FIRE Beyond Dual Portfolios

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JWR1945
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FIRE Beyond Dual Portfolios

Post by JWR1945 »

FIRE Beyond Dual Portfolios

A. The Dual Portfolio Concept
a) Traditional safe withdrawal rate analyzes have examined a single portfolio of stocks and some cash equivalent (such as commercial paper).
b) With only a few exceptions, the single portfolio is re-balanced annually.
c) The dual portfolio concept introduced a second, cash-only account. Although one re-balances the stock portfolio annually, the allocation of the overall portfolio varies.
d) By withdrawing from the cash-only account during the first few years of retirement, you can allow the stock portfolio to grow unhindered.
e) A natural outgrowth of using dual portfolios is to introduce thresholds. When I mention using special thresholds, I mean that you convert your retirement account entirely to cash whenever the balance is high enough. When I mention using thresholds or standard thresholds, I restrict those conversions to specific times, such as 20, 30 or 40 years into retirement. The main reason for looking at standard thresholds instead of special thresholds is that it makes data collection and analysis easier. It helps me reject bad test conditions quickly.
f) It turns out that the idea of using thresholds is much more important than using dual portfolios...although using dual portfolios can help you.
B. What we have learned
1. Thresholds are important.
a) I have examined a variety of approaches.
b) There are usually significant differences prior to using thresholds.
c) Applying standard thresholds (very roughly) reduces the number of failures by 25%.
d) Applying special thresholds (very roughly) reduces the number of failures by 50%.
e) Almost all of the differences among approaches disappear when using thresholds.
2. Data and theory are consistent.
a) The theory examines a volatile component with high growth (stocks) and a non-volatile component with little growth.
b) Safe withdrawal rate studies focus on the trade-off between these components.
c) What hurts portfolio safety is the sale of large volumes of stocks when prices are low.
d) The non-volatile component reduces this effect. But it also reduces the growth rate of the overall portfolio.
e) Using thresholds take advantage of the times when the stock prices are high. There are good times as well as bad.
f) Using thresholds removes portfolio failures that would occur in the later years. A larger effect would be necessary to remove early failures.
3. Analytical conditions should not be used in real life.
a) Traditional studies have used bad investment strategies.
b) These strategies are very good for academic purposes. They are simple and transparent. It is relatively easy to identify cause and effect relationships.
c) They use the equivalent of dollar cost averaging...but in reverse. Dollar cost averaging reduces the average price of shares purchased. Using the same approach during distribution reduces the average price of shares sold.
d) Some details are left out. For example, there are no charges (transaction costs) for re-balancing the portfolio.
e) Traditional studies make no attempt to optimize the non-volatile component (cash equivalents).
4. You have many choices.
a) You can retire earlier by working part time in retirement (semi-retirement).
b) It does not matter very much whether you satisfy an initial deficiency in your retirement account right away or a decade later...just so that you do so eventually.
c) My studies show that you can easily start retirement (actually, semi-retirement) this way with only 80% of the traditionally calculated amount of money. You do have to add the remaining 20% eventually.
d) My studies also show that you can reasonably start retirement (semi-retirement) with only 60% of the traditionally calculated amount of money. There are some special considerations. You do have to add the remaining 40% eventually.
C. What looks promising.
1. We can increase diversification.
a) Using thresholds takes advantage of the upside of stock volatility. With additional investment classes we can take advantage of the upside of each class separately.
b) Notice that we are not simply reducing the overall volatility of the combined portfolio. We are taking full advantage of the volatility of each individual investment class while lowering the overall volatility.
2. We can take advantage of different levels of volatility.
a) High yielding investments (high dividend stocks, REITS, income properties) typically have low volatility. Their yields are especially stable.
b) Low volatility investments do not require as much growth as higher volatility investments (stocks) to provide the same withdrawal amounts at the same level of safety.
3. We can vary allocations.
a) Ben Solar has been doing outstanding research in this area.
b) He has shown that allocation shifts based on stock market valuation produce significantly improved (historical) safe withdrawal rates.
c) His shifts are based on (Yale) Professor Shiller's P/E10 ratios. P/E10 is the current price of the SP500 index divided by the average of the previous ten years of earnings.
d) This is a form of timing. But it is the kind of timing used by leading value investors (such as Sir John Templeton and Warren Buffett).
D. What we can do.
1. We can provide information.
a) I am seldom able to provide an exact answer to a question.
b) I can often provide exact answers to similar questions.
c) I can identify what is known, what is uncertain and what is needed to provide an exact answer.
d) This is often sufficient.
e) Almost always, it is helpful.
f) This information usually helps others with similar, but slightly different, questions.
2. We can learn from what real retirees do.
a) I continue to be amazed at how well actual retirees are in making their decisions.
b) Almost all of my studies validate the decisions and choices that actual retirees have made.
c) In essence, I have extracted an outline of what actual retirees have done. Then I have run the numbers. Almost always, the numbers show that they have made good decisions.
3. We can maintain a balanced perspective.
a) Very often, an analysis does not provide sufficient justification for decisions when its results are taken in isolation. We are often comparing differences of only one or two events (failures).
b) Such an analysis often points toward credible cause and effect relationships.
c) We can then rely on those relationships and the insights that they offer.
d) This takes us away from simple data mining and its hazards. It takes us toward a reliable theory.

