Valuation-Informed Indexing #119

by Rob Bennett

Valuation-Informed Indexing is at the same time both extremely simple to understand and extremely difficult to understand.

It is extremely simple to understand because all that it requires is that you take the concepts of overvaluation and undervaluation seriously. If stocks are priced at three times fair value (according to the P/E10 metric), you need to divide the nominal value of your portfolio by three to know its real value. If stocks are priced at one-half of fair value, you need to multiply the nominal value of your portfolio by two to know its real value.

All sorts of powerful insights follow from this.

Knowing the true value of your portfolio permits you to plan your financial affairs far more effectively than you could when your understanding of the value of your portfolio was wildly off the mark. Since stock prices always move in the direction of fair value in the long run, knowing how far off the mark prices are today lets you know in which direction prices will be moving and thus permits you to set your stock allocation far more effectively. And on and on.

That’s all that is going on with this new model. If mis-pricing of stocks is a real phenomenon (Shiller’s research shows that it is) and if P/E10 accurately identifies the extent of mis-pricing (140 years of historical return data show that it does), all you need to do to become a far more effective investor is to stop placing your trust in the nominal value of your portfolio and instead place it in the P/E10-adjusted value.

That’s easy enough to understand. However, there’s an aspect of this model that makes it very hard to understand. The hard part is figuring out how something so simple could have been ignored by so many investors for so long a time. All investors want to achieve good results with their investments. If Valuation-Informed Indexing really provides far higher returns at greatly reduced risk, why aren’t we all Valuation-Informed Indexers?

The problem is that our understanding of human psychology is poorly developed. In area relating to economics, it is particularly poorly developed. The dominant economic model if often referred to as Rational Man Economics. Economists never proved that we pursue our self-interests rationally, they assumed it.

That unfortunate assumption has now been incorporated into the vast majority of analyses of economic and investing behavior. So moving to a more accurate model means unlearning things that we have taken for granted as being true for many years. If we came to the investing project with no preconceptions, Valuation-Informed Indexing would make perfect sense to all of us. However, coming to Valuation-Informed Indexing starting from a belief in the Buy-and-Hold Model makes for a highly disorienting experience.

One of the struggles that newcomers to the concept face is figuring out how investors know to sell stocks when prices get too high. A core principle of Valuation-Informed Indexing is that investors bid stock prices up too high for a time and then bid stock prices down too low for a time. They bid prices up too high because we all like free money and pricing our stock portfolios too high offers us an easy way to obtain it (for a time). But what makes us decide at some point to instead bid prices down too low?

We bid prices down too low because we all possess common sense as well as a Get Rich Quick urge. Our common sense is offended and alarmed by high stock prices. At the turning point in the bull/bear cycle, our desire to follow the dictates of common sense kicks in and we begin a process that over time leads to us pricing stocks too low rather than too high.

An interesting question is — How do we know when prices are too high?

We could look up the P/E10 value if we were so inclined. Whether stocks are priced high or low is public information. But the practical reality is that most of us do not pay much attention to the P/E10 metric. How is it that we all know when stocks are priced too high even though most of us don’t pay much attention to valuations?

The answer (I believe) is that we humans know all sorts of things that we do not realize we know. A book that offers an in-depth discussion of this point is The Wisdom of Crowds. The Wikipedia entry on the book explains that group assessments of a reality are often better informed than the assessments made by the smartest members of the same group. For example. “the crowd at a county fair accurately guessed the weight of an ox when their individual guesses were averaged. The average was closer to the ox’s true butchered weight than the estimates of most crowd members, and also closer than any of the separate estimates made by cattle experts.” The book discusses many illustrations of the phenomenon. There is an intelligence that only large communities of people possess.

The stock market is comprised of many people. Acting as a community, we know things. We know things that none of the best informed among us know as individuals. We even know things that we don’t know. We know today that stock prices will be headed downward again in days to come even though we do not today possess the confidence in this belief it would take for us to express it in words (or to act on it and thereby to speed up the day when prices fall).

I told you that some of this was going to be hard to take!

The community of investors knows things that no individual investor knows. One of the things it knows is when prices are too high. To know that, it must  know the P/E10 value. Yet most individual investors pay little attention to the P/E10 value!

The phenomenon I am describing is not nearly as odd at it sounds when read on an investing site. Investing analysts rarely talk about this sort of thing. Psychologists talk about this sort of thing all the time. I believe that, as the influence of the Behavioral Finance School grows, we will be seeing more discussions of this sort of thing in the investing literature. The reality is that all investing choices are made by humans and we cannot come to a complete understanding of how investing works without taking these sorts of considerations into account.

Rob Bennett writes about the many investing insights that follow from Robert Shiller’s finding that valuations affect long-term returns. His bio is here.