There’s a Risk Attached to Lowering Your Stock Allocation When Prices Are High

There’s a Risk Attached to Lowering Your Stock Allocation When Prices Are High
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 Valuation-Informed Indexing #384

By Rob Bennett

Buy-and-Holders worry that, if they lower their stock allocations when stock prices go sky-high, they might miss out on gains in the event that prices continue heading upward. I view this risk as greatly exaggerated. If stocks are overpriced when you buy them and always return to fair-value price levels in time, gains resulting from additional overpricing are going to disappear into the mist in any event. The feeling of “missing out” will be a temporary one.

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That said, there is some risk in going with a Valuation-Informed Indexing strategy. We cannot say how long it will take for prices to return to fair-value levels. Short-term timing doesn’t work. Prices could remain at high levels or even rise higher over the next year or two or three. When Robert Shiller advanced his famous prediction that stock prices would be coming down hard in coming days, he was careful to say only that this would happen within 10 years or so, leaving open the possibility that Buy-and-Hold strategies could work just fine for much of the following decade. And it turned out that he was not being cautious enough in the dating of his prediction; the crash did not arrive until 2008, 12 years from the time he made it.

So, while price gains achieved on already overpriced stocks don’t mean much in the long run, those gains can remain in place for long stretches of time. It’s important to understand that, while gains produced from even greater levels of overvaluation always disappear into the mist, stocks do produce real gains of 6.5 percent real even at times of overvaluation. Investors who lower their stock allocation at times of high valuations risk missing out not only on temporary gains resulting from additional overvaluation but also on real gains resulting from genuine economic growth.

The question is — How big a risk is it that valuation-informed investors are taking?

I think that the easiest way to get your head around the question is to consider where different types of investors would stand if stocks were to return to fair-value price levels tomorrow. Stocks are today priced at two times fair value. So a drop to fair-value price levels would require a 50 percent price drop. Would Buy-and-Holders be ahead of the game or behind it if we saw such a price drop? How about Valuation-Informed Indexers?

Stock prices bottomed out from the 2008 crash in March 2009. In the nine years since, prices have increased over 260 percent (assuming reinvestment of dividends). The annualized real return has been 16.8 percent. Stocks were not overpriced in March 2009; valuations were slightly below fair-market value levels. But valuation-informed investors were wary of stocks even at those prices. Stocks had been overpriced for many years at that time. So there was a belief among many that, once prices began to fall hard, they would continue to do so. Buy-and-Holders, on the other hand, generally argued that the price drop created a buying opportunity. I think it would be fair to say that the Buy-and-Holders feel vindicated by the performance that we have seen from the stock market over the past nine years.

Would they still feel vindicated following a 50 percent price drop? A $100,000 lump sum invested in stocks in March 2009 would be worth $360,000 today. A price drop of 50 percent would bring that amount down to $180,000. That’s still a significant gain. A gain of $80,000 on a $100,000 investment over only nine years is a gain of a good bit more than the average long-term stock return of 6.5 percent real and certainly a gain much greater than what was available from most other asset classes during that time-period.

So valuation-informed investors missed out.

I think that’s a reasonable way to look at things. However, there are a few other factors that need to be taken into consideration before reaching a definitive conclusion.

One, prices usually fall to levels far below fair value at the end of a bull/bear cycle. If prices were to fall to one-half of fair value, the historical norm, that $180,000 would become $90,000, an amount lower than the starting-point value of $100,000.

Two, in the event that prices do fall to one-half of fair value, there will be amazing opportunities to invest in stocks available to those who at the time possess both capital to invest and the emotional ability to put it into stocks. Those who have suffered huge losses will miss out on most of those future gains. That’s a cost. Following an investment strategy that raises the possibility of missing out on those gains comes with risks of its own.

Three, the calculation up above was set up in a way designed to make Buy-and-Hold look good. As noted, prices were not at all high in March 2009. In fact, I was asserting at the beginning of numerous podcasts that I recorded at the time that “the long-term value proposition for stocks purchased at these prices is very strong.” Being a valuation-informed investor is not just about avoiding the risks of buying overpriced stocks; it is also about seeing opportunities to buy well-priced stocks when they appear. Stocks were well-priced in March 2009.

The story is different for investors who invested a lump sum $100,000 in March 2008. That portfolio has seen significant gains too. The total gain over those 10 years is 110 percent. The annualized real gain (dividends reinvested) is 8.1 percent. That’s still a super return. But a 50 percent price drop would wipe out nearly all of that gain. And a price drop of much more than that would of course leave the investor with a negative result for giving up control of his financial assets for 10 years.

Crystal balls don’t work. We never know precisely how stocks are going to perform in coming years. The idea behind Valuation-Informed Indexing is not that it is possible to reverse this fundamental law of stock investing. The idea is that the risk of losses is greater when prices are high and the potential for gains is greater when prices are low. Thus, investors can maximize their lifetime return by investing somewhat more heavily in stocks when stock valuations are low and somewhat less heavily in stocks when stock valuations are high. Investors don’t necessarily miss out on gains when overpriced stocks rise to even greater levels of overpriving. But there are risks associated with moving a portion of one’s assets to alternative asset classes with histories of offering lower long-term returns.

Rob’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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