Valuation-Informed Indexing #215

by Rob Bennett

I often refer to Valuation-Informed Indexing as a new investing strategy. Speaking precisely, that’s not what it is. It is a new model for understanding how stock investing works. I’ll try to explain below what the difference is and why it matters.

People often describe the idea of changing your stock allocation in response to big shifts in stock valuations as “tactical asset allocation.” That’s not a phrase that someone who believes in Valuation-Informed Indexing would use. For the valuation-informed indexer, there is nothing optional about changing your stock allocation in response to big valuation shifts. This is something that the rational investor MUST do. And it is a strategic choice, not a tactical one.

The root issue is the question of what causes price changes. If price changes are causes by unforeseen economic developments, as Buy-and-Holders believe, it does not make sense to change one’s stock allocation in response to valuation shifts. Unforeseen economic developments obviously cannot be predicted. So there is never any reason to move away from the stock allocation that you determined at an earlier time was the right one for someone with your risk profile.

The reason why tactical asset allocation is becoming more popular is that there is now 33 years of peer-reviewed academic research showing that long-term timing always works and more and more people are learning about it (despite the best efforts of the Buy-and-Holders to quash such learning experiences). There hasn’t been enough public exploration of the merit of the Valuation-Informed Indexing concept for too many people to have concluded that long-term timing. So many are seeking a middle ground in which one follows a Buy-and-Hold strategy but then makes tactical adjustments to it to make it take on some of the surface appearances of a Valuation-Informed Indexing strategy.

Tactical asset allocation is a bad idea, in my assessment. I don’t feel any more comfortable with it than I do with Buy-and-Hold strategies.

The problem is that the people who engage in tactical asset allocation are not clear on when allocation changes should be made or how large they should be on how they will know whether the changes will be successful or not. I can easily imagine someone making a tactical shift downward when prices crashed in late 2008 and then another tactical shift upward when prices took off again (on grounds that the risk of a total economic collapse had passed). This is of course the opposite of the strategic shifts that a Valuation-Informed Indexer would make (we increase our allocations when prices drop and increase them when prices rise). But it is the sort of change that is made by someone who is thinking tactically rather than strategically.

When people call Valuation-Informed Indexing a “strategy” rather than a “model,” you have to wonder what model they are looking to for answers to the most fundamental questions of how stock investing works. They are almost always looking to the Buy-and-Hold Model for answers to those questions. People who make tactical allocation shifts often believe that long-term timing does not always work or that stock risk is stable rather than variable or that the reason why stock pay higher returns than other asset classes is because investors choosing stocks are being compensation for the extra risk they are taking on. The are engaging in a particular action — changing one’s stock allocation in response to valuation shifts — in a context in which all of their thinking about stock investing questions are influenced by long-discredited Buy-and-Hold ideas.

Valuation-Informed Indexers believe that risk varies with changes in valuations. So investors seeking to keep their risk profiles constant MUST adjust their stock allocations from time to time. The reason WHY you change your stock allocation matters. If you are not clear on the reasons why it is imperative to do this in some circumstances, you will likely not be able to stick with your stock-allocation change long enough for it to pay off.

Stocks are risky when the P/E10 value goes much above 20. A Valuation-Informed Indexer is not going to rethink her decision to lower her stock allocation from 60 percent to 30 percent because the P/E10 value goes from 23 (highly dangerous) to 26 (insanely dangerous). She is not worried about being “left behind.” The Valuation-Informed Indexer understands a high P/E10 value as a signal of widespread investor irrationality and is not persuaded by even higher P/E10 levels to get in on the fun. A higher P/E10 level tells the Valuation-Informed Indexers that the irrationality is even more out of control. He is not worried about “missing out” on even more irrationality because he understands that in the end irrational markets always hurt the investors heavily invested in them.

The point here is that Valuation-Informed Indexing is not one idea (that it is okay for an investor to change his stock allocation in response to a big change in valuation levels) but a family of ideas that all connect to each other. When you understand why prices go too high, you understand why you must change your stock allocation from time to time. And when you understand why you must change your stock allocation from time to time, you understand why stock investing does not need today need to be anything close to how risky it has always been in the past. You have to understand all the principles underlying the new model for any one element of it to make complete sense.

There are numerous Valuation-Informed Indexing strategies, just as there are numerous Buy-and-Hold strategies. Some Valuation-Informed Indexers prefer to limit their allocation changes to one per decade on average. That works fine. Others prefer to make annual changes that are far more gradual in nature. That works fine as well. The fundamental principle that distinguishes all Valuation-Informed Indexers from their Buy-and-Hold friends is that Valuation-Informed Indexers believe that allocation changes are mandatory for those seeking to keep their risk profiles stable.

Valuation-Informed Indexing is a new model for understanding how stock investing works, intended as a replacement of the long-discredited Buy-and-Hold Model. It is not just one new strategy to be practiced under the Buy-and-Hold umbrella, bit an entirely new system for making sense of the market.

Rob Bennett has recorded a podcast titled We Cannot Have Free Markets Without Free Speech. His bio is here.