Valuation-Informed Indexing #355
One of the arguments that you sometimes hear for Buy-and-Hold is that, while it may not be a theoretically pure strategy, it has been a “good enough” strategy over the years. Millions of investors have employed some form of Buy-and-Hold strategy and have achieved results with which they are pleased. So it works.
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I don’t buy it. I say that Buy-and-Hold never works. What I mean by that is that, for the entire 147 years for which we have good records, investors who shifted their stock allocations in response to big changes in valuations have done better in the long term than investors who failed to do so. Valuation-informed investors obtain higher returns (often significantly higher returns) in about 90 percent of the cases that have been examined in the research. And in the rare cases in which the Buy-and-Holders have put up better numbers, they have had to take on significantly more risk. So, on a risk-adjusted basis, Valuation-Informed Indexing has always prevailed.
That said, I don’t deny that millions of Buy-and-Holders have obtained good results. My view is that that is mostly because Buy-and-Hold calls for a large investment in stocks and stocks are an amazing asset class. It is hard to come up with a strategy that produces poor long-term results from an asset class that generates an average long-term return of 6.5 percent real. So I don’t think that the Buy-and-Hold strategy should be given the credit for those results. Stocks should be given the credit. The core Buy-and-Hold idea -- that investors should stick with the same stock allocation regardless of how high stock prices rise -- does much harm to the investors who buy into it.
Say that we were trying to determine whether it is a good idea to smoke. Those seeking to make a case for smoking could point to millions of people who smoked and lived long, fruitful, exciting lives. That’s not an endorsement of smoking. It’s a showing that many people are so full of love that they can make successes of their lives even while their smoking habit holds them back a bit. Smoking is bad and Buy-and-Hold. But there are of course successful smokers and successful Buy-and-Holders.
The question is -- Does refusing to change your stock allocation when the likely return on stocks changes dramatically add anything to the investing experience? It is my contention that it subtracts a great deal and never adds a thing.
Here are eight ways in which following a Buy-and-Hold strategy holds back those following it.
1) Those who refuse to adjust their stock allocations in response to big valuation shifts obtain smaller long-term returns;
2) Those who refuse to adjust their stock allocations when rising prices make stocks more risky thereby cause their risk profiles to go out of whack;
3) Buy-and-Hold strategies make investing a more emotional experience. Valuation-Informed Indexers are indifferent to whether prices go up or down because they understand that excessive price increases must be paid back with lower returns in future years. So there is nothing for Valuation-Informed Indexers to get emotional about;
4) Buy-and-Holders cannot engage in effective financial planning because they never know the true, lasting value of their portfolios. Valuation-Informed Indexers adjust their portfolio values to reflect the effect of valuations. So they always know where they stand. That helps them make effective spending and saving decisions;
5) Buy-and-Holders are not able to buy stocks heavily when they are on sale because they suffer big losses in the price crashes that bring on low prices. Valuation-Informed Indexers are well-positioned to buy stocks when the long-term return on them is the highest because they cut back their stock allocations when prices are high and the risk of crashes is the greatest;
6) This means that Valuation-Informed Indexers end up owning more stocks over the course of an investing lifetime. Stocks are a great asset class. So that is a good thing;
7) Buy-and-Hold causes economic crises. When trillions of dollars leave investors’ hands in crashes, they are not able to spend as much on goods and services and businesses fail. The economic crises of course affect all investors, both those following Buy-and-Hold strategies and those not doing so. But it is the resistance to exercising price discipline encouraged by the Buy-and-Hold strategy that causes crashes. So I think this needs to be counted as a negative for this strategy;
8) The key to long-term investing success is having enough confidence in your strategy to stick with it through good times and hard times. It is hard for Buy-and-Holders to develop a true confidence in their strategy because it defies common sense to believe that price matters with all the goods and services that we buy except for stocks. It takes some time for Valuation-Informed Indexing to click with investors who hear Buy-and-Hold endorsed in so many places. But once it does click, it clicks hard. Valuation-Informed Indexing makes sense.
Rob’s bio is here.