Valuation-Informed Indexing #190
by Rob Bennett
Yale Economics Professor and Nobel Prize Winner Robert Shiller changed stock investing in a fundamental way in 1981. That’s when he published research showing that valuations affect long-term returns. If that’s so, we now know that everything we thought we knew about stock investing prior to that day is wrong. Buy-and-Holders tell people that there is no need to time the market. But, if valuations determine returns, risk varies with changes in valuations and we MUST change our stock allocations in response to big valuation shifts to have any hope of maintaining our proper risk profiles.
The long bull market slowed down the shift to the new model. Buy-and-Hold remains dominant today. That shouldn’t discourage those of us who believe that the Shiller model will prevail in the end from developing it to the greatest extent possible. We want everything to be nicely in place when the winds change!
I was amazed when I took a look around Planet Internet in 2002 and learned that there was not a single site that explored the far-reaching implications of Shiller’s revolutionary findings in any great depth. This was the opportunity of a lifetime! And it’s a lot of fun (and potentially very profitable!) exploring territory that has not been explored by hundreds of others before you came on the scene. So I took on the job.
Shiller has never given a name to his model. It may be that he feels that that’s too immodest a thing for a university professor to do. The reality, though, is that that one big finding (that valuations affect long-term returns) changes everything. It changes how we plan our retirements. It changes how we understand and manage risk. It changes our asset allocation strategies. When a new way of thinking about stock investing changes that much, we need a name for it.
My first thought was that we could call the new model “The New Buy-and-Hold” or “Buy-and-Hold 2.0”. I thought of myself as a Buy-and-Holder in those days. I cared about valuations. But I didn’t know that that would get me excluded from “the Club.” Buy-and-Hold was the first strategy that wa said to be rooted in the peer-reviewed academic research. Shiller’s research just corrected a mistake that was made because the Buy-and-Hold Pioneers naturally didn’t know everything when they started their journey. The new model was a revision, a reform, an enhancement. Add valuations adjustments to all the calculations and Buy-and-Hold really works.
Many Buy-and-Holders did not take too kindly to this idea. They are not interested in corrections or improvements. I still think of myself as advocating an up-to-date version of Buy-and-Hold. But I don’t believe anymore that it makes sense to name Shiller’s model “Buy-and-Hold 2.0.”
For a long time, I called the new model “Rational Investing.” The big difference is that Buy-and-Holders ignore the effect of investor emotions while those following the new model take investor emotion (which evidences itself through overvaluation or undervaluation) in every investing decision they make. Following Shiller’s model lets you know what your return is going to be (not precisely, but roughly) at the time you purchase your shares. That takes the craziness out of stock investing. It is because of Shiller’s revolutionary findings (combined with the many powerful insights developed in earlier years by our Buy-and-Hold friends) that stock investing today can be a simple and and predictable and safe and non-emotional experience.
The problem with that name is that it sounds insulting to the Buy-and-Holders. To say that the defining characteristic of the new model is that it is rational is to suggest that the defining characteristic of Buy-and-Hold is that it is not. I do indeed believe that something close to that description of reality is indeed the case. But I think it is better if that comes out somewhere down the line, not at the time the name of the new model is announced. So I came to feel uncomfortable calling the new model “Rational Investing.”
For a time I considered “Probability Investing.” Shiller’s model is all about assessing probabilities. His research permits us to identify the range of possible long-term returns that applies given the valuation level applicable on the day the purchase of an index fund is made and to assign rough percentage probabilities to each point on the spectrum of possibilities. You decide on your stock allocation by seeing what return scenarios are most likely to turn up and by making determinations as to how each of them will affect you, given your financial goals and life circumstances and risk tolerance.
“Probability Investing” made sense as a name. But I worried that most investors think of themselves as assessing the probabilities of various investing choices and then going with the ones that seem to them to make the most sense. The fact that those following Shiller’s model assess probabilities when making investing choices is not really the distinguishing characteristic of the model.
The distinguishing characteristic is that those following the Shiller model believe that investors must change their allocations in response to big valuation shifts to have any hope of keeping their risk profiles stable. So the best name is one that contains the word “valuations” in it. Still, we couldn’t take full advantage of Shiller’s discovery of the importance of valuations had it not been for the introduction of index funds. It is indexing that makes long-term return predictions so effective. So I concluded that the best name is one that combines the “valuations” element and the “indexing” element — Valuation-Informed Indexing.
Rob Bennett has recorded a podcast titled When Stock Losses Are True Losses and When They Are Not. His bio is here.