Valuation-Informed Indexing #305

by Rob Bennett

Last week’s column set forth the first three of nine rules for exercising price discipline when buying stocks. Set forth below are descriptions of the next three rules.

Rule #4: Small Changes in Valuations Don’t Matter Much.

The Investment Strategy Tester shows that investors who take valuations into consideration when setting their stock allocations (rather than following a Buy-and-Hold strategy) are able to accumulate more assets for retirement in far less time. There are of course exceptions to the general rule. An investor who is lucky with a Buy-and-Hold strategy can do better than an investor who is unlucky with a Valuation-Informed Indexing strategy. But the odds very much favor the investor who follows the Valuation-Informed Indexing strategy and that becomes more and more so as the time-period examined extends from 10 years to 20 years to 30 years.

But small changes in valuations don’t matter much. When I am working the Investor’s Scenario Surfer (a calculator that reports results for a 30-year returns sequence one year at a time, giving the investor an opportunity to change his stock allocation at the end of each year), I often don’t bother to change my stock allocation when the P/E10 level rises or drops only a few points, from 8 to 11 or from 28 to 26. Stocks offer an amazing value proposition both at 8 and at 11 and stocks offer a horrible value proposition both at 28 and at 26.

I am a strong advocate of Valuation-Informed Indexing. But it would be a gross overselling of the concept to argue that the research permits the level of precision that would be suggested by a claim that we know with certainty which allocations work best at all valuation levels. We don’t. We are just not there. I don’t believe that we will ever be there.

The problem is that the short-term, which is governed by investor emotion rather than by the economic realities, is unpredictable. And every year of investment decision-making contains both an element of the long-term and the short-term. Predictions that December will in a general sense be colder than July can be made with a great deal of confidence but predictions re how many degrees colder it will be on one December day compared to one July day are foolhardy.

In-the-neighborhood predictions are both possible and valuable. Precise predictions will probably always remain beyond our reach despite how great an advance it would be if we could learn how to make them. It would be an irresponsible use of the Valuation-Informed Indexing concept for anyone to claim that precise predictions are possible today.

Rule #5: Buy-and-Hold Strategies Can Prevail Over Valuation-Informed Indexing Strategies for Many Years

Valuation-Informed Indexing strategies always prevail over Buy-and-Hold strategies (on a risk-adjusted basis) after the passage of 30 years of time. But Buy-and-Hold strategies often prevail for 10 years or 15 years or even 20 years. It is important that investors converting to the strategy understand this. An investor who converts to the Valuation-Informed Indexing strategy and then becomes disillusioned after 20 years of non-impressive performance will end up worse off than the non-convert if he switches to Buy-and-Hold at the 20-year mark out of exasperation. Valuation-Informed Indexing is an exciting advance but it is only for investors with a strong commitment to focusing on long-term results.

The tricky part is — None of us know if we have what it takes to stick with our strategies for the long term until we have lived through at least one entire bull/bear cycle and it takes roughly 35 years for a cycle to expire. You won’t be given a do-over if you lose confidence in the strategy at the worst possible moment for doing so. I recommend developing a clear understanding of the concept before investing real dollars pursuant to it. This isn’t something that you can try out to see how it goes before making a decision (except through use of the calculators, of course).

Rule Six: The Gains Achieved Through Use of a Valuation-Informed Indexing Strategy Are Usually Won in a Tiny Number of the Years in Which the Strategy Is Employed.

If you compare the results for Buy-and-Hold and for Valuation-Informed Indexing over 30 years, you will see that for the vast majority of those years the results will be comparable. Both strategies call for high stock allocations when prices are at low or fair-value levels. So they obviously yield similar results at most times. When prices are high, Valuation-Informed Indexers go with lower stock allocations. Those lower stock allocations often yield lower returns.

Stocks are more risky when prices are high. But it doesn’t at all follow that returns are never good at high price levels. The reality is that returns are often very good indeed at high price levels. In fact, the odds of high returns go up a bit when prices reach insanely dangerous levels (because price changes are determined primarily by investor emotion and extreme price levels generate even more of the irrational exuberance that produced them).

However, gains enjoyed at times of high prices always prove to be short-lived. That’s the reality that Buy-and-Holders overlook. It can take a good number of years for the economic realities (which justify price gains of 6.5 percent real per year but not more than that) to assert themselves in market prices. But they always do. The greater the artificial gains experienced in a bull market, the greater the real losses experienced once the fantasy investor expectations are exposed for what they are.

The benefits of the Valuation-Informed Indexing strategy are achieved through a lot of waiting for prices to be set right. The waiting pays off big time in the tiny number of years in which the Valuation-Informed Indexing portfolio far outpaces the Buy-and-Hold portfolio. A tiny number of years of extreme outperformance frequently counters a larger number of years of small outperformance by the Buy-and-Hold portfolio. Valuation-Informed Indexing is a strategy of infrequent but big scores.

Rob Bennett’s bio is here.