by Rob Bennett

The biggest problem I face in making the case for Valuation-Informed Indexing is that it is so different from Buy-and-Hold. Most people are open to advances that represent slight improvements from what came before. Valuation-Informed Indexing represents a huge advance. Huge advances are tough for many of us to swallow.

Huge advances are counterintuitive. People wonder: “If this idea is so great, why didn’t anyone come up with it before?”

The reason why no one came up with Valuation-Informed Indexing before it that it is an indexing strategy. Indexes were not available until the mid-1970s.

The power of the strategy lies in the ability it offers those who follow it to predict their stock returns. Stock pickers cannot do that. Value Investors predict their returns to some extent; that’s why Value Investing is the best of the stock picking strategies. But even the smartest Value Investor cannot predict his return to the extent the ordinary Valuation-Informed Indexer can.

There are too many factors playing a role in setting the return of an individual stock. With indexes, there are only two factors that matter: (1) the productivity of the overall economy (which has been remarkably stable throughout the history of the U.S. market); and (2) the valuation level that applies on the day the index-fund is purchased.

So Valuation-Informed Indexing snuck up on us. Indexes became available at roughly the same time as lots of people were coming to believe that market timing is a bad idea. So the two ideas were combined into Buy-and-Hold Indexing. But there was never any good reason why indexers should not feel free to change their stock allocations in response to big valuation shifts.

There was never any showing that long-term timing doesn’t work; the researchers who determined that “timing doesn’t work” failed to make the distinction between the short-term and long-term varieties of timing and in reality discovered only that short-term timing doesn’t work. It’s only in the wake of the economic crisis brought on by the widespread promotion of Buy-and-Hold strategies that many became open to the idea that indexing might be practiced in a more effective way.

Today, there are lots of people open to hearing new investing ideas. However, Valuation-Informed Indexing still hits people as being too “out there.” There’s only one way in which Valuation-Informed Indexing is different from Buy-and-Hold Indexing. But that one difference — Valuation-Informed Indexers consider valuations when setting their stock allocations while Buy-and-Holders do not — results in very different investing perspectives.

Buy-and-Holders believe that stocks always offer a strong long-term value proposition. The theory is that investors are compensated for risk; since stocks are a high-risk asset class, they should always offer at least the potential for high returns.

Valuation-Informed Indexers believe that stocks generally offer high returns not because they are risky but because the U.S. economy is a highly productive economy. We believe that stocks offer a poor long-term value proposition when prices are high. Since prices have been high since 1996, we believe that stocks have been a poor long-term bet for 15 years running. That’s an idea that Buy-and-Holders have a hard time getting their heads around.

For Buy-and-Holders, the safe withdrawal rate is a constant 4 percent. Valuation-Informed Indexers believe that the safe withdrawal rate varies with changes in valuation levels, sometimes dropping to as low as 2 percent and sometimes rising to as high as 9 percent.

The VII numbers strike Buy-and-Holders as outlandish. The idea of a retiree with a portfolio of $1 million limiting himself to an annual withdrawal of $20,000 seems beyond-the-pale cautious and the idea of a retiree with a portfolio of $1 million permitting himself an annual withdrawal of $90,000 seems beyond-the-pale reckless.

To Valuations-Informed Indexers, these percentages are just the product of simple numerical calculations. Is it really so shocking that the safe withdrawal rate would be more than four times greater at times when stocks are priced at more than two times fair value than it would be at a time when stocks are priced at half of fair value? Isn’t that just about what investors who take valuations seriously would expect to be the case?

Valuation-Informed Indexers believe that super-safe asset classes like certificates of deposit and IBonds can at times of high stock valuations offer higher returns than stocks. Buy-and-Holders cannot see how that could be. It makes no sense for a super-safe asset class to pay a higher return than a risky asset class.

No, it doesn’t make sense. But then overvaluation doesn’t make sense either. Valuation-Informed Indexers observe that, in a world in which it is possible for investors to price stocks at two or three times fair value, it is possible for CDS and IBonds to offer better returns than stocks. How can we insist on rationality when talking about a life endeavor in which most of those participating are so clearly not making rational choices?

Valuation-Informed Indexing would be more popular if investors didn’t feel that they need to choose either VII or Buy-and-Hold. People would feel more comfortable taking a compromise choice somewhere between the two extremes. Unfortunately, no compromise is intellectually viable.

If the market is efficient, the Buy-and-Holders are right and the Valuation-Informed Indexers are wrong. If valuations affect long-term returns, the Valuation-Informed Indexers are right and the Buy-and-Holders are wrong.

I dislike dogmatism. But when it comes to numbers, it’s hard to get around the reality that there are right and wrong answers. Valuation-Informed Indexing is a paradigm-buster or it is a waste of time. Either it supplants Buy-and-Hold entirely or there is nothing to it.

Rob Bennett argues that it is essential to follow a valuation-informed strategy when investing in index funds. His bio is here.