Valuation-Informed Indexing #98
by Rob Bennett
At this year's SALT New York conference, Jean Hynes, the CEO of Wellington Management, took to the stage to discuss the role of active management in today's investment environment. Hynes succeeded Brendan Swords as the CEO of Wellington at the end of June after nearly 30 years at the firm. Wellington is one of the Read More
Justin Fox, author of The Myth of the Rational Market, quotes University of Chicago Economics Professor Eugene Fama as saying: “I don’t know what asset pricing would look like in a world that really took behavioral finance seriously. If you really think prices are incorrect, what are you going to tell me about the cost of capital?”
Behavioral Finance Advocate Richard Thaler responded: “It’s going to be a big mess. Because human nature is a mess. It’s a choice between being precisely wrong or vaguely right.”
When I tell people that they need to adjust their portfolio values to reflect the effect of overvaluation or undervaluation, they often object that P/E10 is not a powerful enough tool to tell us what we need to know to make precisely accurate adjustments. Perhaps not. But what is the alternative? Making no adjustments whatsoever? This is what the Buy-and-Holders do. Does that make sense?
Please recall to mind the reality that we are in an economic crisis today before answering.
Say that stock prices are where they were in 2000 (at three times fair value) and that you are an age-60 investor who needs a $1 million portfolio to be able to retire. You are now at $900,000. Assuming continued contributions each month plus earnings on the existing portfolio balance, the odds look good that you are going to be able to retire at age 65. You might even be a bit ahead of the game. It wouldn’t be out of line for you to consider buying a new car or moving to a larger house or going on a longer vacation. These last five years should be downhill sledding.
If valuations matter, that portfolio balance needs to be divided by three to yield the true, lasting value of the portfolio. Your portfolio is properly valued at only $300,000. You are today $700,000 short of your target. You have no realistic hope of being able to retire anywhere even remotely close to age 65. You shouldn’t be buying a new car but trading down to a lower-priced model. You should’t be moving to a bigger house but to a more economical one. You should be skipping vacations, not taking longer ones.
Either valuations matter or they don’t. If they matter, they matter a lot. The numbers tell us this. How did we ever come to think that it might be okay not to adjust our portfolio values for the effects of overvaluation or to fail to change our stock allocations when stocks reached insanely dangerous price levels?
One of our favorite rationalizations is to demand perfection of the numbers used to make valuations adjustments while permitting lots and lots and lots of slack in the numbers we use for all other purposes. It is of course true that P/E10 is not a perfect tool. It is possible that the proper adjustment in 2000 was not to reduce our portfolio values by 65 percent but by 60 percent or 70 percent. The adjustment indicated by the P/E10 valuation metric is merely the best adjustment available to us today, nothing more and nothing less.
The thing that shows that the objections to making valuation adjustments are purely emotional in nature is the failure of those making the adjustments to impose the same perfectionist standards on the non-valuation-adjusted portfolio numbers.
We do not have perfect numbers. But we can hardly fail to make use of numbers in financial planning all the same. We MUST use some sorts of numbers. So the goal should be to generate the most accurate numbers possible. Buy-and-Holders toss out numbers used to make valuation adjustments with disdain but evidence no concern over the widespread use of non-valuation-adjusted numbers for all sorts of financial planning purposes. Huh?
Can any reasonable argument be made that the age 60 investor was not making a mistake to look to the $900,000 portfolio number as legitimate? If it is not legitimate (and it clearly is not), we need a substitute. We need some other number that possesses greater legitimacy.
There’s one benefit possessed by the non-adjusted number. It is a political benefit. That number is generated by the market as a whole. No one person needs to take responsibility for it. No one person can be said to have been “wrong” when that number is shown to be wrong.
That’s not so for any adjusted number. Any adjustment is made pursuant to a decision made by a person with a name and a face, a person who can be criticized for having made a mistake when the adjustment is shown to be wrong.
So people in this field pretend that the unadjusted number is golden. They use it for all sorts of financial planning purposes, knowing it to be wildly wrong but confident that they will not be held accountable for the human misery that will result when people make use of a wildly wrong number to plan their financial affairs.
And those who suggest adjustments are faulted for the imperfections in their suggestions.
Numbers that are wildly off the mark are given credence. Numbers that may be slightly off the mark are dismissed as inappropriate.
InvestoWorld has gone through the looking glass in the Buy-and-Hold Era. We root investing advice on all sorts of topics in what the numbers tells us. But the numbers we use are always numbers we know to be wildly wrong and never numbers that we have confidence are at least roughly right. Those who recommend the use of roughly right numbers are shunned as dangerous extremists (I had such criticism directed at me when I suggested that retirement studies use numbers we believe to be roughly right rather than numbers we know to be wildly wrong).
We need to do it the other way. It’s better to be roughly right than to be precisely wrong.
Rob Bennett writes about new ideas in asset allocation management. His bio is here.