Have fun.

John R.
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Post by raddr »

Hi John, nice post.

3. We can vary allocations.
a) Ben Solar has been doing outstanding research in this area.
b) He has shown that allocation shifts based on stock market valuation produce significantly improved (historical) safe withdrawal rates.

Where can I find his research? I'm skeptical of the effectiveness of dynamic valuation-based allocation with regard to the SWR. You have to be real careful of datamining when you get into this. If he's got something good along these lines I'd love to see it. You out there Ben? :D
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Post by JWR1945 »

raddr

BenSolar's posts have been at the Motley Fool's REHP. His research is still in its early stages. He has presented strong evidence...via counter examples... that refute assertions that valuation is irrelevant to safe withdrawal rates.

There is much more worth doing. The key is to develop a reliable strategy...one that does not depend upon exact historical details. BenSolar has used Professor Shiller's P/E10 numbers for measuring valuation. My impression is that the underlying slow variation in P/E10 has a lot to do with his successes.

BTW, if it is not yet obvious to you, this is why I am keenly interested in your developing an additional Monte Carlo model.

Have fun.

John R.
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Post by BenSolar »

Hi guys,

John, I really liked your post, but you are too kind. The series that I ran using the PE-10 switching are barely a start. I think they show some promise, but are far from conclusive. It does seem that switching from higher to lower stock allocation at higher PE-10 values at least doesn't hurt the historic SWR, when you switch in a broad range of PE-10.

I'll re-post those that I put up over there on the subject. Don't get your hopes up, raddr :?

Ben
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by JWR1945 »

raddr, BenSolar Here are some of my thoughts:

1) hocus suggested long ago that it is a good idea to keep stock allocations lower than indicated in the Retire Early Safe Withdrawal Rate study in times of high valuation.
2) He suggested an allocation in the range of 50% as opposed to 75% or 80%.
3) BenSolar has shown that the historical data suggest that an allocation around 50% is best when the PE10 ratio is above 20. He has nailed advocates of the "you can't time the market...ever...no matter what" philosophy several times on this point.
4) My thoughts are in terms of very slow changes in allocations...of the order of 4 or 5 years or, maybe, once in a decade.
5) I suspect that the key mechanisms are multiple expansion and multiple contraction.
6) I suspect that focusing on slow changes in the P/E10 multiple can help us select better stock market allocations.
7) All of this is in the context that there are several investment options available to us. We are not limited to allocating between stocks versus cash equivalents.

I submit that BenSolar's proof that lower stock allocations are better in times of historically high valulation...times like today...is sufficient to establish that dynamic allocation works. Where we differ is in our time frame. I am thinking in terms of five years to a decade. You are thinking in terms of much shorter periods...such as once every year or two.

Have fun.

John R.
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Post by raddr »

Hi John,

BTW, if it is not yet obvious to you, this is why I am keenly interested in your developing an additional Monte Carlo model.

