can demand proper compensation for the risk they are assuming.

Therefore, any sanely financed company, equity is more volatile than bonds. To compensate for this, equity investors demand a higher yield. So, there is your case for equity having a higher yield (P/E) than bonds.

No advisor required, just fundamentals. I don't think advisors damage the market more than other investors, at worst they add some random noise, but not much. Most ot the shares today get moved by big institutional investors.
 
 
Aug 8, 2014
Try this: http://www.amazon.com/Valuation-Measuring-Managing-Companies-Edition/dp/0470424656

Stock prices (long term) are a function of real cash flow earnings. The risk comes from the necessity to predict future earnings (and therefore future company value) to determine what you should pay today for the stock.

Your complaints about the stock brokers have to do with the fees, etc, that siphon off your returns. They don't actually influence pricing. The guys setting the (long term) prices aren't the ones paying the trading fees.
 
 
Aug 8, 2014
Telling the government to regulate the stock industry, presently, would be like telling each individual politican involved in the process of making this change to take a good chunk of their assets and future options and throw them out the window. They're not going to do it. It takes their options and gives them to us. The way it has always worked is they benefit at our loss, not the other way around.

The obvious and right thing to do, which we can count on Bernie Sanders (the court jester of American politics) to point out, is the thing we all know they will never do.

So you have an excellent idea, Scott, but the more important question is: how can we make something like this happen?
 
 
+7 Rank Up Rank Down
Aug 8, 2014
So..., foxes telling the chickens to look out for the other foxes?
 
 
Aug 8, 2014
@FransV
Firstly, excellent scenario there.
Your strategy was one of relying on dividend income to pay your retirement expenses, hence if stock prices go up AND you retain the same strategy, your are indeed "poorer". Here's the solution:

Lets say that when you bought the stocks at the original-prices, each dollar invested gave you 4-cents in dividends (i.e. a 4% dividend yield). Now one day, stock-prices double (but company earnings & hence dividends remain the same). The dividend yield on the current price works out to only 2%. As you point out, you would have to invest twice as many dollars to get another 4-cents of income.
HOWEVER, you can sell-off your old-shares and put the money into an other income-generating investment. Say, long-term bonds, a pension plan or rent-yielding office buildings. Lets say, the traditional "safe" investment - long-term US government bonds - give you only a (say) 3% return. But every $1 you invested in stocks is now $2. So each former $1 that you invested, will now yield you income of $2 x 3%= 6-cents. So by switching from stocks to bonds, your income goes up 50% from 4-cents to 6-cents. And whereas you were earlier half-way to your goal, you are now 3/4th of the way to your goal.
Plus, you are in a safer investment that you were in earlier.

Stepping outside your scenario:
High P/E stocks have poor dividend yields and are a wrong choice of investment if your aim is a stable annual income TODAY. These stocks work out only IF they multiply in price, allowing you cash out say $3 or 4 for every $1 invested by the time you're ready to retire. These $$ then go into a nice fixed-return product - a pension plan, rented-property, bonds, bank deposits etc. which gives you a stable income on retirement.

If your formerly low P/E stock becomes a high P/E stock and you are close to retirement, it would probably make sense to cash out. If you have time to retire (5-10 years), then you need to assess whether, despite the high P/E, can the company's value go up faster than the interest rate I can earn on a bond or lease-income on a property.
 
 
Aug 8, 2014
"stocks as a whole revert to their mean price-earnings ratio over time".
But this reversion does not always mean that prices come down, earnings can go up. Take a 20 P/E stock which becomes a 13 P/E stock in 3-years, but its earnings double in the same period. The price would still have appreciated by 30%, even though the P/E ratio crashed. (Your original assumption is still valid for probably 7 or 8 out of 10 cases though - earnings often don't grow fast enough to justify high P/E ratios).

