by Rob Bennett
How much of an edge do investors who give up Buy-and-Hold for Valuation-Informed Indexing gain by doing so? It would be helpful to be able to say how much sooner those following the research-supported approach can retire.
Unfortunately, there are many complexities that come into play when determining at what year of his or her life an investor following a particular strategy will be able to retire. These include:
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1) What valuation level applies on the day the investor begins investing (Valuation-Informed Indexing overperforms in all environments but its overperformance is larger in relative terms at times of extreme valuations levels);
2) How big the price drops are that are experienced by Buy-and-Holders (Valuation-Informed Indexers are hurt much less by price drops and thus are far more likely to stick to their intended strategies; Buy-and-Holders may be able to stick if they are fortunate enough to invest at times when price drops are less than severe but are highly unlikely to do so if that is not the case); and
3) What sort of return sequences happen to pop up (Knowing the P/E10 level that applies when a stock allocation percentage is elected tells us a great deal about how successful the choice will be but unlikely return sequences can turn up and cause unanticipated results).
I used an investment strategy calculator at my web site (“The Investment Strategy Tester) to develop a rule-of-thumb answer to the question, The Strategy Tester generates hundreds of 30-year return sequences that follow the general patterns that have always applied in the historical record. It then examines strategic choices selected by the investor making use of the calculator, identifying the percentage odds that each of them will produce satisfactory results.
Since the calculator only generates 30-year runs, I needed to string together two runs to assess the possibilities that apply over the typical investing lifetime of 60 years (from age 25 to age 86). I assumed that a P/E10 level of 20 applied at the beginning of the first 30-year run (since that is close to today’s P/E10 level) and that a P/E10 level of 14 applied at the beginning of the second 30-year run (since that is the neutral scenario). I assumed a return of 3 percent real for money not invested in stocks.
I assumed that the investors started with a portfolio value of $6,000 at age 25 and then made contributions of $6,000 per year for 40 years (in the case of the Buy-and-Holder) or for 35 years (in the case of the Valuation-Informed Indexer). The Buy-and-Holder maintained a constant stock allocation of 60 percent. The Valuation-Informed Indexer went with 100 percent stocks for P/E10 values up to 10, 80 percent stocks for P/E10 values from 11 to 21, 20 percent stocks for P/E10 values from 22 through 25, and 0 percent stocks for higher P/E10 levels. At retirement age (Year 40/Age 65 for the Buy-and-Hold investor, Year 35/Age 60 for the Valuation-Informed Indexer), I began making withdrawals of $50,000 each year rather than contributions of $6,000 per year.
Both portfolios survived until Year 60/Age 85 in each of the hundreds of return sequences tested. The most likely end-point portfolio value for the Buy-and-Holder was $754,000. For the Valuation-Informed Indexer, the most likely end-point portfolio value was $1,095,000.
The VII portfolio also had a higher best result — 2,872,000. This compared to a best result for the Buy-and-Holder of $1,516,000. However, the Buy-and-Hold portfolio registered a much better worst result. This number was $249,000. The VII number was $28,000, showing that there were a small number of return sequences in which the VII portfolio came close to failing.
Valuation-Informed Indexers generally obtain higher returns despite taking on less risk. But Valuation-Informed Indexers who elect to retire at age 60 are taking on slightly more risk in their retirements than their Buy-and-Hold counterparts as the cost of being able to do so. The added risk they are taking on has both its positive and negative aspects. The Valuation-Informed Indexer who retires at age 60 is a bit more likely to experience a close call retirement than the Buy-and-Holder who leaves the workforce at age 65. However, he also enjoys the potential of being able to leave a much bigger estate to his children or to charities. In the typical case, he will end up with the larger portfolio.
There is one important factor that the calculator does not take into consideration. Since the Buy-and-Holder takes far bigger hits in price crashes (recent academic research shows that the maximum drawdown number for Buy-and-Holders is 61 percent but that for Buy-and-Holders the number is 21 percent), he is far more likely to sell stocks in a panic at the worst possible time and to then remain out of stocks after prices hit levels where the likely long-term return is positively mouthwatering.
All investors will experience at least one major price crash in an investing lifetime, perhaps two. And the differential gained by the Valuation-Informed Indexer who is able to stick to his vow not to sell in a downturn grows very large over the years as a result of the powerful compounding returns phenomenon. So I believe that it is fair to say that the calculator greatly understates the Valuation-Informed Indexing edge.
Unfortunately, calculating the financial effect of this factor would require making assumptions about the circumstances in which Buy-and-Holders would sell stocks that Buy-and-Holders would no doubt view as being unfair. So the best we can do today is to say that this factor could be a big consideration indeed in some circumstances. So I tell investors that those making the switch to Valuation-Informed Indexing can realistically expect to be able to retire at least five years sooner and in some circumstances perhaps as much as 10 years sooner.
Rob Bennett often writes about the dangers of Passive Investing. His bio is here.