Valuation-Informed Indexing #99
by Rob Bennett
Michael Mauboussin: Here’s what active managers can do
The debate over active versus passive management continues as trends show the ongoing shift from active into passive funds. Q2 2020 hedge fund letters, conferences and more At the Morningstar Investment Conference, Michael Mauboussin of Counterpoint Global argued that the rise of index funds has made it more difficult to be an active manager. Drawing Read More
I’ve been working on the Valuation-Informed Indexing concept for 10 years now. In the early days, I advocated keeping the number of changes in your stock allocation to a minimum. You can obtain a large increase in your lifetime return by making only one allocation change every ten years or so. If you start with a bias against allocation changes (as I did), you are led logically to a belief that the best way to proceed is to make only the tiny number of allocation shifts that is absolutely required to keep your risk profile roughly constant.
That approach will work. Perhaps it is even the best way to go. However, the longer I have studied these questions, the more convinced I have become that making more frequent but less sizable allocation shifts makes better sense.
My bias against frequent shifts is rooted in my affinity for the Buy-and-Hold Model (I no longer endorse this model but I of course still feel great respect and affection for the fine people who developed it). Valuation-Informed Indexing is an improvement of Buy-and-Hold, one that many Buy-and-Holders find shocking. I obviously want to temper the shock that Buy-and-Holders experience so as to entice as many as possible to consider adopting the new strategy. So my inclination had long been to stress that most of the benefits of Valuation-Informed Indexing can be achieved with few allocations shifts.
That remains true. In recent decades, it hasn’t even been necessary to make shifts each ten years. Stocks were reasonably priced for the entire time-period from 1975 to 1995. So there was no need for an allocation shift for those 20 years. Stocks have been dangerously priced from 1996 forward, with the exception of a few months in early 2009. So, if you made an allocation shift in 1996, there has been no need to make another for 17 years. That’s 37 years with one allocation shift! And yet the numbers show that investors who made that shift will end up with much higher lifetime returns.
There are problems that come with limiting yourself to a small number of shifts, however.
Stocks become increasingly risky each time valuations rise. An increase in the P/E10 level from 15 (fair value) to 18 (slightly above fair value) doesn’t mean much in practical terms because stocks offer such a strong long-term value proposition that sticking with the same stock allocation when the P/E10 is 18 as you went with when the P/E10 was 15 is highly unlikely to do you any harm. In theoretical terms, however, there is a difference.
In theoretical terms, stocks carry slightly more risk at a P/E10 level of 18 than they do at a P/E10 level of 15. Thus, your stock allocation should be slightly lower. Say that you determined that am 80 percent stock allocation is right for you when the P/E10 level is 15. Perhaps the right allocation for you when the P/E10 level is 18 is 70 percent.
Failing to make that 10 percent reduction in your stock allocation is not going to kill you. I still feel confident saying that there is no need to make that allocation shift. When the P/E10 value reaches 25, you must make the shift. At that point, stocks have become so dangerous that you simply must acknowledge the reality. But, while making a small allocation change when the P/E10 level reaches 18 is not required to obtain good results, a strong argument can be made that making that change is the more emotionally balanced approach to take.
The argument against making many small allocation changes is that small shifts in valuation levels are not of great significance. Taking action when nothing important has happened seems inappropriate.
The other side of the story is that, when you hold off on making allocation shifts until key P/E10 levels are crossed, you are taking even more dramatic steps in response to equally insignificant valuation changes.
Say that you make no change in your 80 percent stock allocation when the P/E10 level reaches 18 but drop to an allocation of 30 percent when the P/E10 level reaches 25. That suggests that there is some sort of magic to the “25” number. And of course there isn’t.
If you shift to a 70 percent stock allocation when the P/E10 level reached 18, and then to a 60 percent stock allocation when the P/E10 level reached 20, and then to a 50 percent stock allocation when the P/E10 level reached 22, and then to a 40 percent stock allocation when the P/E10 level reached 24, and then to a 30 percent stock allocation when the P/E10 level reaches 26, you avoid the drama of going from an 80 percent stock allocation to a 30 percent stock allocation all at once. It’s generally a good idea from an emotional standpoint to limit the drama of the stock investing project to the greatest extent possible.
We’ve never seen a secular bear market starting from a P/E10 level of 18. So some will argue that there’s no need to lower one’s stock allocation at that P/E10 level. The reality is that there is a small risk of a secular bear market beginning at that P/E10 level, even though we have never yet seen this happen in our limited historical record. That risk, though small, is slightly greater than what it is when the P/E10 level is 15. If you aim is to keep your risk profile constant (and it should be), an allocation shift is in order.
Make small allocation shifts once per year with each change of two or three points in the P/E10 level, and you will likely never find yourself needing to make big allocation shifts. That’s good. It’s when the realities call for us to make big shifts that our great skill at rationalizing away the need to make shifts of any kind kicks in.
Keeping your risk profile constant is like losing weight. Gaining five pounds really doesn’t matter. But those who fail to take steps when they gain five pounds put themselves at risk of gaining 20 pounds. The best bet emotionally is to make small changes in your stock allocation with each small increase in the riskiness of stocks.
Rob Bennett often writes about Indexing Without the Emotional Baggage. His bio is here.