Valuation-Informed Indexing #191

by Rob Bennett

The conventional view is that most investors should be invested in bonds to the extent that they are not invested in stocks. The idea is that stocks and bonds are the two best investment classes for growth and that, outside of those two investment classes, all you need is an emergency fund invested in a money market account.

I believe that Shiller’s “revolutionary” (his word) finding that valuations affect long-term returns changes all the strategic rules, including the one that argues for investing almost exclusively in stocks and bonds while generally ignoring super-safe but generally low-return investment classes like TIPS, IBonds and CDs.

Shiller’s finding takes most of the risk out of stock investing for long-term investors open to the idea of changing their stock allocations in response to big valuation shifts. The research that I co-authored with Wade Pfau shows that an investor who follows a 90/60/30 stock allocation plan (increasing his stock allocation when prices are low and increasing it when prices are high) thereby reduces his risk by roughly 70 percent compared to the Buy-and-Hold investor who sticks with a 60 percent stock allocation at all times. Stock investing risk is today optional for long-term investors who invest in index funds.

The reason for investing in bonds under the Buy-and-Hold Model was that it is too risky to invest too heavily in stocks. The purpose of investing in the non-stock investing class was to reduce portfolio risk.

For the Valuation-Informed Indexer,  the purpose of investing in a non-stock investment class is different. The primary purpose is to provide a means to conserve one’s money during times when stocks are too overpriced to offer a decent return. The extreme example was in 2000. Stocks were priced to provide a 10-year annualized return of a negative 1 percent real. TIPS and IBonds were paying 4 percent real. The Valuation-Informed Indexer shifted most of his portfolio to TIPS or IBonds because it just does not make sense to let one’s retirement money lie dead for 10 years. That’s 10 years without compounding.

Bonds didn’t offer nearly as appealing an alternative to stocks as TIPS and IBonds. Bonds may work well for people who spend a great deal of time researching the bond market. But the average investor knows little about bonds and one of the worst decisions an investor can make is to invest in an investment class that he does not understand in depth. It’s hard to stick with a plan through the hard times when you don’t possess a good understanding of what is going on.

Bonds sometime move in the same direction as stocks. In those circumstances, they offer little diversification benefit. And of course the investor never knows in advance when such a time is about to turn up. Bonds are also more complicated than TIPS or Ibonds or CDs. Simplicity is always a plus.

Perhaps most important of all, it is an easy thing to shift money from TIPS or IBonds or CDs to stocks when stock prices drop. Bonds are like stocks in that there are time-periods in which you are down and in which you very much do not want to sell. The Valuation-Informed Indexer looks to stocks for growth. So he always wants to be able to take advantage of the juicy long-term returns available when stocks are selling at fair-value prices or better. You don’t want to be stuck in bonds at such times.

The returns available on TIPS IBonds and CDs in 2000 are not the norm. Those returns are not available today in the super-safe asset classes. That causes lots of investors to want to avoid these asset classes.

The other side of the story is that we are closer today to low stock prices than we have been for many years. Low P/E10 levels don’t turn up randomly. They generally turn up only at one point in the bull/bear cycle that has applied in stock investing for 140 years now — we see P/E10 levels far below fair value (which can translate into annualized 10-year returns of 15 percent real) after huge bull markets collapse.

We’re not there yet. The crash of 2008 got us only about halfway there. But we are only one price crash away at this point and that crash is likely to arrive before the end of President Obama’s presidency. It’s important to protect your money today and to have it invested in investment classes that provide a great deal of flexibility. Even TIPS, IBonds and CDs that pay low returns fit the bill well.

It is counter-intuitive how big a difference it makes to be able to move a higher amount of money into stocks when the long-term return for stocks turns juicy. If you work the numbers, you will see that obtaining an annualized return of 15 percent real for 10 years running multiplies your savings in a remarkably short amount of time. Obtaining small returns from TIPS, IBonds and CDs for a few years can pay off big when stock prices fall hard.

The key to all this is understanding that good years for stocks and bad years for stocks do not play out randomly. They play out in the same pattern over and over again. Stock prices head generally upward for many years and then crash and then remain low for a good number of years. We all enjoy the good stretches of time and the bad stretches of time at some points in our investing lifetimes. The trick is to be well-positioned to take full advantage of the good stretches.

To do that, you need your non-stock asset classes to be flexible and to provide predictable (even if small) returns. TIPS, IBonds and CDs generally do a better job of providing what is needed at times when stock prices are high. At times when stock prices are moderate or low, you of course want to be invested primarily in stocks.

Rob Bennett has recorded a podcast titled It’s Not a Conspiracy, It’s Cognitive Dissonance. His bio is here.