Valuation-Informed Indexing #31:
You Don’t Need to Sacrifice Return to Lower Your Risk

Taking on added risk is the price you pay for obtaining a higher return, under the Buy-and-Hold Model. It’s a tradeoff. The highest stock allocation yields the highest return but also requires taking on the greatest amount of risk.

Every reasonable person who explores the implications of this idea is forced to acknowledge that it cannot be strictly true. If it were, a 100 percent stock allocation would be best. It would be risky as all get-out, to be sure. But it would bring in super returns.

Actually, both things cannot be so.

The purpose of investing is to generate good returns. The risk that investors are concerned about is that they will not accumulate enough assets in time to be able to retire when they want to do so. Earning higher returns diminishes the risk that that will happen. So how can it be said that high returns translate into increased risk?

A Buy-and-Holder would respond that it’s a question of when the higher returns would come along. A 100 percent stock allocation really should bring in the highest possible return since stocks pay higher returns than the other asset classes. The risk that it is thought is being taken on is not a long-term risk but a temporary one.

Stock prices are volatile. So it might be that an investor going with a 100 percent stock allocation would suffer a devastating hit to his portfolio. But in time all his losses would be restored and high returns would be added to them, according to the theory.

The obvious question is: How long would it take for the losses to be restored?

If we are talking about a loss that remains in place five years, many would conclude that a 100 percent stock allocation is a logical choice. Actually, many would conclude that a 100 percent stock allocation is a good choice even if the loss were to remain in place for 10 years. Many of us do not expect to retire until far more than 10 years into the future. So what difference does it make if our portfolio balances are down for that amount of time? So long as we are sure to see the losses covered and the strong gains added to them within a decade, a 100 percent stock allocation makes sense.

The reality, of course, is that it can take a lot longer than 10 years for losses to be recovered and for strong gains to be earned on the underlying money as well. A regression analysis of the historical stock-return data shows that money invested in stocks at the prices that applied in January 2000 has only a 50 percent chance of having generated a return in excess of 6 percent real 60 years later. At 20 years out, there’s a 20 percent chance that the investor will still show a negative return on that money and only a 50 percent chance that his annualized return will be greater than 1 percent real.

The risk is not that stock prices will never recover. It is that it could be a long, long time before they do.

This suggests that the proper way to think about stock risk is that it is something that can be measured in time. The risk is not that you won’t get your money back. The risk is that it can take a long time before you get your money back plus a good return on it. The cool thing here is that the extent of the risk being taken on at different valuation levels can be quantified by making reference to the historical data.

The risk environment that applied in 1982 is in no way comparable to the risk environment that applied in 2000.

For money invested at the prices that applied in 1982, the worst-case scenario for 10 years out was an annualized gain of 8.5 percent real. I could live with that! Stocks were essentially a risk-free asset class in 1982 for investors able to wait 10 years for any price drops to be corrected.

Risk, like return, is not a constant in stock investing. It varies with changes in valuation levels.

And we can quantify risk by looking at the P/E10 level that applies at a particular time and by using the historical stock-return data to identify the longest amount of time it could take for us to achieve an acceptable investing result assuming that stocks continue to perform in the future at least somewhat as they always have in the past.

And risk is not something that we must take on to obtain higher returns. It’s not just that risk was high in 2000; likely returns were low. It’s not just that risk was low in 1982; likely returns were high.

Stock risk and stock return move in opposite directions. It is when the risk of losses is least that the potential for good returns is greatest. It is when the risk of losses is greatest that the potential for good returns is the lowest. Stock risk and stock return are not correlated but are inversely correlated.

This claim will strike the mind of the confirmed Buy-and-Holder as exceedingly strange. But it is totally in accord with what common sense tells us should be the case. The object of investing is to earn good returns. At times when returns are likely to be low, your risk of failing to meet your objectives is obviously great. Risk and return are opposites.