Valuation-Informed Indexing #306

by Rob Bennett

The last two columns set forth the first six of nine rules for exercising price discipline when buying stocks. Set forth below are the final three rules.

Rule #7: The Theoretically Pure Way to Practice Price Discipline Is to Make Frequent, Small Adjustments to Your Stock Allocation.

There are lots of ways to exercise price discipline when buying stocks. You could increase your stock allocation a tiny bit each time valuations go down and decrease your stock allocation a tiny bit each time valuations go up. Or you could limit your allocation changes to a tiny number by making them only in circumstances in which it is imperative that they be made. Stocks offer a reasonably strong long-term value proposition so long as the P/E10 level remains below 20 and it is rare (except in recent years!) for the P/E10 level to remain much above 20 for an extended period of time.

In my early days of working with the calculators, I made an effort to limit my allocation shifts as much as possible. I was influenced by the relentless anti-timing preaching of the Buy-and-Holders. I knew that it did not make sense to avoid the exercise of price discipline altogether but I tried to comply with the conventional wisdom to the extent possible by waiting until the case for a change in allocation was so strong that it could not be denied.

Over time, I’ve become more comfortable with the idea of making more allocation changes. I still don’t make them at all frequently. But I permit myself an allocation change whenever a significant valuation change takes place. The only downside to frequent allocation changes is the costs associated with making them. Those costs are small compared to the benefits obtained by choosing the proper stock allocation.

Rule #8: Making Infrequent Changes to Your Stock Allocation Works Just Fine.

Rule 7 reflects my current thinking on how often to make allocation changes. All that said, those who do not feel comfortable making frequent changes should be assured that there is no need whatsoever to make them. You will experience most of the benefits of practicing price discipline when buying stocks by making as few as three allocation shifts over a 30-year time-period. That’s one allocation change per decade on average; however, it is possible that you will need to make three changes within a small number of years and then not make any changes for a long stretch of years.

That’s really all it takes. Making one allocation change per 10 years (on average) reduces risk dramatically while increasing returns dramatically at the same time. You do NOT have to take on added risk to obtain higher investing returns. That’s one of the many investing myths discredited by Shiller’s “revolutionary” research finding that valuations affect long-term returns and by the 35 years of peer-reviewed research confirming this breakthrough advance in our understanding of how stock investing works in the real world.

Rule #9: Compounding Is the Game Changer.

One big problem with Valuation-Informed Indexing is that it sounds too good to be true. A claim that dramatically higher returns are available at greatly reduced risk for those willing to make one common-sense allocation shift every ten years just doesn’t sound plausible despite the mountain of historical data supporting it. My own wife once informed me that I sound like an infomercial when I make the case for the Shiller-based model. So, when I saw the calculators producing their amazing numbers, I often asked myself WHY the exercise of price discipline makes such a huge difference.

It’s the phenomenon of compounding returns that makes it all possible. The magic of Valuation-Informed Indexing is that reversion to the mean MUST take place; it’s a logical impossibility that prices will ever not come to reflect the economic realities in time. So, when you reduce your stock allocation in response to rising prices or increase your stock allocation in response to dropping prices, you are taking a sure bet. It is not possible to say precisely when reversion to the mean will take place. But it is a virtual certainty to say that it WILL take place.

So the Valuation-Informed Indexer always ends up ahead of the Buy-and-Holder sooner or later. The reason why things have been turning out this way for 145 years running now is that things always MUST turn out this way. It has long been known that the price one pays for something affects the value proposition obtained from that purchase in every market other than the stock market. All that Shiller did was to show that the same principle (price matters) that applies in every other market applies in the stock market as well.

And small differences in results grow into large differences with the passage of time due to the power of compounding returns. We all know that this is how it works when saving money. The calculators show that it works this way in the investing realm as well. Follow a strategy that guaranties that you will go ahead eventually and then sit back and wait for the compounding returns phenomenon to work its magic.

Rob Bennett’s bio is here.