Valuation-Informed Indexing #28:
New Research Shows Valuation-Informed Indexing Beats Buy-and-Hold in 102 of 110 30-Year Periods

reminiscences of a stock operator pdf

by Rob Bennett

Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, has posted preliminary research at his web site showing that Valuation-Informed Indexing provides more wealth for 102 of the 110 rolling 30-year periods in the historical record while Buy-and-Hold does better in 8 of the periods.

Pfau’s research is breakthrough stuff, in my assessment. That said, I believe that his research greatly understates the benefits of Valuation-Informed Indexing (changing your stock allocation in response to big swings in valuations). There are six reasons.

1) Pfau’s research assumes an unlikely scenario — that Buy-and-Holders will hold to their high stock allocations in the face of huge losses.


We have seen three secular bull market in the historical record. The average price drop that followed (from the high point to the low point) was  68 percent. The average 20-year return following the bull top was 0.7 percent (including dividends). It is exceedingly unlikely that more than a tiny percentage of Buy-and-Holders stuck with their high stock allocations through so many years of financial pain and yet any investors who sold obtained worse results than the results than caused Buy-and-Hold to come up short in 102 of 110 of the 30-year periods in the historical record.

Valuation-Informed Indexers do not experience the same difficulty sticking to their planned stock allocations because Valuation-Informed Indexers go with far lower stock allocations at times when stocks are priced to crash (times of high valuations). So failing to consider the reality that most Buy-and-Holders are forced to sell when prices crash slants things in favor of Buy-and-Hold.

2) The compounding returns phenomenon will continue to enhance the edge enjoyed by Valuation-Informed Indexers beyond the 30-year period examined by Pfau.

I have run hundreds of comparisons of Valuation-Informed Indexing and Buy-and-Hold using a portfolio allocation calculator (“The Investor’s Scenario Surfer”) that generates realistic 30-year returns sequences and permits the user to shift his stock allocations on a year-by-year basis in response to the changes in P/E10 levels that happen to turn up. By watching Valuation-Informed Indexing prevail in roughly 90 percent of the tests, I have come to understand the two drivers of its long-term superiority: (1) taking valuations into consideration virtually assures that the Valuation-Informed Indexer will sooner or later go ahead; and (2) once the Valuation-Informed Indexer goes ahead, it becomes almost impossible for the Buy-and-Holder to catch up because both types of investors are heavily invested in stocks at times when the long-term value proposition of owning stocks is good (time of low and moderate valuations).

An investor who adopts a Valuation-Informed Indexing strategy at age 25 will indeed almost certainly be ahead at age 55, as Pfau’s research indicates. But the financial edge he will possess at that time (which can be huge — I have seen returns sequences where the Valuation-Informed Indexer has a portfolio double the size of the Buy-and-Hold portfolio at the end of 30 years) will just keeping growing beyond the 30-year period examined in this research. An investor who becomes a Valuation-Informed Indexer at age 25 and dies at age 85 might enjoy 60 years of compounding on the advantage he obtains by taking valuations into account. In fact, an investor who begins at an early age taking valuations into consideration when setting his stock allocation might be able to gain a second edge by living through a second bull-bear cycle and then enjoy years of compounding on the differential obtained via the second edge.

3) The higher returns obtained by the Valuation-Informed Indexers are obtained at greatly reduced risk.

It’s not entirely fair to compare the results obtained with a low-risk strategy with those obtained from a high-risk strategy. Take the 8 cases in which Buy-and-Hold generated slightly better numbers. Is it right to say that Buy-and-Hold ”worked” in those eight cases? I say “no.” There is no way to know in advance when one of the rare cases in which Buy-and-Hold generates good numbers is going to turn up. With the odds that any given time-period will be one of those cases being less than 1 in 10, the investor is taking a long odds bet. It is proper to say that Buy-and-Hold on rare occasions produces better numbers. But I think it needs to be added that it does so at greater risk. On a risk-adjusted basis, Valuation-Informed Indexing is always superior.

4) Valuation-Informed Indexers are able to obtain better returns on their non-stock investments.