What exactly did you have in mind? I can probably come up with something if you have a specific hypothesis in mind.

I submit that BenSolar's proof that lower stock allocations are better in times of historically high valulation...times like today...is sufficient to establish that dynamic allocation works. Where we differ is in our time frame. I am thinking in terms of five years to a decade. You are thinking in terms of much shorter periods...such as once every year or two.

I think that there will be limited utility in this type of dynamic allocation, in large part due to frictional costs and the emotional considerations in carrying out a mechanical strategy which only modestly raises the SWR. I'd be happy to be proven wrong though. 8)

I think that the most promising approach is diversification to other asset classes. For example, according to my calculations a portfolio equally split between S&P500, EAFE, ScV, and TIPS would've raised the SWR a full point for 30-50 year time periods since 1927.

I've also looked at rebalancing and found that results either stay the same or improve slightly if one rebalances only when one of the asset classes gets out of whack by 5% or more. This cuts down on trading costs even more.
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Post by JWR1945 »

raddr

BTW, if it is not yet obvious to you, this is why I am keenly interested in your developing an additional Monte Carlo model.

What exactly did you have in mind? I can probably come up with something if you have a specific hypothesis in mind.

Here are my descriptions:

From the Mean Reversion thread:

Hello raddr.

Consider this description: There are three major components. The first is the underlying behavior of stocks. The second is an ordinary random fluctuation. The third is similar to noise after passing through a low pass filter...with significant components at periods near 26 years. There is also a lower frequency limit (or maximal period) imposed by the length of the historical record.

I really do not know what would be best. My initial thoughts are to take a basic periodic waveform and frequency modulate it or phase modulate it at random. That is, its period is chosen at random within a limited range of values. As for its amplitude...it would be selected to compensate for mean reversion. As for its shape, I imagine that the dory36 calculator can provides some clues or maybe Professor Shiller's S&P500 data would help. If nothing else, you could start with a sinewave. It is unreasonable to do anything complex.

In my FAQ Starter Kit post:

m) I would personally like to see a Monte Carlo model that uses a long-term cyclical variation to account for behavior of the spread in actual returns. We know that there are some factors in the stock market that vary slowly. The SP500 price to earnings ratio (using Professor Shiller's P/E10 numbers) has varied slowly. Most recently, that multiple increased over a period of two decades, the 1980s and the 1990s.

Have fun.

John R.
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Post by JWR1945 »

raddr

I think that the most promising approach is diversification to other asset classes. For example, according to my calculations a portfolio equally split between S&P500, EAFE, ScV, and TIPS would've raised the SWR a full point for 30-50 year time periods since 1927.

I've also looked at rebalancing and found that results either stay the same or improve slightly if one rebalances only when one of the asset classes gets out of whack by 5% or more. This cuts down on trading costs even more.

I believe that we are thinking along the same lines. You are a little ahead of me. I know that I have a lot of reading to do from the Index Funds FAQs.

Regarding dynamic allocation, I am not thinking of it in isolation. I like the idea of something similar to your out of whack by 5% or more description. As a rhetorical question only: is seeing the P/E10 at an all time high very much different from seeing one's stock allocation out of whack by 5% or more (on the high side)?

Have fun.

John R.
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Post by hocus »

My thoughts are in terms of very slow changes in allocations...of the order of 4 or 5 years or, maybe, once in a decade.

JWR1945, I see a need to clarify my own position on this point, given the amount of sand that has been thrown into the gears over at the other board.

My guess is that a plan calling for changes in stock allocation every four or five years is probably not going to produce great results. I favor adjustments in allocation levels only at extreme levels of overvaluation or undervaluation. My TMF profile describes me as a "long term buy and hold" investor, but a realistic--that is, price conscious--version of that type.

I have said that, as prices of stocks come down to a level at which I can purchase them and still maintain the 4 percent withdrawal that my plan calls for, I will buy stocks until they comprise 50 percent of my overall portfolio. Once I purchase these stocks, my expectation is that I will not lower my stock allocation for the remainder of my lifetime. There are circumstances in which I might be willing to lower it a bit, but I would have to see a strong data-backed case before taking such a step. My guess is that doing so would pay off only in cases of extreme overvaluation, and I am not expecting to see levels of overvaluation similar to those experienced in the late 1990s again in my lifetime.

