Valuation-Informed Indexing #366
By Rob Bennett
I have for the past two months been sending my boy Timothy two articles a week on the Valuation-Informed Indexing concept. He reads them and ponders them for a few days and then we talk them over. So I have been digging through the archives at my web site. I came across a quotation from Jack Bogle the other day from an article that I wrote years ago that stunned me.
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Bogle stated on Page 33 of his book Common Sense on Mutual Funds that: “This analysis takes into account my conviction both that the performance of individual securities is unpredictable, and that the performance of portfolios of securities is unpredictable on any short-term basis. While the long-term performance of portfolios is also unpredictable, a careful examination of the past returns can establish some probabilities about the prospective parameters of return, offering intelligent investors a basis for rational expectations about future returns.”
That’s not Buy-and-Hold! That’s Valuation-Informed Indexing!
It sure sounds like Valuation-Informed Indexing to me. I agree with every word of Bogle’s statement. Short-term return predictions don’t work at all. Precise long-term predictions also do not work, However, it is possible by looking at valuations to identify a range of possible returns that will apply in the long term and to assign rough probabilities to each of the points on the spectrum of possibilities.
So Bogle and I agree! This makes me so happy!
There’s that part at the end where he suggests that going through this analysis provides only “a basis for rational expectations about future returns.” To my mind, it follows that the investor who is expecting lower returns will lower his stock allocation as a consequence. I know from 15 years of heated discussions with my Buy-and-Hold friends that this is not what Bogle and the other Buy-and-Holders believe. Buy-and-Holders believe in lowering their return expectations when valuations rise very high. They do NOT believe in lowering their stock allocations as a consequence.
This I do not get.
There are a number of factors that we all consider when we set our stock allocations. One thing that we look at is the returns provided by the various asset classes available to us. Stocks generally provide the highest returns, so most of us believe that the default asset choice should be stocks. But we also take into consideration our risk tolerance. Stocks provide a much more rocky ride than the safer asset classes. So even the strongest stock enthusiasts usually will limit the stock portion of their portfolio to 80 percent. Most investors also take their age into consideration. Young investors have a long time to recover from price crashes and thus feel more comfortable going with high stock allocations than do investors nearing retirement age.
Buy-and-Holders agree with all this. Buy-and-Holders usually invest primarily in stocks. And Buy-and-Holders agree that the investor should take his risk tolerance into consideration when setting his stock allocation because it is essential that the investor be able to stick to his plan during times when prices fall hard. And Buy-and-Holders agree that those nearing retirement should lower their stock allocations a bit.
And, as I noted above, Buy-and-Holders ALSO agree that investors need to lower their return expectations at times of high valuations. But they don’t believe in lowering their stock allocations as a consequence. Is anyone able to say why? This one mystifies me.
It seems to me that one identifies one’s proper stock allocation by playing off one’s desire for high return with one’s desire to diminish risk. If stocks were no more risky than certificates of deposit, we would all invest 100 percent in stocks. If certificates of deposit offered the same return as stocks, we would all invest 100 percent in certificates of deposit. We move to stock allocations of higher than zero percent because we want more return than we can get from certificates of deposit and we move to stock allocations of lower than 100 percent because we cannot bear the risk of 100 percent stocks. Effective asset allocation is the art of mixing risk and return in the proper proportions.
When valuations go to extreme highs and our long-term return expectations for stocks therefore drop dramatically, that changes the stock allocation that we need to choose to achieve the proper balance of risk and return. No? It seems to me that it must do this. This assertion seems to me to have the power of a mathematical equation. If the idea is to balance risk and return and high valuations change the long-term return expectation for stocks, high valuations should change the stock allocation.
If Bogle agreed, I would have no differences with him. An agreement that there are circumstances in which asset allocation changes are required would not spell out what those changes should be. That would be a subject for investors to think through in the various circumstances that come up much as Buy-and-Holders today think through what stock allocation is right for an investor in their particular circumstances -- the Buy-and-Holders do not say that there is one right answer to this question. It is only when the question is to what extent investors should change their stock allocations in response to big valuation shifts that the Buy-and-Holders become dogmatic and respond that the proper allocation change is always to make none at all.
I believe that changes in one’s long-term return expectations for stocks should alter one’s choice of stock allocation. And I believe that this is a big deal. It is essential that investors get their asset allocations at least roughly right. There is probably no other choice that an investor makes that affects his long-term results as much as his choice of an asset allocation. If it is true that stocks offer poorer long-term returns starting from times of high valuations (and even Bogle agrees that this is so!), dramatic changes in valuation levels change the risk/return balance and call for asset allocation adjustments on the part of all long-term investors.
Rob’s bio is here.