Second: being a little pedantic here, Professional Advisors add "Cost" rather than "Risk". 9.5 times out of 10, removing that "Cost" will no doubt improve investor's returns. Part of the cost-saved may well translate into investors paying higher prices for stock, so P/E ratios may well go up. The risk will not have changed much though - it will still depend on business performance, the economy and "market sentiment". Also, long-term returns to investors will not change much if P/E ratios "permanently" go up; you will be both buying and selling and higher P/Es. Returns on legacy investments will be boosted, but on "new" investments will even out.
 
 
+11 Rank Up Rank Down
Aug 7, 2014
Remember that investment advisors are often part of your brokerage.
Your brokerage gets a fee every time you buy or sell a stock.
Effectively, the person giving you advice makes money (and you lose money) every time you buy or sell a stock on their recommendation!
Oh, and if you buy a stock and then sell it for a gain less than a year later, you pay higher taxes.
I used to work at a CPA firm doing taxes, I did the taxes for a widow and her two kids who let the broker just buy or sell with carte blanche, he ate up 90% of the account in brokerage fees and taxes over the course of 16 months...
It is called "churn and burn."
 
 
-4 Rank Up Rank Down
Aug 7, 2014
Let's say I'm halfway to retirement. I've bought enough shares so their dividends will pay half the income I need to live on. I need to double my investment to be able to retire comfortably

Suddenly (this year) the risk reduces drastically, and my shares consequently double in value.

Now I own the same shares, worth twice as much, but still delivering half the income I'll need to retire on.

Just like last year, I still need to double my investment to be able to retire, however, the cost of doing so has suddenly increased to double what it was before, and my salary somehow hasn't.

I would say that I've just become poorer, because in order to buy enough shares to be able to retire, I'll have to spend a much larger portion of my disposable income. Am I wrong?
 
 
+39 Rank Up Rank Down
Aug 7, 2014
I think your post is well intentioned, looking out for low information persons.

personally I'm more concerned about a psychological effect: low information persons believing govt will protect them instead of taking personal responsibility for their own life.

I lived in Europe for a couple years. You not only don't see warning signs for obvious dangers (like a rickety tower), you also don't have handrails for them. You generally don't hear about Europeans dying of stupid accidents because if you don't think you have Big Brother looking over your shoulder you actually take some care.

The unintended consequence of a robust Big Brother who puts up warning signs everywhere is that ppl think its McDonald's fault when some idiot spills coffee on themself. These ppl are insane, and they have one hell of a knee-jerk reflex when things go awry. They don't believe in bad luck or misfortune, they worship the deity of blame, because that's the paradigm the US govt is conditioning them to see.
 
 
Aug 7, 2014
@Admiral
Warren Buffet has said something to the effect that "for a given amount of earnings, the more assets (book value) a company has, the less it is worth."

Just thought of one more thing.
If two companies earn the same year-on-year. One pays out all its profit as dividends, the other does not pay any dividend. By your measure, the price of the company paying out dividends evey year will never rise. The other companies price will increase every year even though it does not give anything to its shareholders.
 
 
Aug 7, 2014
@Admiral
Warren Buffet has said something to the effect that "for a given amount of earnings, the more assets (book value) a company has, the less it is worth."

Just thought of one more thing.
If two companies earn the same year-on-year. One pays out all its profit as dividends, the other does not pay any dividend. By your measure, the price of the company paying out dividends evey year will never rise. The other companies price will increase every year even though it does not give anything to its shareholders.
 
 
Aug 7, 2014
@Melvin1

No argument. Just a polite discussion.

a) Index funds do contribute to price discovery vis-a-vis the other stocks (the stocks which are not constituents of the index).

b) I agree with you that what matters in the end is whether with or without an advisor, you are better or worse off in the end. I was just trying to give a better idea of the costs involved in the whole exercise; the one per cent figure can be quite misleading.
 
 
Aug 6, 2014
@Admiral.

So Wally's stock has a book value of $10, and generates $5 in dividends, and you only want to pay him $15 for it? What if I'm willing to pay $20? And maybe somebody would be willing to pay $25. Are they not allowed to buy the stock?

