Valuation-Informed Indexing #270

by Rob Bennett

There’s only one difference between Buy-and-Hold and Valuation-Informed Indexing. Both are numbers-based strategies rooted in peer-reviewed research. The difference is that Valuation-Informed Indexers always make adjustments for valuation levels (believing, as Shiller showed in 1981, that valuations affect long-term returns) while Buy-and-Holders never do (believing that the market is efficient and that, thus, the market can never be overpriced or underpriced).

I thought that this week I would present here a concise and clear and simple and sincere case for Buy-and-Hold that one of my critics posted as a comment at my site. Then I’ll offer my response to his words.

To me, as a self-described ACTUAL Buy-n-holder, it’s this simple:

* Markets tend to go up over time. Ownership of common stocks have proven to be the best way for an average person to participate in, and profit from this ongoing economic growth.

* It has proven impossible to determine which particular stocks will outperform, or when they might do so.

* Buying, and then holding a market-basket of ALL stocks that constitute the market, on a regular and recurring basis, without respect to ‘timing,’ removes the uncertainty of guessing which particular stocks will be best, or which is the best time to purchase them.

That’s it.

People can refine, add gimmicks, accessories, etc, or even purposefully misconstrue (AHEM, looking at YOU, Rob!) but to me, THIS is the essence of buying and holding. So, for you to go on a decades-long intense daily public jihad against those principles, and the people who espouse, and apply them, seems frankly… well, insane.

You are free to use whatever market timing scheme, or other method you chose to invest, or course. But for you to characterize the above technique as “Get Rich Quick,” just to irk people and to hopefully draw attention to yourself, shows how both intellectually feeble, and also morally challenged you are. (I dare you to publish this.)

Is it a “gimmick” to consider valuations when making decisions as to what stock allocation to go with at a particular time?

I don’t think so.

The research shows that the long-term return earned by an investor changes with changes in valuations. That means that stock investing risk is variable rather than constant. It follows that a investor seeking to keep his risk profile roughly constant MUST change his stock allocation in response to big valuation shifts.

Why do the Buy-and-Holders have such a hard time with this idea?

It’s because they start with an assumption that the market is efficient. That’s another way of saying that the investors who set the market price are rational.

Is it? Are they?

I don’t think so. I have engaged in discussions with tens of thousands of investors over the years. I certainly have seen many rational arguments advanced. But I have also seen many emotional arguments advanced. If investors are as emotional when making decisions as to their stock allocations as they are when presenting arguments on internet discussion boards, I think it would be fair to say that it would be dangerous to assume that the stock market is priced rationally.

That said, I believe that the market in the long term really does set prices properly. It has to. The purpose of a market is to get prices right. In the long term, the stock market is like all other markets.

But in the short term it is not. That makes all the difference.

Take a look at the disparity between the irrational price that applies today and the rational price that applies in the long term and you know in which direction prices will be headed over the next 10 years or so.

It always works. We have 145 years of stock market history available to us. For that entire time-period, investors have been able to effectively predict the price that will apply in 10 years by looking at the price that applies today. That’s amazing. That changes our understanding of how stock investing works in a far-reaching way.

It means that, when prices go up by more than the 6.5 percent gain justified by the economic realities, we are collectively borrowing from our future selves to fool ourselves into thinking that we are richer than we really are today. That causes devastating problems down the line. Investors cannot plan their financial futures effectively if they believe numbers on their portfolio statements that do not reflect the long-term realities. And the bear market that must follow a bull market causes an economic crisis as trillions of dollars in pretend wealth disappears, causing hundreds of thousands of businesses to fail and millions of workers to lose their jobs.

For numbers-based strategies to work, it is critical that we get the numbers right. And, if Shiller is right that valuations affect long-term returns, it is impossible for Buy-and-Holders — who do not make adjustments for valuations — to get any of the numbers right. The valuations factor is not a small factor. It is huge. A regression analysis of the historical data shows that the most likely annualized ten-year return in 1982 was 15 percent real but that the same number was a negative 1 percent in 2000. Yowsa!

The bad news is that it is very hard for Buy-and-Holders to accept these realities. They have staked their lives on the old understanding of how stock investing works.

The good news is that Shiller’s “revolutionary” (his word) findings change things in a highly positive way. If we can effectively predict long-term stock returns, stocks are not nearly as risky an asset class as we have long believed them to be.

Perhaps I am wrong. But, if I am right, the future of stock investing will be a lot better for all of us than anything that we have seen or even dared to hope for in the past.

Rob Bennett’s bio is here.