Valuation-Informed Indexing #194

by Rob Bennett

I have made lots of controversial claims in my 12 years of explorations of Shiller’s “revolutionary” (his word) insight that valuations affect long-term returns. But there is no claim that I have advanced that is more controversial than the one I argue in this column — Price volatility is optional.

It seems like a crazy thing to say. Stock prices have been volatile since the first market opened for business. It is volatility that makes stock investing risky. So every stock investor would like to see volatility reduced. If we could do away with volatility, we would jump at the chance. Yet volatility very much remains with us. So how could it possibly be that volatility is in any way, shape or form optional?

Please take a look at this graphic (it was created by Academic Researcher Wade Pfau during the time we were working together developing the Valuation-Informed Indexing concept):

1996 Forward

The graphic shows results from 1996 for an investor going with a 100 percent stock allocation and for an investor going with Treasury bills for that entire time period. The former investor was obviously taking on FAR more risk since he was invested in stocks rather than Treasury bills. And the former investor experienced FAR more volatility — the blue line dramatically goes up and then dramatically down and then dramatically up and then dramatically down while the red line in great contrast slopes gently upward for the entire time-period.

The results at the end of the day are precisely the same! Investors can obtain the same results without the craziness. Volatility is optional.

It is not only in this one 12-year time-period that this has been so. It has always been so. Here is a graphic making the same comparison for the entire time-period from 1871 forward:

1870 Forward

Staying in stocks when prices are good and getting out of stocks when prices are bad has for 140 years produced the same result as staying in stocks at all times at greatly reduced risk. Most investors are causing their portfolio values to become far more volatile than they need to be for no good reason. The market offers no reward to those who take on extra volatility. That’s a myth. Volatility is optional.

Now —

There obviously was volatility in the market during the 140 years examined in these two graphics. The individual investor had the choice of opting out of the volatility by changing his stock allocation in response to big valuation shifts. But the market itself has of course been highly volatile for its entire existence.

But what if we were to educate investors re the implications of Shiller’s “revolutionary” (his word) finding that valuations affect long-term returns? If all investors knew to lower their stock allocations when prices got too high and to increase their stock allocations when prices got too low, what would happen? There would for the first time in history be a brake on price increases and on price drops.

It is investors who determine price changes. Investors informed of the research findings of the past 33 years are going to act in ways different from how any investors of the past have acted. Because they know something that investors of the past did not know! Investors who are informed of the implications of Shiller’s findings will stop both bull markets and bear markets before they get going.

It seems so strange on first consideration.

But after you think it over a bit, you come to see that it makes perfect sense.

The long-term return has for a long, long time been 6.5 percent real. Economic developments don’t change that. There are always going to be positive and negative economic developments and informed investors know that at the end of the day the economy is likely going to be productive enough to finance an annual return of 6.5 percent real. So why should there be volatility? If the long-term return expectation is always the same, the annual growth in stock prices should also always be the same.

Volatility has been part of the stock investing experience for many years because for many years we did not know the true cause of price changes. We thought that price changes were caused by unforeseen economic developments, which by definition always hit us by surprise. Price changes caused by unforeseen developments cannot be controlled. But price changes caused by investor psychology certainly can be. All that we need to do is to educate investors of the need to abandon Buy-and-Hold strategies and to open to the idea of keeping their risk profiles constant by adjusting their stock allocations in response to big price changes.

Volatility was not optional for many years. But 33 years ago it became optional. Now it’s just a question of getting the word out.

Rob Bennett has recorded a podcast titled What Should You Be Investing In When You Aren’t Investing in Stocks? His bio is here.