It’s a Mistake to Avoid the Risk of Stocks But It’s Also a Mistake to Fail to Temper That Risk by Exercising Price Discipline

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Valuation-Informed Indexing #303

by Rob Bennett

I wrote last week about The Investor’s Scenario Surfer. The calculator permits an investor to compare the results of a Buy-and-Hold strategy (using a fixed 80-percent stocks allocation, a fixed 50-percent stocks allocation or a fixed 20-percent stocks allocation) with the results of a Valuation-Informed Indexing strategy (one in which the investor has the option of changing his stock allocation after seeing his return for each year of a 30-year return sequence consistent with those we have seen throughout the historical record). The Valuation-Informed Indexing strategy has beat all three Buy-and-Hold strategies in 90 percent of the runs that I have performed with the calculator, often by large amounts. But in many runs it appears that for many years that the Buy-and-Hold strategies will prevail. So the calculator shows the importance of investors being patient enough to permit the long-term realities to assert themselves.

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This week I thought that it might be helpful to report on the results of three runs of the calculator and to explain how the results achieved at the end of the 30-year time-periods examined played out over time. I did not perform multiple runs and choose three that make the points that I advance below. I pledged when beginning the test to perform only three runs and to report the results generated regardless of whether the results obtained were typical of those generally obtained or not.

In each run, I established a portfolio amount of $100,000. I did not call for yearly additions to the portfolio or for yearly withdrawals from it. I set the starting-point P/E10 level at “26/bear market” since that’s what applies today. I entered an assumption that assets not invested in stocks would earn 2.5 percent real.

In the first run, the Valuation-Informed Indexing portfolio was worth $818,000 at the end of 30 years. The 80-percent-stocks Buy-and-Hold portfolio was worth $629,000. The 50-percent-stocks Buy-and-Hold portfolio was worth $452,000. The 20-percent-stocks portfolio was worth $295,000.

The returns sequence (which is generated by the calculator to be consistent with returns sequences that we have seen historically) showed a drop to fair-value prices in Year Six. Prices fell to bear-market levels in Year 11 and remained there until Year 27. As a result of the long period of bear-market prices, the 20-percent-stocks portfolio was running ahead of the 50-percent-stocks portfolio and the 80-percent-stocks portfolio through Year 18. It was even running even with the Valuation-Informed Indexing portfolio through Year 17.

In Year 27, the Valuation-Informed Indexing portfolio raced far ahead of the three Buy-and-Hold portfolios. It ended up beating the 20-percent-stocks portfolio by more than $500,000.

I went with a 20 percent stock allocation for the first three years, when stock prices were at very high levels. I then dropped to a 0 percent stock allocation for two years when the P/E10 level exceeded 30. I then went to a 40 percent stock allocation for two years when the P/E10 level was near 20. When the P/E10 level dropped below fair-value levels, I increased the stock allocation to 90 percent. The price level dropped even lower and I went to a 100 percent stocks allocation when it dropped to 10. I stuck with that allocation for 16 years. My biggest gain came when I was going with a stock allocation of 100 percent and the P/E10 level jumped from 14 to 21. In this one year, my portfolio amount increased by $245,000.

In the second run, the Valuation-Informed Indexing portfolio had a value of $622,000 at the end of 30 years. The 80-percent-stocks Buy-and-Hold portfolio had a value of 477,000. The 50-percent-stocks Buy-and-Hold portfolio had a value of $367,000. The 20-percent-stocks Buy-and-Hold portfolio had a value of $268,000.

Please note how the change from a 20-percent stock allocation to a 50-percent stock allocation brought on gains of about $100,000 and the change from a 50-percent stock allocation to an 80-percent stock allocation brought on gains of about $100,000 while the change from a fixed 80-percent stock allocation to a valuation-adjusted allocation brought on gains of almost $150,000. Increasing one’s stock allocation is a big plus in the long run. But switching from a Buy-and-Hold approach to a valuation-informed approach is an even bigger plus. The same general pattern applied in the first run but in that case the relative benefit that resulted from increasing one’s stock allocation was greater and the benefit from going to a varying allocation was less.

In the third run, the Valuation-Informed Indexing portfolio ended up with a portfolio amount of $624,000. The 80-percent-stocks Buy-and-Hold portfolio came in at $496,000. The 50-percent-stocks portfolio was valued at $378,000 at the end of 30 years. The 20-percent-stocks portfolio came in at $272,000.

You see the pattern, no? There is a price to be paid for being too timid to accept the risk of stock investing. But Buy-and-Holders take on unnecessary risks by refusing to exercise the price discipline that is the key to making successful purchases in ANY market. The best long-term strategy is to take on the risks you need to take on to earn the returns needed to finance a solid retirement but also to temper risk by cutting back on stocks when the risk level goes off the charts and by taking advantage of the great value proposition made available when prices drop so low that risk virtually disappears.

Exercising price discipline when buying stocks pays off in the long run. Big time.

Rob Bennett’s bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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