by Rob Bennett

Study stock investing and you are exposed to a lot of numbers. It’s numbers, numbers, numbers, everywhere you look!

Most of them don’t mean too much. Many of them are employed to support rationalizations that end up doing you a lot of harm.

But some numbers matter. I learned about one the other day that in my view tells a story more important than any story told by any other number I have come across in my explorations of what works in stock investing.

The number comes from a new study by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, that offers a number of powerful insights.

We’ve all of course heard for years about all the studies that show that short-term timing doesn’t work. But what about long-term timing (changing your stock allocation in response to big price swings with an understanding that you may not see benefits for doing so for as long as 10 years)? Surely long-term timing works. Long-term timing is just taking price into consideration when buying stocks. How could that possibly not work?

Pfau went looking for studies on this point and was surprised to find only one, a study that its authors suggested lent support to the proposition that long-term timing doesn’t work. Pfau ran the numbers. His study is titled Revisiting the Fisher and Statman Study on Market Timing.

He of course found that long-term timing always works. The new study states: “On a risk- adjusted basis, market-timing strategies provide comparable returns as a 100 percent 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.”

Pfau charts the nominal wealth accumulation of $1 invested at the start of 1871. The Buy-and-Hold strategy examined is one in which the portfolio was comprised 100 percent of the S&P 500 index. The market timing strategy is one in which a choice is made to go with either 100 percent stocks or 100 percent Treasury bills at the start of each year, depending on whether the value of P/E10 is below or above it’s historical average at that time.

The Buy-and-Hold portfolio was worth $95,404 at the end of 139 years. The Valuation-Informed Indexing portfolio was worth $124,147.

Pfau writes: “For every risk measure considered, the market-timing strategies result in less risk and higher risk-adjusted returns than the 100 percent stocks Buy-and-Hold strategy. The highest standard deviation for portfolio returns from market timing is 13.93 percent, compared to 18.02 percent for buy-and-hold. The Sharpe ratios are also larger using two different definitions, showing that market timing provides higher returns on a risk-adjusted basis…. The maximum drawdown, which is the maximum percentage drop in wealth between high points and any subsequent low points in the historical period, is also significantly less for market timing. The maximum drawdown was only 24.16 percent, compared to 60.96 percent for buy-and-hold.”

That maximum drawdown number is now my favorite numerical way of illustrating the secret to successful stock investing. Many experts define risk as volatility. But volatility is often not that big a deal. Moderate volatility, volatility not strong enough to cause you to sell your stocks, will not hurt you in the long run. But volatility that scares you enough to cause you to sell stocks when prices are down can set back your retirement dreams by many years.

So the best way to diminish the risk of stock investing is to invest in such a way that your maximum drawdown number is low. If your worst-case scenario is not that bad, you are never going to feel compelled to sell when prices are low and in the long run you will do fine. Being willing to abandon Buy-and-Hold for Valuation-Informed Indexing in one moment lowers your maximum drawdown from 61 percent to 24 percent. That is no small improvement!

The biggest mistake that stock investors make is thinking that stocks are equally risky at all times. Stocks are a virtually risk-free asset class at times of low valuations and carry only modest risk at times of moderate prices. It’s at times of super-high prices (like those we have been living through from 1996 forward) that stocks are super-risky, so risky that it is a rare middle-class investor who is able to overcome the pressures to sell that follow from the multiple crashes that always come at such times. Times of super-high prices comprise probably no more than 30 percent of an investor’s lifetime. Keep your stock allocation low at those times and you dramatically diminish the risk of this asset class for you.

Noting that the Valuation-Informed Indexing portfolio is able to generate the same returns as the Buy-and-Hold portfolio while being out of stocks half of the time and thus putting itself at what should be a huge disadvantage according to Modern Portfolio Theory, Pfau also compares the Valuation-Informed Indexing portfolio, which has an average stock allocation of 50 percent, with a 50 percent Buy-and-Hold portfolio.

In this case, the risks of the two portfolios are roughly equal but the returns for the Valuation-Informed Indexing portfolio are dramatically superior. The Buy-and-Hold portfolio has an end-point (2010) value of $13,426. The Valuation-Informed Indexing portfolio has an end-point value of $94,866.

The study concludes: “Valuation-based market timing with PE10 has the potential to improve risk-adjusted returns for conservative long-term investors.”

You don’t say!

Rob Bennett has written a case study in financial life planning. His bio is here.