Five Strategies For Weathering Market Declines Ineffectively

Five Strategies For Weathering Market Declines Ineffectively
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I do not believe in the conventional Buy-and-Hold investment advice. I believe that Robert Shiller’s “revolutionary” (his word) research showing that valuations affect long-term returns discredited the old model and that it needs to be replaced by a Shiller-rooted model that I call “Valuation-Informed Indexing.”

The other day I saw an article titled Five Strategies for Weathering Market Declines that I thought did a good job of summing up the conventional advice. I thought that it might be helpful if I went through the article line by line, pointing out how I believe that Shiller’s finding that valuations affect long-term returns should change our take on just about every question that comes up in the stock investing project. Please don’t think that I intend to ridicule the authors of the article by labeling their strategies “ineffective.” I sincerely believe that they did a good job of summing up the advice that has won the confidence of millions of good and smart people. My purpose is to show that there is another way to look at these issues. I believe that the conventional advice is ineffective because a Nobel=prize-winning economist has in recent years showed us all a better way.

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The first strategy advanced by the article is to “Consider the Big Picture.” The article explains that: “the market has dropped 20% every three-and-a-half years or so…. Having that historical context can strengthen your resolve to stay invested, which can be key to long-term success. After all, pulling out of the market at a high point and buying back in at a low one is almost impossible to do once, let alone a few times.”

Investors certainly need to keep the big picture in mind. But the big picture envisioned by the Buy-and-Holders is very different from the big picture envisioned by Robert Shiller. The suggestion in the words quoted above is that a price drop of 20 percent is no big deal because we have been seeing those sorts of price drops regularly ever since the market was opened for business and stocks have been providing generally good returns through all those years.

The flaw in the reasoning used here is that on some occasions price drops of 20 percent are followed by further price drops and in some cases they are not and in some cases price drops remain in place for a long time and in some cases they do not. The thing that lets investors know in advance which sort of price drop is coming is the CAPE level that applies at the time. Shiller showed that stock investing risk is not static but variable. The probability of a bad outcome when prices are high is much greater. Investors should be taking the added risk into consideration when setting their stock allocation. Investors should aim to keep their risk profile roughly constant over time and to permit their stock allocation to vary as needed, not to keep their stock allocation constant and to permit their risk profile to bounce all over the place.

There is nothing difficult in knowing when to lower one’s stock allocation in response to increased risk. The historical return data showing us how stocks have performed starting from any of the various CAPE levels is available to all of us. Investors who want to keep their risk profile constant by adjusting their stock allocation in response to big price swings can do so. That strategy has always paid off in the long term. It is certainly so that investors cannot guess in advance when price drops are going to appear. But there is no need for investors to pull off this parlor trick. Investors who keep their risk profiles roughly constant over time do well in the long run. You don’t need to know the precise time when the strategy is going to pay off to understand why sooner or later it will. Stocks are a more risky investment class at times of high valuations. Investors should respect that well-documented reality.

The second strategy is to “Avoid Sudden Movements.” The argument here is that short-term timing usually hurts the investors who make use of it. I certainly agree with that much. But the last two sentences of the description of this strategy state that: “Market turnarounds often happen suddenly and unpredictably. Being out of the market when it bounces back can mean missing out on significant return potential.” The question is whether the potential for significant returns is the same at all valuation levels. It is not. Investors should go with the stock allocation that makes sense for them considering the valuation level that applies. That stock allocation percentage will shift with changes in the CAPE ratio.

The third strategy is: “Don’t Follow the Herd.” The article notes that investors who buy more stocks when most investors are panicking can do well. That is certainly the case. But it is the investors who lowered their stock allocation when stock risk became greater who are emotionally prepared to buy in the face of big prices drops. Buy-and-Holders are far more inclined to panic in the face of price drops than are Valuation-Informed Indexers. Buy-and-Holders do not anticipate the price drops that always follow once stocks reach dangerous price levels while Valuation-Informed Indexers both anticipate such price drops and take steps to protect their portfolio when they occur.

Strategy four is: “Try to Keep Emotions in Check.” Again, it is a lot easier for investors who are keeping their risk profile constant over time to do that than it is for Buy-and-Holders to do that.

Strategy five is: “Stay Focused on Long-Term Outcomes.” The article urges investors to: “Review the value of your investments only at regularly scheduled times, like when you receive your quarterly statements.” This one makes sense to me. I believe that investors should take valuations into account when setting their stock allocation. But it is not necessary to take a look at the CAPE ratio more than once a year. Both high and low valuations tend to remain in place for long periods of time. And, on those occasions when there are quick jumps or quick drops, there really is nothing that the investor can do about it. No one can anticipate the short-term direction of market prices. So it is better for the investor not to even try to do so.

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