Valuation-Informed Indexing #279

by Rob Bennett

Buy-and-Holders believe that it is okay to maintain the same stock allocation regardless of how much valuations change. Valuation-Informed Indexers believe that investors should seek to maintain the same risk level at all times and must adjust their stock allocations in response to big valuations shifts to do that.

The research shows that Valuation-Informed Indexers earn far higher long-term returns at greatly reduced risk. How can that be possible? Market returns are determined by the productivity of the economy. How can one investing strategy earn far higher returns than another off of the same level of economic productivity?

There are four explanations.

First, to some extent the higher returns enjoyed by Valuation-Informed Indexers come out of the pockets of Buy-and-Holders. Buy-and-Holders are confident that they will receive the average long-term return of 6.5 percent real that the U.S. market has generated for 140 years now. The reality is that they are fooling themselves.

Stock valuations can move gradually upward for 20 years and then drop hard. During the 20 years of upward movement, stock investors enjoy the 6.5 percent real return supported by the economic realities as well as the pretend gains generated by the increases in valuation levels. The small price drops that are mixed in with the gains are in a big picture sense inconsequential. But the investors who ride out these price drops congratulate themselves for doing so, thinking that the small bits of pain that the market has dished out over this 20-year period is as bad as it gets and that they have demonstrated the tenacity needed to stick with stocks for the long run.

The devastating price drops that come only in the aftermath of huge bull markets shock most investors. Those who had come to believe that they were tough enough to stick with their high stock allocations through the worst that the market is capable of dishing out learn that they underestimated how difficult it is to follow a Buy-and-Hold strategy in the real world. They sell at low prices and hold back from buying back in when stock prices reach rock-bottom levels. They diminish their lifetime return dramatically by doing so.

Those lost returns end up in the hands of the Valuation-Informed Indexers, who are able as a result of their willingness to go with low stock allocations when prices are sky high to afford to go with very high stock allocations when prices are low and long-term returns are off the charts. It’s not just that paying attention to valuations permit those who follow the first true research-based strategy to capture the 6.5 percent real return that the Buy-and-Holders seek but fail to obtain. Followers of the new strategy actually earn a return a good bit higher than 6.5 percent real.

The second explanation is that Valuation-Informed Indexing diminishes inequities in how returns are distributed throughout the population. Periods in which stock returns are poor are not randomly distributed across time. Amazing returns are supplied throughout the 20 years or so of increasing valuations, then awful returns are supplied during the 15 years or so of poor returns that follow. This means that investors who happened by virtue of being born at the right time to have lots of assets to invest during the bull phase end up with higher lifetime returns than those who by virtue of being born at the wrong time cannot earn much on their stock investments during the stage of their lives when they have lots of assets to invest.

A shift to Valuation-Informed Indexing would diminish or reduce these inequities. This factor does not increase or decrease the returns earned collectively by all investors but it smooths them out. A higher percentage of investors earns returns good enough to finance a decent middle-class retirement in a world in which the last 34 years of peer-reviewed research is widely promoted than is the case in a world in which Buy-and-Hold is the dominant strategy.

The third factor is that risk is greatly diminished by Valuation-Informed Indexing. This factor does not increase the returns enjoyed by investors in a direct way. However, it does increase the return obtained in response to taking on a specified amount of risk, which is a benefit of significant value.

Valuation-Informed Indexing reduces risk by stabilizing returns. Investors who change their stock allocations in response to price shifts act as a brake on the general inclination to push stock prices ever higher. Investors who understand that stocks offer a less appealing value proposition when prices are high counter the effect of the emotional investors who get caught up in the irrational exuberance of bull markets. Stock prices are self-regulating in a world in which the “revolutionary” (Shiller’s word) findings of recent years are widely known and understood. In such a world, all investors (even Buy-and-Holders) get a better deal for their investing dollar because the price they must pay in terms of risk to obtain their stock returns is smaller.

Don’t be so surprised! Valuation-Informed Indexing is an intellectual advance. Learning new things is one way in which humans have been tapping into free lunches ever since caveman days and the discovery of the wheel and of fire.

The final explanation of where the money comes from to support the better results of Valuation-Informed Indexing is that effective investing makes the economy more productive. Look at how many great businesses were destroyed in the economic crisis that began in 2008 and that was caused by the out-of-control bull market of the late 1990s. Entrepreneurs struggled for years to build those businesses and then lost everything when most of their customers lost so much money in the inevitable price crash that they could not longer afford to purchase their goods and services. It’s not only entrepreneurs who lose something of value when good businesses fail. We all do.

We should all want more stable stock prices. The only way to avoid huge price drops is to avoid huge price gains. The only way to avoid huge price gains is to educate investors re the research showing that stocks offer a poor long-term value proposition when prices reach insanely dangerous levels.

Rob Bennett’s bio is here.