Valuation-Informed Indexing #126

by Rob Bennett

The subtitle of Robert Shiller’s book Irrational Exuberance describes the new model for understanding how stock investing works set forth therein as “revolutionary.” Is it ever!I I’ve learned during my 10 years of writing about the implications of the Shiller model (Valuation-Informed Indexing) that his research findings throw our most fundamental beliefs about stock investing into question.

Stocks are riskier than bonds.

Everybody knows that.

That’s why stocks offer better long-term returns.

We’ve known that stocks are risker than bonds for a long, long time.

Except they aren’t. Not if you accept Shiller’s findings and appreciate what they tell us about how stock investing really works.

The research that has been done in the wake of Shiller’s findings shows that investors who adjust their stock allocations in response to big changes in valuation levels thereby reduce the risks of stock investing by 70 percent.  Even those who believe with their hearts, minds and souls that stocks are risker would acknowledge that it would be bonds that would be the more risky asset class if a way became available to reduce the risk of stock investing by 70 percent. There you have it!

In a real-world sense, stocks remain more risky. But that’s only because we have not yet as a society seen fit to launch the national debate we need to have to come to terms with what Valuation-Informed Indexing is all about. Once we do that, we really will all learn how to reduce the risk of stocks by 70 percent and bonds really will from that point forward be the more risky asset class.

The high returns provided by stocks are NOT provided as compensation to investors willing to take on the greater risk of stocks. In fact, there is often a reverse correlation between risk and return. Stocks were the riskiest they have ever been in history in 2000, when the likely going-forward return was the lowest it has ever been. Stocks were the least risky they have ever been in history in 1982, when the likely going-forward return was the greatest it has ever been.

The idea that investors are compensated for taking on risk makes sense. In fact, all of the Buy-and-Hold model makes sense. That’s just the problem. Investing is done by humans. Humans are emotional creatures. Emotional creatures often do not make sense. An investing model that always makes sense is an investing model that cannot possibly do a good job of explaining how stock investing works.

It’s not taking on risk for which investors are compensated. Investors are rewarded for taking on perceived risk. The perception that stocks are risky was sky high in 1982 even though actual risk was rock-bottom low. The perception that stocks are risky was rock-bottom low in 2000 even though actual risk was sky high. Shiller’s research teaches us that it is perceived risk that we need to look to rather than actual risk to explain investor behavior and that it is real risk rather than perceived risk that we need to look to to invest effectively ourselves.

When we invest pursuant to what we have learned from the new research, stock risk drops dramatically, enough to make stocks less risky than bonds. Buy-and-Holders just cannot get their heads around this concept. Bonds should be riskier than stocks. Bonds must be riskier than stocks. That’s the argument. It doesn’t matter what the historical stock-return data says. Stocks should be more risky and stocks must be more risky — So stocks ARE more risky.

The reason why bonds are more risky is that investors can avoid stock risk by taking valuations into consideration when setting their allocations while they cannot avoid bond risk. The biggest risk in owning bonds is that inflation will get out of control. There’s nothing that the investor can do about inflation. The inflation factor is neutralized for the stock investor because the 6.5 percent real return always provided by stocks in the long term is a real (inflation-adjusted) return.

But the market cannot permit a less risky asset class to provide a higher long-term return!

Oh, yes it can!

Those who own index funds own a share of the productivity of the U.S. economy. The U.S. economy has for 140 years now been sufficiently productive to finance an average annual stock return of 6.5 percent real. There is little reason to believe that that number will be dramatically higher or dramatically lower in the future. The market can temporarily change that return by temporarily pushing valuations to high levels or low levels. But valuation levels always revert to the mean. So that return always ends up being the return that applies for the valuation-informed investor.

Bond returns, in contrast, are set by the companies issuing the bonds. When most investors become irrationally exuberant for stocks, the companies issuing bonds can get away with lowering the returns paid on them, even to levels far below the levels being paid to those investing in less risky stocks. The market is rational only in part. It strives to be rational but can achieve its goal only to the extent that it is not blocked from doing so by the popularity of irrational stock investing strategies.

As word about the implications of Shiller’s findings spreads, stock investors will become more rational. That will increase the returns that most of us obtain from stocks. It will also impose pressures on companies offering bonds to offer higher returns on them. It’s unlikely, however, that bond returns will rise enough to match stock returns. Stocks will be the higher return/reduced risk investment class of the future. People will buy bonds for reasons other than seeking to minimize risk or to maximize return.

Rob Bennett created The Retirement Risk Evaluator. His bio is here.