Valuation-Informed Indexing #92

by Rob Bennett

I have been asked on occasion whether there should be a fund that would  provide a convenient means for those who want to invest according to Valuation-Informed Indexing principles to do so. Some have even suggested that, given my non-stop evangelizing, I should start such a fund myself.

No. That would be a terrible idea.

I am not an investing expert. I am a journalist. My interest in Valuation-Informed Indexing came about because I am a big believer in Robert Shiller’s model for understanding how stock investing works and was shocked and appalled to learn that few of the tens of thousands of investors I have met on the internet know that there is an alternative to the Buy-and-Hold Model.

Many have come to believe as a result of Wall Street’s promotional efforts that the case for Buy-and-Hold has been “proven.” That’s not even close to being true (the reality is quite to the contrary). So I have taken it upon myself to spread the word and to explore aspects of the model that Shiller has not addressed (Shiller generally sticks to theory and ignores the strategic implications of his research findings).

So I have zero knowledge of how to go about starting a mutual fund and zero interest in acquiring that knowledge.

But what if someone else did it? Would it be a good idea then?

I don’t think so. Funds have expenses. Those expenses are covered by fees imposed on investors. Investors are better off avoiding such expenses and thereby earning higher returns.

Some would argue that more would follow a Valuation-Informed Indexing strategy if they didn’t need to go to the trouble of knowing themselves when to make allocation changes.

Perhaps. But allocation changes are needed so infrequently that I don’t see much point in starting a fund. Stocks were selling at low or moderate prices for the entire time-period from 1975 through 1995. That’s 20 years in which no allocation change was needed. Stocks have been selling at high prices from 1996 through today. That’s 16 years in which no allocation change was needed. An allocation change is needed at most once every ten years or so.

And there are big problems with letting a fund manager make your allocation changes for you.

One is that you will never have confidence in a fund manager that makes allocation changes unless you know why he is doing it. Say that your fund manager lowered the fund’s stock allocation in 1996 and you then watched as stock prices soared in 1997, 1998 and 1999. Your fund manager was doing the right thing. You would be ahead today as a result of his choices. But how would you have felt about the choices he was making at the time he was making them?

There are two possibilities. One is that you would not understand why he made those choices and would quit the fund. If enough investors did that, the fund would fail.

The other possibility is that you and most other fund investors would understand the choices and stick with the fund. In that case, the fund would be a big success. But in the event that you possessed an understanding of why the allocation changes were needed, you could just as easily have made them yourself. So why invest through a fund in the first place?

The question people should ask when determining whether mutual funds should be formed is — Does having a fund add something important?

I like the idea of achieving the level of diversification I can obtain by investing in all U.S. stocks and I cannot possibly invest in all U.S. stocks by myself. So a Total U.S. Stock Market Fund serves an important purpose for me and for other investors like me. I am glad that there are such funds available to us. To get excited about the idea of a Valuation-Informed Indexing fund being started, I would need to be persuaded that such a fund would serve a similar purpose.

I don’t see it. The fund wouldn’t provide investors anything they couldn’t easily obtain for themselves with a tiny bit of effort.

But wouldn’t it be a good thing if investors could see how well a Valuation-Informed Indexing strategy would perform in the long run?

Theoretically, it would be a good thing for investors to see this.

In the real world, it wouldn’t matter. In the real world, investors can already see how well Valuation-Informed Indexing performs in the long run by looking at the 140 years of historical stock-return data available to us today. Those who are opened to being convinced are already convinced.

Those who are not convinced would not change their views by seeing a fund that achieved a great long-term track record. They would direct their mental energies to developing rationalizations for why the good long-term performance didn’t really matter much, just as they today direct them to developing rationalizations for following Buy-and-Hold strategies.

We don’t need one VII fund. We need all investing experts to come to appreciate that Buy-and-Hold has been discredited and that Valuation-Informed Indexing is today what the people who developed Buy-and-Hold intended Buy-and-Hold to be in its early days — a simple, research-supported strategy for the long-term investor.

We don’t need a mutual fund with the words “Valuation-Informed Indexing” in the title. We need to help all investors come to understand why Buy-and-Hold is so dangerous and why Valuation-Informed Indexing is the research-based investing strategy of the future. We need to see the principles of Valuation-Informed Indexing reflected in almost every mutual fund being offered for sale, just as the core principle of Buy-and-Hold (that the investor does not need to change his stock allocation in response to big swings in valuation levels) is reflected in just about every mutual fund being offered for sale today.

Rob Bennett has written about what really matters most to the success of a money management strategy. His bio is here.