Valuation-Informed Indexing #223
by Rob Bennett
Most of my column entries here argue for the merits of Valuation-Informed Indexing (the model for understanding how stock investing works rooted in the research of Yale Economics Professor Robert Shiller) over Buy-and-Hold (the model for understanding how stock investing works rooted in the research of University of Chicago Economics Professor Eugene Fama). The reality is that most investors follow modified versions of one of the two research-based models, strategies that I refer to as Strategy C (the modified version of Buy-and-Hold) and Strategy D (the modified version of Valuation-Informed Indexing).
The easiest way to differentiate the four strategies (Buy-and-Hold is Strategy A and Valuation-Informed Indexing is Strategy B) is to compare the stock allocations percentage chosen by investors following each of them.
Buy-and-Holders believe that risk is constant and that, thus, investors should generally maintain the same stock allocation percentages at all times. There is research showing that the “optimal” stock allocation is 75 percent stocks. So the pure Buy-and-Holders are investors who go with stock allocations somewhere in the neighborhood of 80 percent at all times (I am using 80 percent rather than 75 percent because using a round number makes it easier to compare Buy-and-Hold with the other three strategies).
Valuation-Informed Indexers believe that risk is variable and that it increases with increases in valuations. At today’s price level, the research shows that the best stock allocation for the typical middle-class investor is something in the neighborhood of 20 percent stocks.
Buy-and-Hold has been the dominant model for some time and remains popular today. But knowledge of the inconsistencies in the logic behind the Buy-and-Hold Model has been growing for decades and few investors are comfortable following a pure Buy-and-Hold strategy. Even Vanguard Founder John Bogle has acknowledged that it might make sense for investors to lower or increase their stock allocations by about 15 percent at times when valuations are “stupidly high or stupidly low.” Strategy C investors are investors who are convinced that Buy-and-Hold is essentially right but who have doubts that it is precisely on the mark. Strategy C investors might go with 60 percent stock allocations at all times.
Just as there are investors who prefer a non-dogmatic approach to the Buy-and-Hold concept, there are investors who see merit in the idea of changing their stock allocations in response to big price swings but who view it as being too extreme to go with a stock allocation as low as 20 percent stocks. Strategy D investors might go with a stock allocation of 40 percent when stocks are priced as they are today.
The numbers I am going to put forward as my estimate of what percentage of the investing population falls into each of the four camps are entirely non-scientific. These numbers are not taken from surveys. They are my best guesses based on the feedback that I have heard from the thousands of middle-class investors with whom I have interacted on internet discussion boards and blogs over the past 12 years.
My rough guess is that about 20 percent of investors are pure Buy-and-Holders and about 5 percent are pure Valuation-Informed Indexers. The majority of investors use the academic research only as a rough guide and prefer non-dogmatic approaches to asset allocation. Most of these follow a modified version of Buy-and-Hold (Strategy C), the most popular of the four strategies. I would put the percentage of the investing population that follows Strategy C at about 60 percent. The remaining 15 percent of the investing population leans toward believing in the precepts of Valuation-Informed Indexing but is not sufficiently convinced to go with the extremely low stock allocations that the research on the effect of valuations suggests is appropriate when stocks are selling at the prices that apply today.
How will this change in the event that we see another price crash within the next two years?
The percentage of investors following a pure Buy-and-Hold strategy will obviously drop. However, my guess is that even another price crash will not cause all of this model’s dogmatic followers to give up the fight. My guess is that we might see 10 percent of the investing population continuing to sing the praises of the pure Buy-and-Hold approach, even in the face of another unsettling price crash.
We will of course see more Valuation-Informed Indexers following another crash. But, again, I do not anticipate huge changes in the number following one of the two dogmatic (I am not using this word as a pejorative — it is the fact that Buy-and-Hold and Valuation-Informed Indexing are both research-based and numbers-based strategies that makes them more “dogmatic” than the two more flexible but non-research-based strategies) approaches. My guess is that we might see the percentage following Valuation-Informed Indexing increase from 5 percent to 20 percent of the population.
The big changes will be with the two non-dogmatic strategies.
I expect that another crash might cause the percentage of the population following a modified version of Valuation-Informed Indexing to increase from 15 percent to 30 percent. And we might see a change in the percentage following a modified version of Buy-and-Hold drop from 60 percent to 40 percent.
Thus, the total percentage following either a pure Buy-and-Hold strategy or a modified Buy-and-Hold strategy might drop from 80 percent to 50 percent while the total percentage following either a pure Valuation-Informed Indexing strategy or a modified Valuation-Informed Indexing strategy might increase from 20 percent to 50 percent.
With an equal number of investors following either a pure or modified version of each of the two research-based school of thought, our knowledge of the realities of stock investing will begin advancing at a much quicker pace than what we have seen in the 33 years since publication of Shiller’s revolutionary (his word) finding of 1981 that valuations affect long-term returns. No one wants to see the human misery that will accompany another stock crash. But the unfortunate reality is that humans are often unwilling to embrace change until they see no other options and Buy-and-Hold has performed well enough for many of us to feel comfortable ignoring its theoretical shortcomings and continuing with it for a bit longer. Such complacency will not survive the financial setbacks that would come from another price crash so close on the heels of the one that hit with such a shock in late 2008.