Valuation-Informed Indexing #163

by Rob Bennett

What would you think of an investment advisor who told you that you should be going with an 80 percent stock allocation or a 20 percent stock allocation but who wasn’t willing to say which of the two possibilities made the most sense?

You probably would think he was worthless.

Perhaps you would be right.

Still, the truly honest investing professional of today has to acknowledge that that’s the advice he should be giving.

There was time when just about everyone thought that Buy-and-Hold was the answer. The Buy-and-Hold Model argues that stocks are always the best choice in the long run. So, for a young investor comfortable with taking on some risk in return for the promise of solid portfolio growth, an 80 percent stock allocation makes sense. I have even heard Buy-and-Holders say that stock allocations in this general neighborhood are “optimal.”

However, it is now 32 years since Yale Economics Professor Robert Shiller published his “revolutionary” (Shiller’s word) research showing that valuations affect long-term returns. If that’s so, the optimal allocation is not a constant percentage of your portfolio but a percentage of your portfolio that VARIES with changes in valuations. The numbers reveal that, at today’s valuations, an allocation of 20 percent or so makes sense for the typical middle-class investor.

There are smart and good people on both sides of the Buy-and-Hold/Valuation-Informed Indexing divide. So what is the conscientious investment advisor to do? Recommend an 80 percent stock allocation, ignoring Shiller’s findings and the 32 years of peer-reviewed research finding no significant problems with Shiller’s work? Or recommend 20 percent, ignoring the publicly expressed beliefs of 90 percent of those working in this field today? When expert opinions produce results so poor that litigation follows, a showing by the expert that he followed a common industry practice often goes a long way toward exonerating him. Can today’s stock advisors afford to ignore the beliefs of the Buy-and-Holders, even if they personally lean towards a belief that Shiller is on to something?

It’s quite a little fix we find ourselves in.

Could the answer be to pick a number in the middle? Halfway between 80 percent and 20 percent lies 50 percent. Is it investing professionals who recommend stock allocations of 50 percent who are taking the most prudent path?

I don’t think so. The benefit of rooting one’s opinions in research is that by doing so one escapes the influence of one’s personal biases. There’s research thought by many to support Buy-and-Hold. And there’s research thought by many to support Valuation-Informed Indexing. There’s no research supporting the idea of advocating the stock-allocation percentage that is at the mid-point of the percentage that follows from a belief in the Buy-and-Hold Model and the percentage that follows from a belief in the Valuation-Informed Indexing Model. Try to avoid the “extreme” recommendations that follow by going with either model by splitting the difference and you end up out on your own in the middle of an ocean of non-research-supported recommendations.

Responsible people like to take moderate positions. Responsible people are drawn to compromise. Where is the acceptable compromise re this matter?

I think the acceptable compromise is to acknowledge the confusion that dominates all discussions of the investing realities today. We do not know what is best. 

We like to think we do. We all have our strongly held opinions. But the full reality is that the Buy-and-Holders are being arrogant when they talk as if they have it all figured out and don’t even bother to try to integrate Shiller’s findings into their understanding of how stock investing works. I believe that Shiller corrected the Buy-and-Hold Model and make it workable in the real world. But the full reality here is that I would be arrogant myself if I declared that there is zero possibility that my many sincere Buy-and-Hold friends are surely off base. They seem to me to be off base. But I am one of those flawed humans. In their eyes, I am the one who is off base.

So the right way to handle things is to say: “I believe that the best allocation for someone in your circumstances is 80 percent but I have to add that there are good and smart people out there who believe just as strongly and with research every bit as serious backing up their belief that 20 percent is the better choice.” The Valuation-Informed Indexers need to say it the other way around, of course.

It’s not a super message from a marketing standpoint. Investors don’t want to hear a wishy washy message. They pay experts to tell them what to do. They view an expert who fails to take a stand as an expert who is not doing his or her job.

So all investing professionals need to take a stand. We all need to be saying “I believe that 80 percent is best and that the research supports me on that point” or “I believe that 20 percent is best and that the research supports me on that point.”

The idea here is that we ALSO need to note that there is another strongly held viewpoint out there that is every bit as legitimate (at least in the eyes of some). It’s wrong to fail to mention that. Investors need to know that the research is not settled, that a respected economics professor has raised a challenge to the premises of the now-dominant model and that that challenge has not been effectively countered in over three decades.

I believe in Valuation-Informed Indexing. But I have made lots of big mistakes in the course of this lifetime and it could be that I am doing it again. Before you listen to anything I say on investing, you need to know that I could be wrong.

(But I’m not.)

Rob Bennett has recorded a podcast titled Investing Is a Science (When It’s Not Science Fiction).

His bio is here.