The Investment Strategy Tester: Part Two — Changing Your Stock Allocation in Response to Valuation Shifts Beats Sticking with a High Allocation

The Investment Strategy Tester: Part Two —  Changing Your Stock Allocation in Response to Valuation Shifts Beats Sticking with a High Allocation

By Rob Bennett

Please see Part One of this article for a background description of The Investment Strategy Tester and for a discussion of the first of the six tests examined.

Please don’t make the mistake of thinking that that rule [that high-stock-allocation portfolios offer higher returns at less risk than low-stock-allocation portfolios] applies at all price levels. Graphic Two shows what happens when we test the same strategies beginning with a starting-point valuation level of 32, an insanely high price level.

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(You can click on all the images to increase size.)

asset allocation

The 20-percent-stocks portfolio still performs poorly on the upside. But the worst-case scenarios are far better for the 20-percent-stocks portfolio when starting from the high valuation level. Now there’s a trade off between return and risk for that portfolio.

Now it’s the 100-percent-stock portfolio that lacks a tradeoff. Look at the 10-year and 15-year and 20-year numbers. The 100-percent-stocks portfolio has worse worst-case scenario results. But it does not have better best-case scenario numbers. When stock prices are out of control, high stock allocations offer added risk with no potential for added return. Not too appealing a deal!

Different strategies make better sense at different starting-point valuation levels. That’s the takeaway point here.

Let’s take it in the other direction. Graphic #3 looks at what the possibilities are when starting from a super-low P/E10 level of 8 rather than a super-high P/E10 level of 32.

asset allocation

Here the rule is — More stocks means higher returns and reduced risk. Investor heaven!

Compare the results for 50 percent stocks with the results for 100 percent stocks at Year 30. The best-case result for 50 percent stocks barely beats the worst-case result for 100 percent stocks! Yowsa!

Now let’s throw a Valuation-Informed Indexing strategy into the mix. In the three following tests the four strategies examined are: (1) 20 percent stocks; (2) 50 percent stocks; (3) 80 percent stocks; and (4) a strategy in which the investor goes with 100 percent stocks up to a P/E10 level of 12, 80 percent stocks from a P/E10 level of 13 through a P/E10 level of 18; 50 percent stocks from a P/E10 level of 19 through a P/E10 level of 21, and 20 percent stocks for all higher P/E10 levels.

Graphic #4 shows what happens when the starting-point P/E10 level is 14 (fair value). Graphic #5 shows what happens when the starting-point P/E10 level is 32 (insanely high). And Graphic 6 shows what happens when the starting-point P/E10 level is 8 (insanely low).

Here’s Graphic #4:

asset allocation

The 20-percent-stocks and 50-percent-stocks portfolios cannot keep up. The contest is between the 80-percent-stocks portfolio and the Valuation-Informed Indexing portfolio. At Five Years, the 80-percent-stocks portfolio offers slightly more appealing probabilities. At 10 years, it’s a draw. At 15 years, the Valuation-Informed Indexing portfolio gains a tiny edge. At 20 years and 25 years, that edge grows. At Year 30, the Valuation-Informed Indexing portfolio offers higher returns at reduced risk. Nice!

Here’s Graphic #5:

asset allocation

Here the 20-percent-stocks portfolio makes some sense in the early years. At Year 10, it is competitive in the upside it offers while offering a far more appealing worst-case-scenario returns.

The Valuation-Informed-Indexing portfolio gains its edge over the 80-percent-stocks portfolio sooner and grows it larger over time. At every time-period, the 80-percent-stocks portfolio has a greater downside. Only at Year Five does it offer an enhanced upside. Sticking with a single stock allocation (Buy-and-Hold) imposes a double cost on investors at times of high valuations — lower returns, greater risk. That’s not supposed to happen according to the Efficient Market Theory!

Here’s Graphic #6:

asset allocation

You want to invest heavily in stocks when they are available at low prices. But you don’t want to stick with that high stock allocation when prices get out of hand (over the course of a 30-year return sequence beginning at a time of low prices there will of course be times when prices get out of hand). The 50-percent-stocks portfolio beats the 20-percent-stocks portfolio. The 80-percent-stocks portfolio beats the 50-percent-stocks portfolio. And the Valuation-Informed-Indexing portfolio beats the 80-percent-stocks portfolio.

Buy-and-Hold is rooted in a belief (the Efficient Market Theory) that investors always price stocks properly, that overvaluation and undervaluation are thus meaningless concepts and that investors may therefore feel free to stick with the same stock allocations at all price levels. It’s not so (at least not according to the historical stock-return data). Overvaluation and undervaluation are meaningful concepts. To invest heavily in stocks when they are selling at three times fair value (as they were in January 2000) makes about as much sense as paying $90,000 for a car with a fair market value of $30,000.

It’s true that the most important decision that an investor makes is his choice of a stock allocation. It is not true that an investor can afford to make this decision once and then stick with the allocation chosen forever. Stocks are riskier at high valuation levels and provide lower returns at high valuation levels. All investors should be changing their stock allocations in response to big valuation shifts. We need to move beyond the one-stock-allocation-fits-all-valuation-levels mentality of the Buy-and-Hold Era and begin teaching investors how to go about knowing when to change their stock allocations and how much to change them. This is the future of investing analysis, in my view.

Rob Bennett writes frequently on behavioral finance. He recently authored a Google Knol entitled Why Buy-and-Hold Investing Can Never Work.

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