by Rob Bennett
It makes no sense to stay at the same stock allocation regardless of valuation levels (Buy-and-Hold) if valuations affect long-term returns, as was shown in research done by Yale Economics Professor Robert Shiller in 1981. Yet most of us have been reluctant to make the move to the Valuation-Informed Indexing Model fof understanding how stock investing works, the model rooted in Shiller’s research findings.
Column #15 explored seven popular rationalizations. Last week’s entry looked at seven more. Today’s article looks at the final seven rationalizations for sticking with the conventional investing wisdom despite the growing mountain of evidence that it cannot work.
Rationalization #15: It’s Depressing to Think That My Portfolio Is Not Worth As Much As My Portfolio Statement Indicates It Is Worth at Times of High Valuations. This is an expression of an emotional concern that properly elicits sympathy. But it is not a rational reason for failing to change one’s stock allocation in response to big valuation swings. Investors cannot make informed decisions on any investing question without knowing the true value of their portfolios. Depressing or not, investors need to look at the realities straight on. Once accepted, this reality need not be depressing at all. Investors required by the demands of reason to lower their net worth figures from those indicated on their portfolio statements at times of high valuations are also required by the demands of reason to increase them at times of low valuations. The net effect is a big plus; investors following a rational approach see the bigger numbers when they most need to see them — times of economic turmoil — and see smaller numbers at times when placing their confidence in the too-high portfolio-statement numbers could get them into a great deal of trouble.
Rationalization #16: Stocks Are Always Best in the Long Run. This statement is true if the term “long-term” is defined as describing the time-period that comes into effect 30 years after the portfolio allocation choice is made. But how many investors can afford the sorts of losses at 10-year and 15-year and 20-year time-periods that follow from adopting a Buy-and-Hold strategy? This way of looking at things ignores the psychological realities that apply when human investors suffer devastating losses.
Rationalization #17: Using Valuations to Set One’s Stock Allocation Would Have Caused One To Go with a Low Stock Allocation for the Entire Time-Period from 1996 through 2008. This is so. But this is more an argument for trying to persuade other investors to follow rational strategies than it is one justifying not following rational strategies oneself. It is the popularity of Buy-and-Hold that caused stocks to become a poor long-term value proposition for so extended a period of time. The remedy is not to ignore valuations but to work harder to see that all investors learn the realities.
Rationalization #18: Short-Term Timing Doesn’t Work. There is a wealth of evidence showing that short-term timing — changing your stock allocation with the expectation of seeing a benefit for doing so within a year or two — does not work. Many investors reject long-term timing because they are persuaded that short-term timing does not work. A finding that short-term timing does not work does not justify a belief that long-term timing is not necessary,. The two approaches to timing are entirely different. Short-term timing doesn’t work because stock returns are primarily determined by unpredictable emotions in the short term. In the long-term, stock returns are determined primarily by predictable economic factors.
Rationalization #19: Changing Stock Allocations Would Cause Me to Incur Transaction Costs. Valuation-Informed Indexer can often go 10 years or longer without being required to make an allocation change. Stocks offered a strong long-term value proposition from 1975 through 1995; a high stock allocation made sense for that entire time-period. Stocks offered a poor long-term value proposition for the entire time-period from 1996 through 2008; a low stock allocation made sense for that entire time-period. If anything, Buy-and-Holders are likely to incur larger transactions costs because of their need to rebalance their portfolios (Valuation-Informed Indexers do not generally need to rebalance so long as stock prices remain in the same general neighborhood).
Rationalization #20: Rebalancing Requires Buy-and-Holders to Sell Stocks when Prices Are High. This is so. Rebalancing is a form of timing (Buy-and-Holders should try to keep this in mind when they assert that “timing doesn’t work”). But rebalancing hardly does the job that needs to be done. At the prices that prevailed in 1982, the most likely annualized 10-year return was 15 percent real. That fell to a negative 1 percent real at the prices that prevailed in 2000. There is no one stock allocation that makes sense both when the likely long-term return for stocks is 15 percent real and when the likely long-term return for stocks is a negative 1 percent real. Rational investors change their stock allocations in response to dramatic price swings.
Rationalization #21: There Is No Agreement on How Much of an Allocation Shift is Needed at Times of High Valuations. There is no compelling need for agreement on this point. It is healthy for people coming at the question from different perspectives and from different sets of life experiences to put forward different suggestions as to how much of an allocation adjustment is proper in different types of circumstances. The important step that we need to take is for all investors to accept that some allocation adjustments are needed. When there is a consensus that some adjustment is needed, we will have many more people contributing to discussions aimed at advancing knowledge on all of the various questions that need to be studied. The one viewpoint that does not stand up to scrutiny in light of Shiller’s findings is the Buy-and-Hold claim that no adjustment whatsoever need be made even at times of extreme high or low valuations.