Valuation-Informed Indexing #62:
Valuation-Informed Indexing Will Keep Working After Everyone Finds Out About It

The academic research of recent years shows that Valuation-Informed Indexing (changing your stock allocation in response to big valuation shifts) provides investors with far higher returns than they can obtain following Buy-and-Hold (staying with the same stock allocation at all times) strategies while greatly reducing their risks. Investor heaven! What’s not to like?

Buy-and-Holders warn that deals this good cannot last. Wait until lots of people find out about Valuation-Informed Indexing, they say. That will cause the edge that appears to apply in the historical record to disappear.

No.

The edge will not disappear. This concern evidences a fundamental misunderstanding of what Valuation-Informed Indexing is all about.

There is a hyper-technical sense in which the concern is valid. First I will describe why returns really will drop if all investors learn about Valuation-Informed Indexing. Then I will explain why those who make the switch to Valuation-Informed Indexing will still be obtaining a huge benefit by doing so.

The average long-term return for stocks is 6.5 percent real. We know that the average long-term return for middle-class investors (most of whom follow some form of Buy-and-Hold strategy) must be much lower. The return at times of high valuations obviously must be a good bit lower than the average and the return at times of low valuations obviously must be a good bit higher. A much higher percentage of middle-class investors invests in stocks at times of high valuations than at times of low valuations. So middle-class investors must collectively earn a return a good bit lower than 6.5 percent real.

If the average return is 6.5 percent real and most investors are earning a return far less than that, there must be a small group earning a return far greater than that. That group is the investors who follow valuation-informed strategies.

It is true that this edge would disappear if all investors were to become educated as to the realities of stock investing. In that limited sense, it is true that the benefits of Valuation-Informed Indexing will not be as great if knowledge of what the academic research of recent decades says becomes widespread.

There is another side to the story, however.

If knowledge of how market works spreads, the market will work more effectively. We all benefit from a market that works more effectively.

If knowledge of the realities spreads, price volatility will be greatly diminished. In a world of Valuation-Informed Indexers, there will never again be another bull market. Each time prices go up more than the amount justified by the economic realities, investors will lower their stock allocations because the long-term value proposition of stocks has been diminished. Those sales will bring prices back to fair-valuation levels. Stock market prices are self-regulating in a world in which investors have access to accurate information about how stock investing works.

Valuation-Informed Indexers will obtain lower returns in a post-Buy-and-Hold world. But the return they obtain will not be bad at all. The return obtained when stocks are selling at fair-value prices is 6.5 percent real. That’s good enough to help most of us finance retirements beginning at a reasonable age.

And we would be obtaining that return in a world of minimal stock volatility. That’s another way of saying that we would be obtaining that return in a world of minimal stock risk. A 6.5 percent real return from an asset class of little risk — I can live with that! I bet you can too.

The full truth is that we all would be better off earning solid but somewhat reduced returns in a world in which the risk of stock investing is greatly diminished. It’s the losses brought on by the promotion of Buy-and-Hold strategies that were the primary cause of today’s economic crisis. The economic crisis may end up putting us in the Second Great Depression. I’d be thrilled to earn a bit less on my stock portfolio in exchange for enjoying a thriving economy rather than one at grave risk of falling into a Depression.

Buy-and-Holders make this claim abut every strategy that comes along. It’s circular reasoning. They start with the premise that Buy-and-Hold is the best strategy ever concocted by the human mind, Then, when they see that another strategy performs better in the historical record, they conclude that this must be a temporary phenomenon. If the other strategy continued to provide better results indefinitely, it could no longer be said that Buy-and-Hold is the best strategy. And that would contradict the starting premise!

The reality is that Buy-and-Hold can be beat.

How? By advancing knowledge of how stock investing works.

Mankind’s ability to enjoy the night was enhanced when electricity was harnessed. Mankind’s ability to get from one place to another quickly was enhanced when the automobile was created. Mankind’s ability to communicate with like-minded people all over the globe was enhanced when the computer was invented.

Advances in knowledge in all sorts of areas of human endeavor are achieved all the time. Thank goodness! Seeing big steps forward is one of the things that makes it possible to bear seeing the stupid, destructive things that are also a reality of the ongoing story of the humans.

We should celebrate advances, not dismiss them as impossible from the standpoint of the limited understanding of how the world works that helped us back in earlier days. Buy-and-Hold itself was a big step forward from what had been available to us before it came along. Valuation-Informed Indexing is the next big advance. Progress happens.