Stocks

Valuation-Informed Indexers Have A Big Edge Over Buy-And-Holders In Trying To Focus On The Long-Term

Both Buy-and-Holders and Valuation-Informed Indexers believe that the key to successful stock investing is to focus on the long-term. Buy-and-Holders say all the time that investors need to “tune out the noise” and ‘stay the course.” What they mean is that investors should ignore the ups and downs in stock prices because they don’t amount to much and just stick to the plan that they determined made sense at a time when they were calm and thinking clearly. Valuation-Informed Indexers encourage investors to adjust their stock allocation in response to big price swings not because they think doing so will produce better short-term results but because they believe that it is critical to keep one’s risk profile roughly stable and because that cannot be done without allocation adjustments in a world in which valuations affect long-term returns.

price jumps and price drops

It of course sounds sensible to focus on the long term. The trouble is that investors are always under emotional pressure to abandon their plans when they are not producing their intended results. Buy-and-Holders are far more likely to experience feelings of panic at such times. Valuation-Informed Indexers are more likely to stick with their plan through thick and thin.

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I remember when a poster at the Bogleheads Forum who is the author of a book on Buy-and-Hold reacted to the 2008 price crash by reconsidering his allegiance to the strategy. If there is one person who you would think would be sufficiently convinced of the merit of the Buy-and-Hold strategy to stick with it no matter what, it would be someone who wrote a book making the case for it. This guy had studied the matter from every possible angle and had made the case for it for years in thousands of posts advanced to a discussion-board community. What could possibly cause him to get sweaty palms?

Reality.

This fellow was retired. Stock prices fell dramatically in late 2008 and early 2009. He was seeing the money that he had planned to use to cover his costs of living for the remaining years of his life disappear into the mist for no good reason. Sure, he knew when he became a Buy-and-Holder that big price drops take place from time to time. But it is one thing to accept on a theoretical basis that large amounts of stock wealth can disappear overnight and something very different to experience it happening in real time. Staying the course sounds like a good idea until your staying-the-course ability has been tested in a very personal and concrete way.

Staying the course is not easy for Valuation-Informed Indexers either. I have no doubt that there were many investors who lowered their stock allocations in 1996, when Robert Shiller advised doing so, and who then regretted the decision in 1999, after stock prices had continued rocketing upward for three more years, and returned to a high stock allocation at the worst possible time. The stock market has a way of playing with the investor’s mind and there is no strategy that immunizes us from its temptation to make emotional choices.

However, I believe that Valuation-Informed Indexing gives the investor seeking to keep his emotions in check a big edge because it trains him to view both price jumps and price drops as inconsequential.

Buy-and-Holders believe that price changes are rooted in economic realities. If that is so, then both price jumps and price drops mean something. Price jumps signal that the economy is doing better than expected and price drops means that the economy is doing worse than expected. Stock investors are hoping that the economy will produce enough growth in their lifetime to finance their retirement plans. How could a Buy-and-Holder not have some emotional reaction to a report that stock prices are signaling whether his hopes in that regard will be realized or not?

Valuation-Informed Indexers approach the investing project with a very different perspective. We start with an assumption that the economy will continue in the future to generate enough wealth to support stock gains of roughly 6.5 percent real per year and ignore gains of more than that as the product of irrational exuberance rather than of anything of lasting economic significance. For us, price gains are no better than price drops. Price gains increase the size of our portfolio (a plus) while lowering the expected long-term return from that point forward (a negative) and price drops diminish the size of our portfolio (a negative) while increasing the expected long-term return from that point forward (a plus). We are able to tune out the emotional noise that the Buy-and-Holders very much take to heart because the positives and negatives of both price gains and price drops cancel each other out.

Valuation-Informed Indexers expected the big price drop that we all experienced in late 2008 and early 2009. We didn’t know in advance when it would arrive. We started anticipating it in 1996, when prices first reached crazy levels, and thus experienced no great feelings of surprise when Shiller’s warnings finally proved out. We suffered losses in the price crash. But those losses were not nearly of the same magnitude as the losses suffered by our Buy-and-Hold friends because we had lowered our stock allocation in response to the rise to super-high CAPE values. When the authors of books about Buy-and-Hold were talking about lowering their stock allocation, we were talking about increasing ours because stocks were once again selling at prices at which higher stock allocations offered a good long-term value proposition.

It is the emotions prompted by big price swings that make stock investing risky. Valuation-Informed Indexers are better equipped to keeping those destructive emotions in check because we possess a better understanding of what causes stock prices to rise and fall. When you don’t treat big price gains as real when they appear on your portfolio statement, you feel much less of a sense of panic when they disappear into the mist a number of years down the road. Only gains rooted in economic realities count and those have been limited to 6.5 percent real per year for as far back as we have good records of U.S. stock prices.

Rob’s bio is here.