Pfau assumes that Valuation-Informed Indexers and Buy-and-Holders will obtain equal returns on their non-stock investments (he uses the returns earned on Treasury bills for the non-stock money and intends also to test what would happen if the money were instead placed in bonds). Treasury Inflation-Protected Securities were paying 4 percent real in early 2000. Valuation-Informed Indexers were able to lock in that return because they were at the time looking for alternatives to high-priced stocks. But Buy-and-Holders disdained the 4 percent real return on TIPS as not being comparable to the 6.5 percent real average return for stocks (which Buy-and-Holders believe to be the most likely return starting from any valuation levels). Any analysis presuming that Valuation-Informed Indexers and Buy-and-Holders will earn the same return on their non-stock investments is thereby slanted in favor of Buy-and-Hold.

5) Stock investing is not a zero-sum game.

Pfau’s analysis ignores the damage done to the general  economy when large numbers of investors follow a Buy-and-Hold strategy. Investors always have available to them the option of granting themselves pay raises by increasing stock prices irresponsibly. The one possible limit on this Get Rich Quick behavior is the historical data showing that investing heavily in stocks at times of high prices always produces poor long-term results. The promotion of Buy-and-Hold removes this brake from the stock investing car, causing crashes and economic crises in the wake of all secular bull markets.

If discussion of the dangers of Buy-and-Hold became common, we could avoid most economic crises and thus we would see far greater levels of economic growth over time. We would all be far richer than we can ever hope to be in a world in which Buy-and-Hold remains the dominant model for understanding how stock investing works. The edge for Valuation-Informed Indexing grows far greater than what is indicated in Pfau’s research once the economic expansion permitted by a shift to Valuation-Informed Indexing is taken into consideration.

6) Valuation-Informed Indexing encourages a new way of thinking about stock investing that permits benefits in addition to those obtained from employing better asset allocation strategies.

Asset allocation is of critical importance. The fact that Valuation-Informed Indexers set their stock allocations rationally provides them a huge advantage. However, it is unfortunate that most research examines only this one benefit. I write weekly at this column about the many ways that the Valuation-Informed Indexing Model permits us all to understand better how stock investing works and thus to have more confidence in our strategies than was possible during the Buy-and-Hold Era.

Valuation-Informed Indexers follow different and more effective retirement planning strategies. Valuation-informed Indexers follow different and more effective risk management strategies. Valuation-Informed Indexers enjoy greater emotional balance (because they view each stock price increase and each stock price decrease as containing both positive and negative elements). Valuation-Informed Indexers even enjoy better money management abilities (because they discount their nominal portfolio values to reflect the transitory nature of bull market price increases). When these benefits are taken into consideration, the edge for the Valuation-Informed Indexer grows far larger than the substantial edge demonstrated in Pfau’s research.

Please do not think that I intend any of these arguments as criticisms of the wonderful work done for us by Wade Pfau. To the contrary, I view his research as one of the most important pieces of investment research of recent decades. Pfau’s research is very much pointing us in the right direction. My take is that his work seriously understates the case for all of us quickly moving beyond Buy-and-Hold.

Rob Bennett created a stock valuation calculator that performs a regression analysis on the historical stock-return data to reveal the most likely 10-year return starting from any valuation level. His bio is here.

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13 Comments on "Valuation-Informed Indexing #28:
New Research Shows Valuation-Informed Indexing Beats Buy-and-Hold in 102 of 110 30-Year Periods"

  1. O, hey Rob did not realize it was you, you used a pseudonym! I thought you might have been refering to Value Investing Insight, If I knew it was you Rob I would have picked up on that acronym. I pick individual stocks, and do not index (although I think this is appropriate for 99% of investors maybe even myself!!), that being said I am very conscious of market valuations, so I do keep in mind what the Shiller PE is and am holding more cash, as a protection. That being said I would never sell out all stocks even if the Shiller pe was 100 (alright, maybe at that level I would), but I do keep overall market valuations in mind, and that being said based on current market valuations, I think we will get REAL returns of less than 3% going forward, as I noted in my article about pension funds. I think inflation will eat up these returns, and if we have hyper inflation like the 1980s, which is a very real possibility, the pe of the market could go down to 8 or so, meaning a 66% drop. I am not predicting this just keeping it in mind as I invest in individual stocks that look to provide a margin of safety, and as my portfolio as a whole. I would rather under-perform the market for a few years based on the greater fool idea (meaning in this case hope the shiller pe goes even higher or even stays the same), but I try to find individual securities that have a pe well below 15.

