Valuation-Informed Indexing #345

by Rob Bennett

ctribeiro / Pixabay

I pay close attention when investors tell me why they don’t buy into the Valuation-Informed Investing strategy. To bring people around, I first need to develop a good appreciation of the concerns that are holding them back.

The strongest case for the new approach is the 145 years of historical return data showing that practicing price discipline has always helped investors reduce risk dramatically while also increasing returns dramatically. Long-term market timing is a win/win. Or at least it has been for as far back as we have good records of how stocks have performed.

One way in which skeptics respond is to argue that we humans often see patterns where they do not exist.

That one often slows me down for a bit because I have sympathy for the general thrust of the point being made. I believe that we have an inclination to make order out of chaos. It would be so nice if it were possible to earn higher returns from stocks while also taking on less risk. Could it be that we Valuation-Informed Indexers are seeing something in the data that doesn’t exist? Could we be making too much of a correlation that no one recognized in earlier days when it would have been a plus to know about it and that may disappear now that some are counting on a repeat performance? Is it all just a coincidence?

It could be that it’s all just a coincidence. It could be that I am fooling myself. It has been known to happen.

But I don’t view this argument as a good reason for rejecting Valuation-Informed Indexing altogether. It’s grounds for skepticism. But that’s as far as I would go with it.

Say that it really is true that we often see patterns that don’t exist because we are driven to trying to make order out of chaos. Then it would be a mistake to place too much confidence in the regression analysis showing that the 10-year annualized return for a purchase of a broad index fund selling at today’s prices is likely to be something in the neighborhood of 1 percent real rather than the 6.5 percent real return that applies on average.

But if you don’t believe in the historical pattern, what DO you believe in?

We all have to invest our money somewhere. The first step to making an intelligent choice is to form some sort of impression as to what the likely return will be. What else do we have to go by in forming that impression than historical return patterns? Is there some other way to proceed?

I don’t see any other way to proceed. I believe that the Buy-and-Holders are seeing historical patterns that don’t exist of their own. They are looking at that average return of 6.5 percent real and telling themselves that that’s the best guess as to what the future return will be. It’s not so. The valuation level that applies on the day the purchase is made has always played a big role. But it is easy to imagine a pattern in which the long-term return is always something close to the average return when you want to see it bad enough.

Or they are looking at what happened in 2008, when prices crashed and then recovered a few months later, and seeing a pattern that doesn’t exist there. That happens. But is it a pattern of great significance? The reality is that price recoveries that take prices back to dangerous levels never last long enough to provide much of a payoff. Perhaps it’s not so much that we need to avoid seeing patterns that don’t exist as that we need to be more selective re the patterns we let influence us.

Our minds really do look for patterns to make order out of chaos. I think that the Buy-and-Holders are on to something important with that observation. But I believe that we also fail to see patterns that really do exist. I look at the pattern of valuation levels rising and falling in long-term hills and valleys for 145 years running and I see a pattern that I find compelling. It does not seem possible to me that that pattern could sustain itself for that long a time if prices followed the random walk perceived by the Buy-and-Holders.

The random walk is a pattern!

Is it one of those imaginary patterns that the Buy-and-Holders so often warn us about? I believe it is.

Prices have never fallen in the pattern of a random walk except in the short term. And the fact that prices fall in the short term in the pattern of a random walk does not show that price changes are determined by economic developments, as the Buy-and-Holders maintain. Prices determined by shifts in investor psychology would fall in the pattern of a random walk in the short term. It’s only in the long term that they would fall into a hill and valley pattern because it takes time for irrational exuberance to be transformed into irrational depression. The random walk itself is one of those patterns that many of us see only because of our deep-seated need to find order in chaos.

I like the Buy-and-Holder’s warning to be skeptical of perceived patterns because it advises us to be humble in our assessment of our abilities to understand how stock investing works. I believe what I believe, which is very different from what the Buy-and-Holders believe. But I try to remind my readers from time to time that I may have it all wrong, that I am just another one of those flawed humans. When we tell ourselves that it is only the patterns that others see that are imaginary while the ones we see are real, we run the risk of getting ourselves in big trouble by closing our eyes to patterns that really do exist but that we have not come to appreciate just yet.

Rob’s bio is here.