Valuation-Informed Indexing #176

by Rob Bennett

Say that you converted to Valuation-Informed Indexing at the beginning of 2013. You had earlier been going with a 70 percent stock allocation. But your concern over today’s high valuations and the likelihood of a devastating price crash persuaded you to lower your stock allocation to 20 percent. You moved half of your life savings from stocks to Certificates of Deposit paying  a return of 2 percent real.

Stocks did well this year.

Better than your CDs.

So you did poorly. Valuation-Informed Indexers came up losers.

That’s how Buy-and-Holders think about it. That’s not how Valuation-Informed Indexers think about it. Our differences with the Buy-and-Holders extend to the basic question of how to determine whether one’s investing strategy is working or not.

You know what? My guess is that, if you went through the 140 years of historical return data to determine how many years Buy-and-Holders did better for the year and how many years Valuation-Informed Indexers did better for the year, the Buy-and-Holders would be shown to have more victories. The trouble is, you can have better years 60 or 70 or even 80 percent of the time and still end up behind at the end of your investing lifetime.

At the beginning of this year, I knew that there was a good chance that the return paid by stocks was going to beat the return paid by CDs. Does it follow that stocks were the better bet? It does not. Stocks are insanely overpriced today. When stocks are insanely overpriced, there is still a chance that they will do well over the next 12 months. However, there is also a chance that they will do very, very, very poorly. When stocks are insanely overpriced, there is a significant chance that we will see the sort of price crash that wipes out DECADES of savings. A 50 percent price crash wipes out nearly half of the accumulated savings of a lifetime. Many investors can never recover from the sort of price crash that has a good chance of coming about when stocks are priced as they are priced today.

The likelihood of a crash is never so high that the odds are that stocks will under-perform the super-safe asset classes. Crashes are always a less-than-50-percent possibility. But, when prices reach the levels where they reside today, the odds of a crash are great enough to warrant shifting a good percentage of your portfolio to an asset class that doesn’t experience crashes. Stocks are not the place to be today, according to the last 32 years of peer-reviewed academic research (the Shiller-based research ignored by most Buy-and-Holders)

I didn’t make a mistake by “missing out” on this year’s stock gains. I deliberately chose to miss out on any gains because the risk of a crash is so high when prices are where they are today. I “missed out” on that risk and that is what I wanted to do. The lower return I obtained by going with a low stock allocation is a trivial thing, something that can be made up in a short amount of time. The setback I would experience by being heavily invested in stocks during a price crash is something that would take me years or even decades to set right. No thanks.

The full truth here is that I never invest only for the returns I will receive over the course of a single year. Stocks are priced to deliver a 65 percent price crash sometime within the next year or two or three. Any money I can hold onto until the P/E10 level is back at 8 is money that I will be earning an annualized ten-year return of 15 percent real on in the days following the crash. An investor can make a lot of progress toward financing a retirement in a short amount of time earning 15 percent real for ten years running.

But you don’t find yourself in those sorts of promising circumstances by luck. You need to position yourself to enjoy them to the fullest. That means limiting your losses in the crash. That means going with a lower stock allocation in years in which the return paid on stocks beats the return paid by the super-safe asset classes. Earning a smaller return for a few years opens up the possibility to earn a far higher return over the course of an investing lifetime. Earning the smaller return for a few years is a good thing, not something to feel even a tiny bit bad or apologetic about.

The strategic points that I am making here are very basic. If I were describing a baseball manager who called for a sacrifice bunt because he saw that giving up an out in the short-term increased the odds of ending the inning with a potential game-winning run, everyone would get it. The sad reality is that most investors do not get this simple point when it comes to making strategic choices re their stock allocations. The Buy-and-Holders teach that it is always a good time to buy stocks and many believe them. Once you let your thinking be confused by the thought that there is one asset class that is always a good one, your ability to understand 80 percent of the strategic possibilities of the investing game is gone.

Who will end up ahead at the end of 10 years?

That’s the question that matters.

No one knows the future, of course. So we cannot say anything for certain on this point.

But we can look at the historical return data. Do that and you will see that the Valuation-Informed Indexers have ended up ahead of the Buy-and-Holders on a risk-adjusted basis for the entire 140 years. Valuation-Informed Indexing has won every contest. There’s never been an exception.

But that is so only in the long term.

Most investors want to do well this year.

That’s why most investors are drawn to Buy-and-Hold strategies.

That’s why most investors are not seeing their portfolios accumulate enough to support a decent middle-class retirement.

Most of us are overly impressed by short-term results and The Stock-Selling Industry plays to that weakness to promote the Buy-and-Hold strategies that doom our long-term hopes.

I obtained a poor return on my portfolio in 2013. Another great year!

Rob Bennett has recorded a podcast titled The Future of Investing. His bio is here.