I consider myself to be a fierce critic of timing strategies. I try to keep an open mind on these things, but my research was not supportive of the timing concept. So what I looked for in putting together my plan was an approach that would call for the least amount of timing possible.

I consider the intercst approach to be more timing oriented than my own. The historical data says that many investors who put 74 percet of their assets in stocks at times of extreme overvaluation will lower their allocations during the price-adjustment periods that follow. This lowering of allocations means selling shares when their prices are low, which is the single biggest risk of a timing strategy, to my way of thinking. What I am seeking to do is to purchase stocks at prices that offer me a realistic chance of being a buy-and-hold investor not just for the length of a bull market, but for the remaining years of my life.

I am confident that 40 or 50 years from now, when we compare notes as to which approach resulted in more buys and sells of stock shares, my approach will show fewer buys and sells than the intercst approach. I say that because that is what the historical data tells me. The historical data says that a key component of a successful buy-and-hold strategy is purchasing stock shares at prices that allow you to hold them for long periods of time, given your particular life goals and financial circumstances.

I think that there will be limited utility in this type of dynamic allocation, in large part due to frictional costs and the emotional considerations in carrying out a mechanical strategy which only modestly raises the SWR. I'd be happy to be proven wrong though.

raddr, I believe that you are making a mistake in comparing what you get with a real-world dynamic allocation stratgey with what you get from a fantasy world fixed 74 percent stocks strategy. In the real world, the SWR for 74 percent stocks is nowhere close to 4 percent. If you adjust the SWR for that approach to something more in line with what the historical data tells you is possible, I believe that you will see that dynamic allocation will push the number up considerably.

I think that the most promising approach is diversification to other asset classes. For example, according to my calculations a portfolio equally split between S&P500, EAFE, ScV, and TIPS would've raised the SWR a full point for 30-50 year time periods since 1927.

There are a lot of things we do not know at this stage about SWRs. But I don't see how any fair-minded person could question at this stage that diversification pushes the SWR up, and that a failure to diversify pushes it down. Perhaps I'm getting ahead of myself, but to me, that is one of the ABCs. I believe that this point has been conclusively demonstrated in earlier posts on this board.

The series that I ran using the PE-10 switching are barely a start. I think they show some promise, but are far from conclusive.

You state it well, BenSolar. My single biggest complaint about the other board has nothing to do with personal attacks. My biggest criticism is the board policy that says that no one is permitted to present information on SWRs that has not first been put through some sort of backtesting analyzer with 130 years of data. That policy keeps the board community from hearing 80 percent of the valid information available on this critical question.

Why should board members be denied access to valid insights, just because they are, in your words, "far from conclusive.?" Isn't the whole point of a discussion board to learn? If you already possess conclusive information on a subject, there is no need to participate on a discussion board. The whole point is to take information that is less than conclusive, share it with others interested in the subject matter, and thereby enhance your confidence in your understanding of the subject matter over time.

The reason why there are so few on-topic posts at the Motley Fool REHP board is that the policy there is that no information can be presented that is less than conclusive before it is taken to the board. That's such a serious restraint on the scope of debate that it leaves little on-topic material to talk about. The political chat came in to fill the void because there are a lot of people in the Motley Fool community with an interest in how to retire early who can't resist regularly visiting a board that in its title offers a promise to allow exploration of this exciting subject matter.

So long as on-topic threads are answered with fierce ridicule campaigns, people will turn to political chat in a desperate desire to keep the board technically alive a few months longer. To achieve long-term growth, the board community must find a way to permit on-topic discussion there.
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Post by raddr »

me:

I think that the most promising approach is diversification to other asset classes. For example, according to my calculations a portfolio equally split between S&P500, EAFE, ScV, and TIPS would've raised the SWR a full point for 30-50 year time periods since 1927.

hocus:

My biggest criticism is the board policy that says that no one is permitted to present information on SWRs that has not first been put through some sort of backtesting analyzer with 130 years of data.

