The only difference between Buy-and-Hold and Valuation-Informed Indexing is that Buy-and-Holders stick with the same stock allocation at all times while Valuation-Informed Indexers make adjustments in their stock allocation in response to big shifts in valuations with the aim of keeping their risk profile roughly constant over time. Shiller showed in 1981 that valuations affect long-term returns. So we know that stock investing risk is not static but variable and that at least occasional allocation changes are thus required. Yet Buy-and-Holders to this day resist the idea ferociously. Why?
There are probably multiple reasons. But I think that one big one is that it seems more complicated to follow a strategy that requires allocation changes than to follow one that does not. Simple is good. I certainly agree with the principle. However, I think that it is easy to exaggerate the amount of complexity that must be accepted to engage in effective long-term market timing.
ADW Capital’s 2020 letter: Long CDON, the future Amazon of the Nordics
ADW Capital Partners was up 119.2% for 2020, compared to a 13.77% gain for the S&P 500, an 11.17% increase for the Russell 2000, and an 8.62% return for the Russell 2000 Value Index. The fund reports an annualized return of 24.63% since its inception in 2005. Q4 2020 hedge fund letters, conferences and more Read More
The fair-value P/E10 level is 15. The increased risk faced by the investor when the P/E10 level rises to 16 or 17 or 18 is insignificant. So there is no need for an investor to make frequent allocation shifts. Much of the complexity that one might fear would follow from making the shift to a Valuation-Informed Indexing strategy is thereby easily avoided by simply making a decision to make allocation changes only in circumstances in which they are real difference-makers.
How often does an investor need to make an allocation shift to enjoy the benefits of Valuation-Informed Indexing without adding too much of a complexity burden to his portfolio management efforts? Once every 10 years will do it! Valuations do not change that much that often for more frequent changes to be required. The P/E10 level might drift from 15 up to 19 and then from 19 back down to 12 over a number of years and the investor who chose a stock allocation that makes sense for him when the P/E10 level is 15 will be positioned well for that entire length of time.
The trouble for the Buy-and-Holder shows up when valuation shifts of greater magnitude take place. And they always eventually do! When stocks are priced at the super-low valuation levels that applied in 1981, there is a 50 percent chance that the 10-year annualized return will be greater than 15 percent real. When stocks are priced at the super-high valuation levels that applied in 2000, there is a 50 percent chance that the 10-year annualized return will be less than a negative 1 percent real. There is no one stock allocation that makes sense at both of those two price levels. All investors must be open to making allocation changes at some point in the course of an investing lifetime to be said to be investing in a rational, informed, common-sense, intelligent way.
I can hear the gnashing of the teeth of my Buy-and-Hold friends when they read those words. The first thought that pops into their heads when they are exposed to those words is: How will the investor know when to make the change?
This question is the product of confusion between how short-term timing works and how long-term timing works. With short-term timing, it really is imperative to get the precise timing of an allocation change right. Make your allocation change a little too early or a little too late and you can miss out on the benefits that otherwise might have followed from making it. Short-term timing calls for a level of precision that just cannot be achieved in the investing field. Shiller showed that it is investor emotion that drives stock price changes. Shifts in investor emotion are highly unpredictable. That’s why short-term timing does not work. It’s not possible to consistently identify the points at which stock prices will turn in a new direction.
The beauty of long-term timing is that it is not necessary to identify turning points. I mentioned up above that stocks were priced to provide a 10-year annualized return of 15 percent real in 1982. What if you were busy with work stuff in 1982 and did not get around to increasing your stock allocation to the level where you needed it to be to take advantage of those juicy valuation levels? No problem. Stocks were still priced to offer a strong long-term value proposition in 1983 and in 1984 and in 1985. There is no need for quick zigs or sudden zags in the implementation of a long-term market timing strategy.
Do you know when it became truly necessary for a long-term market timer to retreat from the high stock allocation he adopted in 1982? Not until 1996, when the P/E10 level rose to the mid-20s. And there is no need for the long-term timer to check the P/E10 level every day to know when it is time to make another change. One check per year gets the job done. Would it add too much complexity to your investing routine to spend 10 minutes each New Year’s Day identifying the P/E10 level that applies and then deciding whether the change from the prior year has been big enough to require an allocation shift? If you look into how many years sooner you will be able to retire for going to that little bit of trouble, I think you will agree that it would not.
Say that you increased your stock allocation in 1982 to take advantage of the super-low valuation level that applied at the time and then lowered your stock allocation in 1996 to protect yourself from the super-high valuation level that applied at that time. At what point would you have needed to make a third change? In early 2009, when valuations briefly dipped below fair-value levels. Then, a few months later, when prices rose to dangerous levels again, you would have wanted to reverse that allocation increase and return to the cautious stock allocation that started to make sense in 1996 and that remained the best choice until the 2008 crash. And that’s where you would still be today.
That’s a total of four allocation changes in 36 years, not much more than one every 10 years. And the benefit would be a portfolio that earned significantly higher returns while facing dramatically reduced risk. Complex? I don’t think so. To my eyes, the more complex strategy is the Buy-and-Hold strategy. Buy-and-Hold sounds simple. But sticking with a stock allocation chosen at a time when stocks are a low-risk asset class during times when the risk goes sky high causes an emotional toll that adds to complexity in its own way. No long-term strategy will work if you don’t stick with it and a Buy-and-Holder just experiences too much change in his risk profile for him to be able to stay the course indefinitely. Valuation-Informed Indexers enjoy a smoother ride and that makes all the difference.
Rob’s bio is here.