Valuation-Informed Indexing #102
by Rob Bennett
There’s a sense in which Valuation-Informed Indexing and Buy-and-Hold are similar strategies. Both are research-based strategies that call for the investor to focus on long-term results, to avoid short-term timing, and to Stay the Course.
There’s another sense in which Valuation-Informed Indexing and Buy-and-Hold are opposite strategies. For Buy-and-Holders, to Stay the Course means to remain at the same stock allocation at all times. For Valuation-Informed Indexers, to stay with the same stock allocation is to fail to Stay the Course. The research shows that stocks are more risky when they are selling at high prices. So an investor who remains at the same stock allocation at all times is permitting his risk profile to jump around like crazy. It is only by permitting yourself to make allocation changes as needed that you can hope to Stay the Course in a meaningful way.
There’s no one set of allocation changes that an investor must make to be a Valuation-Informed Indexers any more than there is any one stock allocation an investor must stick with to be a Buy-and-Holder. Different investors have different risk tolerances and different investment goals and different financial circumstances. So different Buy-and-Holders choose different stock allocations. Those factors can cause different Valuation-Informed Indexers to follow different allocation shifting strategies too.
Is it possible, then, for an investor who acknowledges that valuations affect long-term returns but who is not sure how much he needs to change his allocation in response to valuation shifts to stick with the same stock allocation and still be viewed as a Valuation-Informed Indexer?
An investor who always went with a high stock allocation (70 percent or more) could not properly be viewed as a Valuation-Informed Indexer. That’s Buy-and-Hold. The entire idea of Valuation-Informed Indexing is to steer investors away from the dangers associated with going with a high stock allocation at all times. So that’s out.
But what about an investor who goes with a 40 percent stock allocation at all times? The risk there is not too great. The investor might say that he finds it simpler to not have to worry about when to make changes to his stock allocation. So he has elected to go with a modest stock allocation at all times. Is it appropriate to refer to that investor as a Valuation-Informed Indexer?
I say “no.”
There’s of course nothing wrong with an investor electing to take that course. It’s the investor who has to withstand whatever emotions follow from adoption of his investing strategy. An investor who believes that he will sleep better at night knowing that he need not concern himself with deciding when to make allocation changes should adopt the strategy that helps him sleep better at night.
That investor is not following a Valuation-Informed Indexing strategy, however. There are many breeds of this cat. Some might go with 90 percent stocks at times of low valuations, 60 percent stocks at times of moderate valuations and 30 percent stocks at times of high valuations. Other might elect a 75/50/25 set-up. Still others might go with a cliff approach — 80 percent stocks until the P/E10 goes above 21 and then 40 percent stocks. There are lots of other possibilities.
The common theme to all the possibilities is that the investor is trying to keep his risk profile roughly stable at all times. There is no one right way to do that. Or, if there is, we are not today able to identify it. So we have to permit and even encourage a great deal of flexibility until we know more.
Still, we have to draw a line somewhere. If we call all allocation strategies Valuation-Informed Indexing strategies, the concept becomes meaningless. An investor who never changes his stock allocation isn’t playing the game that Valuation-Informed Indexers play. He might be a fine fellow. But he is not one of our fine fellows.
The thing that makes you one of us is your desire to keep your risk profile constant. Some people want to limit their allocation shifts as much as possible. So their preferred means of keeping their risk profiles constant might be to follow a cliff approach. There obviously are times when those following a cliff approach have permitted their risk profiles to go a little off the mark. Still, they never let things go too crazy. So long as they draw a reasonable line somewhere (that is, so long as they are not Buy-and-Holders!), they merit membership in The Club.
Investors who make no allocation changes may be following the strategy that’s best for them. But they may not be handed membership cards. They are not endeavoring to keep their risk profiles constant. They are not playing the game. They are not with it.
This suggests that a big element of the Valuation-Informed Indexing agenda is participating in The Struggle to overcome investing risk. And, yes, that indeed is the idea. The failure to engage in this struggle is precisely what messes up the Buy-and-Hold project.
Buy-and-Hold starts out as a good thing. Buy-and-Hold was a wonderful strategy from 1982 through 1996. The trouble with this strategy is that it always eventually turns sour. It always eventually leads to a wipeout of the investor’s accumulated wealth of a lifetime. It always eventually leads to an economic crisis for the society that tolerates widespread promotion of it.
Why? What’s the time time-bomb that sooner or later always causes Buy-and-Hold to explode?
It’s the failure of the Buy-and-Holders to take prices into consideration when setting their allocations. LIke so many things in life, this is easy to do once you get into the habit and very difficult indeed to do if you never develop the habit. What you want to do is to develop the habit.
It’s not so much which allocation strategy you choose as it it whether you choose one that calls for you to make adjustments in response to big swings in valuation levels. So long as you understand that there is a need to make changes at some point, you will probably get things close enough to right to do fine.
It’s when you fall for the Buy-and-Hold fantasy that there is no need ever to change your stock allocation that you get into trouble. That way lies doom.
Try to get your allocation right by opening yourself to the need to change your allocation in some way in response to valuation shifts, and you are a Valuation-Informed Indexer. Close your mind to the possibility of doing that and you have put yourself on a path that leads over time to greater and greater levels of self-deception and portfolio destruction. As Stevie Wonder once so elegantly put it, superstition ain’t the way!