Yeah, that's kind of the way I remember it. Fact is, though, the two bear markets that shoved the SWR down the most occured after 1927. That's where the SWR action is, if you will. So really the post-civil war, pre-depression, on-gold-standard data is of pretty limited utility anyway in today's economy.
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Post by hocus »

The two bear markets that shoved the SWR down the most occured after 1927. That's where the SWR action is, if you will. So really the post-civil war, pre-depression, on-gold-standard data is of pretty limited utility anyway in today's economy.

Of course. I think we can safely conclude at this point that the motivation for the regular references to the 130 years of data supporting the intercst investment preference is to fool people into thinking that the study possesses a greater measure of statisitcal validity than it in fact does possess.

If the tables were turned, and we had 130 years of data for real estate and only 30 years of data for stocks, who do you think would be making the claim that only the most recent data is valid and stuff pulled from 1870 is of no value whatsoever in telling us how best to invest today, and anyone who thinks different is in obvious need of psychological counseling.
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Post by JWR1945 »

I have glanced at the Index Funds FAQs. I noticed some comments about re-balancing by William Bernstein. The data tend to support the idea of periodic re-balancing...but only under unrealistic conditions. He argued against using the idea under real world conditions. It produces a very small gain that is unlikely to overcome transaction costs. There was a statistically significant trend indicating that longer intervals improve results. His longest period was 4 years.

He mentioned the possibility of using thresholds for re-balancing, such as raddr has mentioned. But he defined his context in such a way that an analysis would not be meaningful.

When I have mentioned 4 or 5 years...and the fault is mine for being unclear...I have not been thinking of something that is driven by time. I have been thinking of something related to infrequent events. I am excluding more rapid changes. I am not requiring that any changes take place.

raddr's 5% threshold is something that makes sense. hocus's reluctance to invest heavily in the stock market at times of extreme valuation makes sense. His 50% allocation goal makes a lot of sense. Let me suggest that if the stock market multiple P/E10 were to drop below 10 and remain there for a while...as it did 25 years ago...it might be a good idea to become more aggressive. I think that you can be comfortable about sticking with stocks that you buy at a P/E10 of 7 or 8.

Perhaps the next event is 20 years off. That is OK. Perhaps having something like TIPS become available with real rates of return at an all time high at the same time that stock valuations are at an all time high is two or three decades away. That is OK. But if these kinds of events do happen, let's take advantage of them.

In terms of re-balancing portfolios, I am thinking along the lines of doing so gradually while making normal purchases (during accumulation) and withdrawals (during distribution). I have not been thinking about re-balancing for the sake of it. I do think that it can be a good idea in special cases...such as raddr's 5% threshold.

Have fun.

John R.
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Post by hocus »

There was a statistically significant trend indicating that longer intervals improve results.

JWR1945:

There was some stuff in Chapter Two of Bernstein's "The Four Pillars of Investing" that made a big impression on me. He makes a sharp distinction between trying to predict how stocks will perform in the short term and trying to predict how they will perform in the long term, saying that the former appears to be impossible but that the Fisher analysis he describes is quite effective at predicting long-term stock performance.

If this is so, I believe that it is an important insight. There are lots of people who are uncomfortable with "timing" and I am not at all unsympathetic to their viewpoint. But, presuming that people who put together plans for early retirement are interested primarily in long-term results, the idea that there is a tool available that tells you what those long-term results will be seems to me to be a very compelling discovery.

It would be good if others would read the chapter for themselves because I don't feel comfortable having the board rely on my understanding of it. But Bernstein makes several claims that seem to me to be consistent with this idea that it is possible to predict long-term results with a good degree of confidence. He suggests that extreme valuations on the high end must be followed by downward price adjustments, and vice versa. I think that's a big deal, if true.

The implication is that there is no great risk of missing out on big gains from failing to be fully invested in stocks at times of extreme overvaluation, that if you are patient the prices in real terms will work their way back to a more reasonable range. If that is so (and I am not stating that I am sure that this is what he is saying, only that it sounds that way to me), that tells me something terribly useful in my attempts to plan a successful early retirement.

