Valuation-Informed Indexing #59:
Indexing Changed Everything

Stock prices are volatile.

Everybody knows this. It has always been so and it will always be so.

Right?

I don’t think so.

I believe that we are today’s in the last days of stock price volatility. I believe that we are in the early days of a transition to the most exciting time ever to be a stock investor, an era in which stocks will continue to produce high returns but in which price volatility will be reduced to a tiny fraction of what we see today.

The development that brought on the change was the introduction of index funds. The prices of individual stocks will always be volatile. That’s because we are always discovering new things about individual companies. New products are introduced, old ones fail. New marketing campaigns are developed, old ones are shelved. New managers are hired, old ones are let go. All of these changes affect the profits generated by the company and thus the share price of the company’s stock. Individual stock price volatility is here to stay.

None of these things affect the share price of broad indexes. The value of a share of a stock index is determined by the productivity of the economy in which the companies operate. The U.S. economy has been sufficiently productive to support an average long-term return for stocks of 6.5 percent real for as far back as we have records. It is unlikely that the long-term average return for U.S. stocks is going to vary too much from that anytime within the lifetime of anyone reading these words.

When you buy an index fund, you buy an income stream of 6.5 percent real per year. It’s a simple, no-muss, no-fuss economic transaction. You turn over control of your money for as long as you own the index fund. In return you obtain an income stream of 6.5 percent real. Where would volatility come into the picture?

The reality, of course, is that we still have volatility today. Index funds generated returns of far greater than 6.5 percent real throughout the 1990s. And index funds generated returns of far less than 6.5 percent real throughout the 2000s.

Yes, the average long-term return will probably end up being somewhere in the neighborhood of 6.5 percent real. But that return is being delivered through return patterns evidencing a great deal of price volatility. We see returns of 13 percent real or higher during some time-periods and returns of zero or less in other periods. The 6.5 percent average comes to apply only after enough time has passed for the time-periods with super high returns to be countered by the time-periods with super low returns.

But how likely is it that that is going to remain the case for too much longer?

People expect and accept volatility in index fund prices only because index funds are a type of stock investment and the earlier types all produced volatile prices. But index funds are different in a fundamental way. With index funds, you know what the return is going to be before you buy. So there is no reason why index fund prices should be volatile. As people catch on to this, index fund prices will not be volatile. Investors will not tolerate it. Why should they?

Shiller showed that the price at which you purchase an index fund determines the long-term return you obtain from it. Sure, the average long-term return is 6.5 percent real. But index funds purchased at high prices offer returns much lower than that. And index funds purchased at low prices offer returns much higher than that.

We don’t see much discussion of this today because of the popularity of Buy-and-Hold strategies (developed in pre-Shiller days). But Buy-and-Hold is becoming less and less popular as the economic crisis it brought on causes more and middle-class investors to lose confidence in their retirement hopes. Once Buy-and-Hold is only something people read about in history books, there are going to be all sorts of discussions of the implications of Shiller’s findings.

What happens to price volatility then?

It goes “Poof!”

Who needs it?

People should buy index funds because they want to participate in the productivity of the U.S. economy. They shouldn’t be looking to make a killing by seeing a return of higher than that amount for a few years and they shouldn’t be willing to tolerate the lower returns that follow from pushing returns above that amount for several years running.

A return of 6.5 percent real is plenty for investors who are not willing or able to put in the time and research needed to pick stocks effectively. And those sorts of investors are better off without the economic crises that out-of-control bull markets bring on.

It will be a better world when price volatility is a thing of the past. Investors who know what their returns are going to be in advance are better able to plan their financial affairs. And economies that are not subject to irrational bull markets and the depressing bear markets create more lasting wealth.

Stock price volatility adds nothing of value to the stock investing experience. Now that we possess the means to banish it to the history books, I very much look forward to the day when we all reach a consensus to do just that.

Indexing changed everything.