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Simple Investing Strategies Cannot Remain Entirely Simple for Long

Valuation-Informed Indexing #283

by Rob Bennett

Simple investing strategies are sound investing strategies. The key to success is sticking with a strategy long enough for it to pay off. Complex strategies cause investors to lose focus. Unfocused investors have a hard time sticking with their strategies through dramatic changes in circumstances.

The greatest virtue of Buy-and-Hold is its simplicity. However, Buy-and-Hold purists take the desire for simplicity too far. Buy-and-Holders have told me that one big reason why the strategy was not changed following Robert Shiller’s “revolutionary” (his word) finding that valuations affect long-term returns is that it would complicate it to add a requirement that investors adjust their stock allocations in response to big valuation shifts in an effort to keep their risk profiles roughly constant.

If that’s so, they made a terrible mistake.

Buy-and-Hold does not call for allocation adjustments to be made in response to valuation shifts because the research showing the need for them did not exist at the time the Buy-and-Hiold strategy was being developed. Once the strategy was set up in the way that it was, changing allocations came to be seen as a complication. Isn’t it more simple to stick with one allocation at all times?

I don’t think so. Buy-and-HoldĀ seemedĀ simple in the days when we did not realize how much the long-term value proposition of stocks is altered by the valuation level that applies at the time the purchase is made. We now know that the investor who fails to make allocation adjustments is thereby permitting his risk profile to swing wildly about as valuations move from low levels to moderate levels to high levels. In the long term, there is more complexity in a strategy that calls for wild risk profile shifts than in one that requires the investor to check valuation levels once per year and to change his stock allocation once every ten years or so. That’s all that is required for investors seeking to keep their risk profiles roughly stable.

That extra one hour or so of work performed every decade reduces the risk of stock investing by 70 percent and saves the investor a lot of emotional angst during price crashes. It is the losses suffered in price crashes that cause investors to abandon Buy-and-Hold strategies (at the worst possible time!). Devoting an additional one hour of work to the investing project renders price crashes virtually painless for investors following the updated Buy-and-Hold approach (Valuation-Informed Indexing). It’s not only engaging in transactions that adds complexity. Figuring out how to respond when large losses of accumulated wealth are experienced is a huge complication, one that Buy-and-Holders did not consider when devising the first-draft version of the strategy.

There are other ways in which Buy-and-Hold has become more complicated over the years.

In the early days, there were few types of index funds available. Investors were generally advised to go with a Total Stock Market Index Fund. That’s still a good choice. But today’s investor has dozens of options available to him. He can invest only in small caps or only in mid caps or only in large caps or can mix or match in all sorts of ways. Traditionalist Buy-and-Holders often express dismay at the number of choices available, bemoaning the added complexity that comes with added options.

I am sympathetic to those feelings. The core Buy-and-Hold idea — that it is by keeping it simple that investors avoid falling into emotional traps and confusions — is an idea of great power. Purchasing a Total Stock Market Index Fund still makes a great deal of sense for the typical, average investor.

But I don’t believe that dogmatism on this question is justified. It adds only a limited amount of complexity for an investor to focus on small caps or large caps or mid caps. And some investors find appeal in focusing their investing dollars in the ways that new types of index funds permit. Some investors don’t feel safe investing in anything other than large caps. Some like the excitement of small caps and would be inclined to try to pick individual stocks rather than to index if investing in a Total Stock Market Index Fund were the only available option. In relative terms, an investor who purchases a large cap index fund or a small cap index fund or a mid cap index fund might thereby be avoiding more complex options that would draw him in if he were to try to follow a purist path.

And of course many investors like to invest in different segments of the market. Investing in a high-tech index fund is riskier than investing in a broad index fund. But it is less risky than investing in any one high-tech company. Buy-and-Hold dogmatics would argue that only the investor who chooses a broad index fund is a true Buy-and-Holder. My take is that the success of the Buy-and-Hold strategy inevitably created demand for a greater variety of investing options and that there is no way to keep the Buy-and-Hold concept from becoming a bit more complicated over time.

Another big change since the early days of Buy-and-Hold is that many investors no longer limit themselves to broad U.S. indexes but seek participation in the global marketplace. That makes sense, doesn’t it? Our economy is gradually becoming a global economy. There are numerous complexities that come into play as the transition proceeds. The U.S. has long had a stable economic system. So going global adds risk. However, that might be true only historically and not on a going-forward basis. It might be that the risky thing on a going-forward basis is to continue to invest solely in the U.S. market.

The Buy-and-Hold Pioneers did not anticipate having to make decisions re such questions. They thought they had solved the complexity problems once and for all. These questions just turned up as time passed. The full reality is that they always do! Simple investing strategies cannot remain entirely simple for long.

Valuation-Informed Indexing will become more complex over time too.

We have 145 years of U.S. stock market data available to us today to determine when valuations have changed enough to require an allocation adjustment and how big a allocation adjustment is required. As more years of data are recorded, our understanding of what sorts of allocation adjustments are either needed or desired will become sharpened and refined.

That’s good. We want to have as much historical data available to us for guiding our allocation shifts as possible. But it cannot be denied that the decision-making process will become somewhat more complex as more considerations are taken into account. That’s just the way of the world. Humankind’s understanding of the world about it improves over time and those improvements undermine our ability to keep things simple.

Simple is good. But a purist stance is not realistic in the fast-changing (because it is fast improving!) world in which we live today.

Rob Bennett’s bio is here.