Valuation-Informed Indexing #111

by Rob Bennett

This one is easy. The fact that the U.S. stock market has been delivering an average long-term return of 6.5 percent real for 140 years obviously does NOT make that return a lock for the future.

The real question is — Does the fact that the 6.5 percent return is not a lock undermine the case for Valuation-Informed Indexing, a strategy rooted in the idea that investors should set their stock allocations AS IF the 6.5 percent long-term return WERE a lock?

I don’t think this reality presents much of a problem.

While it is certainly the case that the 6.5 percent return  is not a lock, the more important reality is that there is a high probability that the future long-term average return is going to be something in that neighborhood. The return provided by stock markets for emerging economies can change dramatically with changes in circumstances. Our economy is a large and well-established and stable one. There may be small changes in either direction. Big changes in either direction are not at all likely.

Those small change can be accommodated by the strategy.

Say that you believe, as many did in the 1990s, that the United States is entering a golden age because of its discovery of new technologies. You can make upward adjustments in the numbers generated by Valuation-Informed Indexing calculators. The calculators of course use the historical record to generate their numbers. But there is no law that prevents the individual investor from using higher numbers. So, if that’s the only thing holding you back from using the strategy, do that!

Others believe that it was the past 140 years that were the golden age. Those people can of course make downward adjustments to the historical numbers while still making use of the core insight that drives this strategy — that both overvaluation and undervaluation are temporary phenomena that should be ignored by those investing for the long term.

The principles that underly the Valuation-Informed Indexing strategy provide great benefits for those who adjust the historical numbers. The benefit is that the process of making adjustments makes the investor aware of how far off current prices are from the long-term norm. When you see how far off current prices are from the norm, you might be inclined not to make as large an adjustment as you initially planned. The long-term realities pull you in the direction of acceptance of long-term realities. That’s a very good thing.

Is it possible that the years ahead will bring us returns the like of which we have never seen before?

It’s possible. However, the full reality is that the Valuation-Informed Indexer is likely to do well even in this unlikely scenario.

Say that we see returns greater than any ever seen before in history. Valuation-Informed Indexing encourages high stock allocations. So, in most circumstances, those following VII strategies are going to do well if we see returns larger than those we have ever seen in the past.

The one exception is the case in which we see great returns starting from a time of insanely high valuations; VII calls for investors to go with low stock allocations at times of insanely high valuations. If you do the math, you will see that the odds of us seeing good stock returns starting from times of insanely high valuations are not just small but exceedingly small.

It’s not just that this has never happened. It’s that we have seen exceedingly poor long-term returns each time in the past that we have reached insanely dangerous valuation levels. For us to see good returns this time, we would need to see a reversal of the historical pattern so large as to be shocking.

Most of us don’t intuitively appreciate this; our cognitive processes are slaves to the information bits fed to them in the current era. The point of Valuation-Informed Indexing is to force ourselves to stand outside the prejudices and myth-making of the current day. Looking at numbers helps us do that because numbers are objective and thus not subject to the social pressures that cause so many “experts” in this field to be pro-stocks just at the worst time to be pro-stocks and to be anti-stocks just at the wrong time to be anti-stocks. Look at the numbers and my guess is that you won’t worry anymore that future returns may be so different from historical returns as to cause the Valuation-Informed Indexing strategy not to deliver.

What alternative do you have in any event?

Does it make sense to ignore the historical numbers and to ASSUME that future returns are going to be different?

Many investors have a longing to follow Buy-and-Hold strategies because doing so permits them to count the phony portfolio gains of a bull market as real. They think of their choice of treating their nominal portfolio value as real as a reasonable default. Valuation-adjusted numbers seem odd, different, foreign. So they place weight on criticisms of Valuation-Informed Indexing that they do not apply to Buy-and-Hold strategies.

Treating nominal portfolio numbers as real is not a reasonable default. If stocks are greatly overvalued, the reasonable default belief is that prices will fall hard. We cannot say with certainty that what has always happened in the past will happen again this time. But we can say that that is the best assumption possible.

There is no certainty in this field. Those who demand certainty before putting their money down in the table will never invest. No one should think of Valuation-Informed Indexing as a sure thing. It is the most reasonable thing given the circumstances we face and the options available to us.

Rob Bennett has written an article titled Why Buy-and-Hold Investing Can Never Work. His bio is here.