So, maybe now you can see that, in fact, it is YOU that wants to set and ARBITRARY price on the stock. In your proposed world, you have dictated from on high that all stocks should trade at book value plus 1x earnings. Where did you come up with that? Sure, you probably just threw a number out there, but that's the rub. Any formula you come up with is exactly what you don't want - arbitrary.

Conversely, in a free market, the share price is based on what the company can earn, adjusted for the uncertainty of those earnings. What's more, in your world you are valuing the company based on what it has done in the past, so we would be paying high dollars for Nokia right before the iPhone came out, or Barnes & Noble right before Amazon emerged.

Sure, the stock market is messy and disorderly, and there are charlatans on every corner. Guess what - that messy, noisy, volatile, BS-driven market has a much better chance of properly assigning a value to a stock than any individual, elected official or rigid formula you can come up with.
 
 
-2 Rank Up Rank Down
Aug 6, 2014
@Tonyo123... Not following... Is it because I was trying to illustrate an example of an alternate way for the stock market to work? Using a very, very truncated view, So that our economic system isn't continuously being bunghole-rammed by all the evil that money creates? Please help me understand your statement. Also, read my other post firs.
 
 
Aug 6, 2014
THIS is why i teach a short economics class each year to the seniors at my kid's school

@AtlantaDude: Ok, I'll give and example....

No one is going to take the company public with just a few desks and computers. That's the job of the VC's and Angel investors. And this isn't the 90's.

I'm talking about a company that has value, revenue and for lack of a better term, an actual business.

Now let's say this business called Dogbert Corp. wanted to sell off part of its revenue (ownership) in exchange for a lot of cash now. They offer their shares at $10 each and there is 1 million shares put out on the market, thereby generating a potential 10 million dollars.

Let's say Wally purchased 10 shares for a total of $100. So far the math works.

Now as part of a publicly traded company, the value of those shares are recalculated each month whereby they report their earnings to Uncle Sam. Through the miracle of book cooking, that value and sway wildly or marginally. I'm assuming there are FCC rules covering the recipes you can cook the books with.

So, let's say next month the value of each share is calculated at $15 per share. The value is calculated by looking at the profit earnings of the company. Not the value of the company. So, desks and computers don't count. Just the profit from the revenue.

Woohoo! Wally sees that he's made $5 per share for an increase of 10 x $5 = $50. Wally needs to pay off his bookie and sells his shares that month and cashes them all out. When someone sells something, someone buys something. So, Loud Howard sees a future in this company and wants to buy shares. He sees that the going rate is $15 and there is a block of 10 shares, he buys them. Wally unloads this turd of a stock and Loud Howard tells Topper of his genius buy.

The difference here is that the value of the stock is based on the performance of the company, not the arbitrary value of buying and selling shares to drive the price up or down. A business is NOT a commodity. There is no supply and demand of businesses.

All this and I only have an Art degree. But at least it's a Fine Art degree.
 
 
-6 Rank Up Rank Down
Aug 6, 2014
@AtlantaDude: Ok, I'll give and example....

No one is going to take the company public with just a few desks and computers. That's the job of the VC's and Angel investors. And this isn't the 90's.

I'm talking about a company that has value, revenue and for lack of a better term, an actual business.

Now let's say this business called Dogbert Corp. wanted to sell off part of its revenue (ownership) in exchange for a lot of cash now. They offer their shares at $10 each and there is 1 million shares put out on the market, thereby generating a potential 10 million dollars.

Let's say Wally purchased 10 shares for a total of $100. So far the math works.

Now as part of a publicly traded company, the value of those shares are recalculated each month whereby they report their earnings to Uncle Sam. Through the miracle of book cooking, that value and sway wildly or marginally. I'm assuming there are FCC rules covering the recipes you can cook the books with.

So, let's say next month the value of each share is calculated at $15 per share. The value is calculated by looking at the profit earnings of the company. Not the value of the company. So, desks and computers don't count. Just the profit from the revenue.