  2. My return was 3.5 percent real, MPFJ.

    Rob

  3. Hi, Jacob.

    My Personal FInance Journey is using the acronym “VII” to refer to “Valuation-Informed Indexing.” It’s a good sign if we get to a point where people are talking about it enough that they feel a need to start employing acronyms!

    Rob

  4. Very interesting to hear how long you have been at it! What has been your return that you experienced during that time using your money with VII?

  5. MPFJ:

    Valuation-Informed Indexing is something that I have been developing and refining for over 15 years. I got started on this in the mid-1990s, when I was putting together a Retire Early plan. I took a look at the safe withdrawal rate research of the day to determine how much I could afford to take from my savings each year. Something about it didn’t seem right to me.

    I was able to put my finger on what that was when I read John Bogle’s book “Common Sense on Mutual Funds.” Bogle explains why Reversion to the Mean is an “Iron Law” of stock investing. If Reversion to the Mean takes place, the safe withdrawal rate cannot be the same number at different valuation levels (the return varies with changes in valuations, so the amount that can be taken out must change too).

    I did follow-up research that confirmed what Bogle said. This convinced me to take my money out of stocks in the Summer of 1996. I put the money in CDs paying a real return of 4 to 4.5 percent real for a few years, then moved it to TIPS and IBonds paying 3.5 percent real when they became available.

    In May 2002, I put a post to a Motley Fool discussion board asking whether valuations need to be taken into account in calculations of the safe withdrawal rate. A fellow named John Walter Russell did some research showing that the answer is “yes.” John and I then spent the next seven years (John died in October 2009 — I miss him every day) researching hundreds of questions and developing four unique calculators together.

    My understanding of how stocks works has gotten stronger and stronger as I have researched more topics and tried to develop sound responses to the thousands of questions about this that have been directed to me over the course of the nine years of discussions on boards and blogs. I learned the most in the 15 months following the September 2008 crash, when I recorded 200 podcasts on every angle I could think of. That forced me to organize my thinking and drill down on all sorts of questions I hadn’t taken on until then.

    I’ve benefitted from wonderful feedback from hundreds of my fellow community members and from a good number of experts in the field. Even a good number of Buy-and-Hold advocates have been extremely helpful. And the calculators have been a huge help. They allow me to test lots of different ideas and see where they lead according to the historical record. Wade Pfau’s research has now of course also been a big help.

    The short answer to your question is — I first took action on these ideas in the Summer of 1996, when I took my money out of stocks because of the excessive valuations (this was a few months prior to when Shiller gave his “Irrational Exuberance” to the Federal Reserve). I didn’t begin calling it “Valuation-Informed Indexing” until years later, however. I think I may have first started using that terminology in early 2006.

    I hope that helps a bit.

    Rob

  6. Another interesting post on the VII strategy Rob! Thanks for sharing and submitting to the Carnival of Passive Investing.

    I forgot to ask you on your last post about VII. How long have you been employing this in your personal investing?

  7. Okay, Evidence.

    Rob

  8. Evidence Based Investing | Feb 9, 2011, 12:49 pm at 12:49 pm |

    And you’re saying that the fact that The Stock-Selling Industry spends hundreds of millions pushing Buy-and-Hold is not having any influence on investor behavior?

    It obviously didn’t work because as you said
    “It is exceedingly unlikely that more than a tiny percentage of Buy-and-Holders stuck with their high stock allocations through so many years of financial pain

  9. We take a VERY different perspective to this investing stuff, Evidence.

    Have you ever looked at personal finance blogs on the internet? There are thousands of them. They tell the same story over and over and over again — you need to manage your money, try not to waste your money, don’t spend foolishly.

    Then the topic turns to investing and the SAME PEOPLE say “I am just going to stick at the same stock allocation no matter what,” or “I don’t believe in market timing” or “stocks are always best for the long run.”

    And you’re saying that the fact that The Stock-Selling Industry spends hundreds of millions pushing Buy-and-Hold is not having any influence on investor behavior?

    I think the promotion of Buy-and-Hold is having an influence.

