Theoretically, there’s no middle ground between Buy-and-Hold and Valuation-Informed Indexing. The premise of the Buy-and-Hold Model is that the stock market is efficient; if prices are set rationally, stock investing risk is a constant and investors have no way of knowing when it is a good idea to change their stock allocation. The premise of Valuation-Informed Indexing is that stock valuations affect long-term returns; so investors have no choice but to adjust their stock allocation in response to big valuation shifts if they hope to keep their risk profile roughly constant over time.
Few investors seek to invest in a theoretically pure way. Most are open to making occasional, modest allocation changes. But few are willing to make changes as dramatic as those suggested by the historical return data. Most investors follow a mix of the two strategies with a heavy bias in favor of Buy-and-Hold.
Q4 hedge fund letters, conference, scoops etc
Compromises are possible. We don’t know everything there is to know about how stock investing works. I am a big believer in Valuation-Informed Indexing. But I certainly acknowledge that the millions of people who believe that Buy-and-Hold is the answer are smart and good people. I’ve experienced a lot of push-back (to put it mildly!) from my Buy-and-Hold friends. But there have been occasions when I have heard Buy-and-Holders express a willingness to consider ideas coming from the other side. It might help to explore some possibilities.
The Buy-and-Holders say that the safe withdrawal rate is always 4 percent. The Valuation-Informed Indexers say that it is a number that drops to as low as 1.6 percent at times of super high valuations and rises to as high as 9 percent at times of super low valuations. There’s a lot of distance between those two perspectives!
But it is not too hard to identify a compromise take. Say that an investor was thinking of retiring at a time when valuations were as high as they were in 2000 and the safe withdrawal rate was only 1.6 percent. Is there a way to permit a withdrawal closer to the 4 percent number favored by Buy-and-Holders without putting the retirement at excessive risk? There is.
The 1.6 number assumes an 80 percent stock allocation. Move the stock allocation down to 50 percent and put the remaining 50 percent in Treasury Inflation-Protected Securities (TIPS) paying 3 percent real (it was possible to obtain TIPS paying 4 percent in 2000, when the P/E10 level was 44) and you move the safe withdrawal rate to 3.4 percent. Accept a withdrawal rate that has only an 80 percent chance of working out for 30 years rather than a 95 percent chance and the number moves up again to 3.7 percent. That’s not quite 4 percent, but it’s not too terribly far off. It’s a compromise that might make neither “side” ecstatic but that both sides might be able to live with.
How about stock allocation changes for those not entering their retirement years? Compromises are possible there too.
Buy-and-Holders generally oppose stock allocation changes motivated by a concern over high stock valuations. But even John Bogle, the king of Buy-and-Hold, has acknowledged that allocation changes of 15 percent may in some circumstances be sensible. The allocation-change strategy suggested by Benjamin Graham in his book Security Analysis many years ago was for the investor to go with 50 percent stocks when prices are moderate, 25 percent stocks when prices are high and 75 percent stocks when prices are low. From the highest stock allocation suggested to the lowest suggested, that’s an allocation change of 50 percent. But Graham’s approach would never call for an allocation change at any one time of more than 25 percent. Would that at least have come close to getting Bogle’s approval?
Would any of Bogle’s followers be willing to go along with a 20 percent change instead of a 15 percent change in the name of compromise? If so, I believe we’ve got a deal! The investor could plan to go with a stock allocation of 50 percent at times of moderate prices, of 30 percent at times of high prices and of 70 percent at times of low prices.
For investors who do not feel comfortable making many allocation changes, it is possible to obtain most of the benefits of Valuation-Informed Indexing without making many switches. Valuations were low in 1982. They did not reach dangerously high levels until 1996. So a change was required at that time. The investor could get by without making another change until late 2008 and then another soon afterward when prices rose again the following year. No further changes have been required. That’s three changes in 36 years, less than one every 10 years. Is that a compromise that at least some Buy-and-Holders would find acceptable -- to change stock allocations only when valuation changes are so dramatic that it has become dangerous to ignore the need to do so?
The other way to play it is to make a larger number of smaller allocation shifts. Some Buy-and-Holders might not like the idea of lowering their stock allocation by 30 percentage points all at one time because the reality is that there are no magical thresholds that cause the value proposition of stocks to change markedly in a short amount of time. Investors in that camp could increase or lower their stock allocation by only five percentage points at a time but a good bit more frequently. The concept can be tailored to fit the preference of the investor making use of it. Some investors would prefer to make as few allocation shifts as possible and would be willing to accept somewhat large shifts to make that possible. Others would prefer to go with a larger number of shifts in exchange for never having to make a large allocation change all at one time.
Rob’s bio is here.