Woohoo! Wally sees that he's made $5 per share for an increase of 10 x $5 = $50. Wally needs to pay off his bookie and sells his shares that month and cashes them all out. When someone sells something, someone buys something. So, Loud Howard sees a future in this company and wants to buy shares. He sees that the going rate is $15 and there is a block of 10 shares, he buys them. Wally unloads this turd of a stock and Loud Howard tells Topper of his genius buy.

The difference here is that the value of the stock is based on the performance of the company, not the arbitrary value of buying and selling shares to drive the price up or down. A business is NOT a commodity. There is no supply and demand of businesses.

All this and I only have an Art degree. But at least it's a Fine Art degree.
 
 
Aug 6, 2014
@Admiral

So, if there is a young publicly traded advertising agency that basically has no assets beyond some desks and computers, and it pays out it's earnings in dividends, the stock price is forever fixed based on what those desks and PCs are worth?

If agency grows and has $1 million dollars worth of desks and PCs, and it generates off $5 million worth of earnings every year, the stock is only worth $1 million? So, you are saying that if there are 1 million shares, and the dividend is $5 per share, the price of the stock is fixed at $1 per share? In your scenario, how would you stop someone from offering me $2 for the right to receive $5 every year? And, if you could somehow stop it, what would my incentive ever be to sell the share of stock at the fixed price? Does every share have to go to the grave with the original shareholder?

And, if I am a founder of the company, and I spend $1 million to furnish it with desks and PCs, are you telling me the most I can ever sell my company for is $1 million? What's my incentive to start a company?
 
 
-4 Rank Up Rank Down
Aug 6, 2014
The stock market probably had good intentions when it was created. It provided a way for businesses to offer percentage ownership by selling off small slices of itself. However, over time, the human spirit of greed took over and it has now become a volatile cesspool of all that is wrong with our economy.

Without going to much deeper in to its flaws, here's a simple fix that would solve just about all the problems, though it would be impossible to implement due to the greed and self-interest of too many people.

Instead of arbitrarily assessing the value of a company based on the fluctuating stock price, the value of the stock is based on the actual (book) value of the company. Ta-da!

Furthermore, to be publicly traded, a certain percentage of ROI would be expected based on profitability each quarter or monthly. If the company needs to raise more capital, they can release more shares of the stock, diluting its value, but still gaining revenue. Likewise a company can purchase back shares either from shareholders (who basically cash out their stock) or any outstanding shares. The value of each share would then go up. This gives the company the incentive to be a strong, well run business that looks for the long-haul potential and not just the short-term F.U. where they do anything for profits including killing the company so the shareholders (namely the executives) try to cash out quickly for all its worth.

This would also decrease the income gap and force a company to pay a CEO a reasonable salary instead of bazillions of dollars for who knows what.

This simple alteration to the stock market and how it functions would solve a great many problems facing the world economy today and for future generations.

Oh, there is one difference, commodities kind of work the same way as they do now... think corn is a big thing, invest in that commodity. If you're going to gamble, do it with something that has a tangible item. But do not tie it to a persons saving or retirement investment portfolio.

Lastly, to address Scotts article... if you give your money to someone to make you money, all you're doing is giving them your money so they can make more money for themselves. You're job is to take it in the shorts.
 
 
+9 Rank Up Rank Down
Aug 6, 2014
@hbmindia - I don't mean to start a argument, but you are mistaken on a couple of counts:

It's interesting that you perceive that "most of the so called financial advisors are thirty-something year old kids." Perhaps these are the newbies cold-calling you. But the ACTUAL average age is 50.9 years old. (Financial Advisor magazine - other sources peg it at 53).

Also, index funds do not contribute to price discovery because they are not deciding which stocks to buy based on analysis. Similarly, a fund that bought randomly or alphabetically wouldn't contribute. To make the market [somewhat] efficient, you need speculators or at least people doing fundamental analysis.

And your concept of giving 26% over a thirty year period assumes that the investor would have achieved the same results without the advisor, which misses my point about most people doing worse without guidance. I believe this is a Logical Error - the number is irrelevant; if you do worse, then you're worse off.
 
 
 
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