Valuation-Informed Indexing #153

by Rob Bennett

I have a calculator at my site (“The Investor’s Scenario Surfer”) that lets me test whether Valuation-Informed Indexing or Buy-and-Hold provides better long-term results. I have run hundreds of tests and Valuation-Informed Indexing always puts me ahead.

In fairness, I need to report that from one way of looking at things, that is not quite true. Of the tests I have done, Valuation-Informed Indexing has left me with a larger portfolio value 90 percent of the time. The Buy-and-Hold portfolio that sticks with an 80 percent stock allocation at all valuation levels usually comes in second. The Buy-and-Hold portfolio that sticks with a 50 percent stock allocation at all valuation levels usually comes in third. The Buy-and-Hold portfolio that sticks with a 20 percent stock allocation at all valuation levels usually comes in last.

I believe that it is fair to say that Valuation-Informed Indexing always wins. A strategy that offers only a 10 percent chance of providing superior numbers is obviously much risker than a strategy that offers a 90 percent chance of providing superior numbers.

Also, in the cases in which Valuation-Informed Indexing provides superior numbers, the difference is often quite large. I have seen cases in which the Valuation-Informed Indexer had a portfolio of double the size of the portfolio held by the Buy-and-Holder at the end of 30 years. In contrast, the difference in portfolio amounts is usually small in the cases in which one of the Buy-and-Hold portfolios (almost always the 80 percent stocks portfolio) ends up on top.

It’s also good to remember that the calculator only shows results for a 30-year time-period. Most of us have investing lifespans of about 60 years. The Valuation-Informed Indexing edge would grow much larger over an additional three decades.

So I think it is fair to say that Valuation-Informed Indexing always beats Buy-and-Hold in the long run.

But why?

Five reasons.

One, a key principle of Valuation-Informed Indexing is that stocks are generally the superior asset class. For good long-term results, you want to be as heavily invested in stocks as possible. I of course lower my stock allocation dramatically when valuations go so high that stocks become truly dangerous. But at all other times — that is, at MOST times — I go with a stock allocation of 70 percent or 80 percent. So the Buy-and-Holder rarely has a chance to catch up with me once I go ahead. If I am able to gain an edge during the limited number of years when stocks do not offer a strong value proposition, I am likely to gain an edge that I will never give up.

Two, all stock crashes of lasting consequence take place at times of insanely high valuations. There’s never been an exception. So Valuation-Informed Indexing lets me take advantage of all the benefits that stocks really do possess while not ever getting hurt by the one major downside of stock investing, the price crashes that wipe out decades of wealth accumulation in a few months of time.

Three, the compounding returns phenomenon grows the edge gained by going with a low stock allocation at a time of high prices into a very large number over time. It is hard for people who have not studied the numbers to get their heads around this one. I have seen the power of compounding work its magic so many times that I now can predict how a 30-year returns sequence is going to turn out in Year 10 or 12 or 15. Often, the Buy-and-Holder will go ahead of me for a few years at times of high valuations (when I go with a low stock allocation but a bull market pushes crazy prices to even crazier levels). Then there will be a price crash that will put me ahead by a modest amount. Then, with prices back at reasonable levels, I will return to a high stock allocation matching the one held by the 80-percent-stocks Buy-and-Holder. But compounding will cause my differential to get bigger and bigger over the years and I will end up with a far larger portfolio amount at the end of 30 years.

Four, Valuation-Informed Indexers don’t freak out during crashes. I assume for the purposes of the calculator tests that the 80 percent Buy-and-Holder will stick with his 80 percent stock allocation even after suffering devastating losses. Adopting this assumption slants things heavily in favor of the Buy-and-Holder. In the real world, most Buy-and-Holders abandon stocks after enduring price crashes and thus miss out on the price recoveries that follow the worst crashes.

Five, because I lose less money in price crashes, I have more money to invest in stocks in years when stocks are selling at reasonable prices. My critics often argue that the reason why I go with low stock allocations at times of insanely inflated prices is that I am a bit of a scaredy cat. Nothing could be further from the truth. I go with low stock allocations at times when super-safe asset classes are offering higher returns than stocks because I want to have as much money as possible to invest in stocks when they are priced well. The market does not provide equal results at all time-periods. Most returns are telescoped into the time-periods that follow price crashes. The key to long-term success is being able to participate in those boom times for stocks to the greatest extent possible. And the key to being able to do that is being sure not to lose too high a percentage of your life savings in the price crashes that set the stage for the boom periods.

Rob Bennett has recorded a podcast titled “The Last Bear Market.” His bio is here.