    Rob

  10. Evidence Based Investing | Feb 9, 2011, 9:41 am at 9:41 am |

    Do you think that most people would have a hard time lowering their allocations in response to big price jumps if Money magazine were running cover article after cover article pointing out how much sooner they could retire if only they were willing to do so? I sure don’t. The experts were able to persuade millions that there is no need for them to change their allocations when stocks get dangerous. Why would they not be able to persuade millions of the accurate story just as effectively?

    Actually the experts were NOT able to persuade millions to keep their stock allocation constant. In the late nineties investors poured money into stocks, ignoring bonds, CDs and the like. The after the bubble popped the money poured out of stocks and safer investments became more popular.

    If investors had followed the advice to buy and hold rather than the CNBC/buy this hot stock now approach then we would not have seen the bubble and burst that we saw.

    People are emotional, and come the next bull market the same thing will happen.

  11. Thanks for taking the time to share your thoughts, Evidence.

    You make a good point. Other smart and good people have offered this criticism of the Valuation-Informed Indexing concept to me on numerous occasions. I don’t see it as being as big a negative as you do. But I do think you are making a legitimate point. It is entirely possible to imagine this being a problem for some Valuation-Informed Indexers.

    Are you taking into account how different the Valuation-Informed Indexer is going to feel after stock prices fall? One, he has long been anticipating a big price drop. So it comes as no surprise. And, two, the price drop is not a big hit for him (since he lowered his stock allocation in anticipation of it).

    It’s not that Valuation-Informed Indexing does not take emotions into account. It’s that Valuation-Informed Indexers PREPARE for possible emotional hits to come by setting their stock allocations accordingly. So they do not suffer the same emotional distress as Buy-and-Holders in response to big price drops.

    An even more important point is that VII is not something that the investor will need to practice entirely on his own. What we should be doing is spreading word about what really works everywhere we can. Then we should encourage all the investing experts to encourage our best emotional inclinations rather than our worst.

    Do you think that most people would have a hard time lowering their allocations in response to big price jumps if Money magazine were running cover article after cover article pointing out how much sooner they could retire if only they were willing to do so? I sure don’t. The experts were able to persuade millions that there is no need for them to change their allocations when stocks get dangerous. Why would they not be able to persuade millions of the accurate story just as effectively?

    We are all influenced by what we hear on television and on web sites and in newspapers. If all media outlets were promoting responsible investing strategies, my strong sense is that millions of middle-class investors would eat that up. My strong sense from having talked to thousands about these issues and about the effect of the economic crisis on their financial futures is that there are millions today who CRAVE responsible investing advice. I very strongly believe that the time is right for a big change.

    I think you are making excuses for Buy-and-Hold, Evidence. I mean no personal offense but that is my sincere belief. I believe that we have discovered something far superior and that we all should be dancing in the streets about what is now possible and that a good number of people have become emotionally invested in Buy-and-Hold and instead feel a need to make excuses for it. I look forward to the day when we get beyond all that and instead spend our energies making things better together instead of dragging our feet.

    We agree about the importance of considering the emotional side of the question, Evidence. We are soul brothers re that one. And I am sincerely grateful that you took the time to share your thoughts. I am obviously not unbiased re this matter. You have added a good bit of balance to the discussion here by explaining how things look from those holding a different perspective.

    I hope we will all hear from you again. Please take care, my good friend (I have had many conversations with Evidence at other blogs and boards).

    Rob

  12. Evidence Based Investing | Feb 8, 2011, 4:03 pm at 4:03 pm |

    1) Pfau’s research assumes an unlikely scenario — that Buy-and-Holders will hold to their high stock allocations in the face of huge losses.

    It also assumes another even more unlikely scenario – that Valuation-Informed investors will raise their stock allocations in the face of huge market losses (up to 90% in his example).
    It also assumes they will lower their stock allocations in the face of a huge bull market.

    VII takes the one difficult part of buy and hold, sticking to your plan by rebalancing (ie selling stocks and buying bonds in a bull market, buying stocks and selling bonds in a bear market), and puts it on steroids.

    If staying with “just” 60% stocks in 1999 was hard then dropping to 30% is more difficult. If keeping 60% of your portfolio in “dead” equities in the early 1980s was hard then raising your allocation to 90% is harder.

    What VII doesn’t consider is the emotional side. Getting it to work on paper is fine in theory, getting it to work in real life would be a lot more difficult.

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