What it tells me is that, if I just wait, stocks will someday again be available at reasonable prices, that I can purchase them then and obtain the benefits of growth that come from this asset class without taking on the risks of buying into the asset class at a time when the downside risk is as great as it is today.

Again, I am only putting forward a tentative observation. I would like to hear what other people who have read the chapter have to say about it, or, if no others have read it, to entice some to do so. My sense is that Chapter Two of the Bernstein book may open the door to some compelling insights if we tried to tease out its implications a bit.
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Post by raddr »

John,

When I have mentioned 4 or 5 years...and the fault is mine for being unclear...I have not been thinking of something that is driven by time. I have been thinking of something related to infrequent events. I am excluding more rapid changes. I am not requiring that any changes take place.

Just to amplify a bit, I looked at rebalancing both at fixed intervals of time (1-5 years) vs. percentage thresholds. The percentage thresholds (5 ro 10%) give the best results. Bernstein believes that this is because of momentum which has been demonstrated in the markets over short time periods.
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Post by wanderer »

For the record:

I welcome psychological counseling. It's just that I can't get it from the people I want when/how often I want it. The people that say I need it and are offering it are usually incompetent/scary.:wink:

wanderer
regards,

wanderer

The field has eyes / the wood has ears / I will see / be silent and hear
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Post by raddr »

John,

Consider this description: There are three major components. The first is the underlying behavior of stocks. The second is an ordinary random fluctuation. The third is similar to noise after passing through a low pass filter...with significant components at periods near 26 years. There is also a lower frequency limit (or maximal period) imposed by the length of the historical record.

I believe, as do you, that long term stock prices are not random. I attribute the non-random aspect to mean reversion and that is what I have chosen to model. Is there solid evidence of 26 year cyclicality not related to mean reversion?
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Post by JWR1945 »

raddr asks:

Is there solid evidence of 26 year cyclicality not related to mean reversion?

hocus where are you?

You once quoted from the book Stock Cycles at the Motley Fool's REHP. It provided a strong argument that there is such a long term cycle. Can you provide a good reference for raddr?

In my reply to your REHP post, I stated that the author made a convincing argument (statistically) that something is there. But I thought that his procedure was too tortuous to give me as much confidence in his other (more detailed) conclusions.

Have fun.

John R.
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Post by Dagrims »

I found a few links relevant to stock cycles:

http://www.cpcug.org/user/invest/secular.html - Written in 1997, this summary speaks of a 32-year stock market cycle

http://www.ici.org/pdf/per02-02.pdf - Need Adobe Acrobat for this one - discusses mutual fund shareholder activity during stock cycles. Conclusion is that there were not large outflows during downturns, even the most precipitious ones, between 1946-1995. Perhaps more investors than expected are able to maintain there stock allocation during such times.

http://csf.colorado.edu/authors/Alexand ... Trends.htm - Good article on secular market trends. Author claims 14 secular markets since 1800 - seven bulls and seven bears - lasting between 8 and 20 years each. He's also written the book Stock Cycles that JWR may be referring to - has anyone read this?

Chris
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Post by hocus »

He's also written the book Stock Cycles that JWR may be referring to - has anyone read this?

Dagrims:

Here's a link to a post I put up at the Motley Fool REHP board in which I transcribed some key material from the book.

http://boards.fool.com/Message.asp?mid=17404851
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Post by JWR1945 »

raddr asked:
I believe, as do you, that long term stock prices are not random. I attribute the non-random aspect to mean reversion and that is what I have chosen to model. Is there solid evidence of 26 year cyclicality not related to mean reversion?

The more that I think about this question, the less that I am convinced that the two are different...except in this respect: Using a cyclical approach automatically orders the data for you. One asks: where are we in the cycle? With a mean reversion approach, one asks a somewhat different question: what is the likely return from the stock market in the future (making a long term projection)?

There is a certain amount of plausibility behind assuming that there exists a long term cycle. It has to do with the number of years in a generation. However, there are many qualitative changes...and there are only a limited number of completed cycles in the historical record...and those completed "cycles" have poorly defined characteristics.

I suspect that one can relate long term cycles and mean reversion by using some mathematical algorithm. I am not sure that doing so would enhance our understanding. It might.

Have fun.

John R.
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