Considering Valuations Does Not Make a Stock Investor More Fearful

There are a lot of things that Buy-and-Holders say about you once you abandon the strategy and become a public advocate of long-term market timing. One is that you are a “scaredy cat.” When stock prices are as high as they are today (and have been for most of the last 24 years), Shiller’s research shows that long-term stock returns are likely to be sub-par. So Valuation-Informed Indexers go with a stock allocation lower than what they would go with if stock prices were more reasonable (perhaps 30 percent stocks). According to the Buy-and-Hold mindset, stocks are always the best asset class. So a 30 percent stock allocation is evidence of fearfulness.

I don’t buy it.

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Q2 2020 hedge fund letters, conferences and more

Seth Klarman Tells His Investors: Central Banks Are Treating Investors Like “Foolish Children”

Volatility"Surreal doesn't even begin to describe this moment," Seth Klarman noted in his second-quarter letter to the Baupost Group investors.  Commenting on the market developments over the past six months, the value investor stated that events, which would typically occur over an extended time frame, had been compressed into just a few months. He noted Read More


Stock Investing Risk Is Directly Proportional To CAPE Levels

I agree with my Buy-and-Hold friends that stocks are the best asset class. And I agree that an investor needs to be willing to take on risk if he wants to accumulate enough assets to finance a retirement that will begin at a reasonable age. What I don’t agree with is the idea that an investor should take on unnecessary risk. Shiller showed that valuations affect long-term returns. If that, so, stock investing risk is not constant but variable, rising when the CAPE level increases and diminishing when the CAPE level drops. The investor who seeks to keep his risk profile constant over time (and shouldn’t we all seek that?) is required to adjust his stock allocation in response to big changes in the CAPE level. There is no other way to achieve the goal.

The Valuation-Informed Indexer has gone with a low stock allocation for most of the past 24 years. So he has indeed taken on less risk during that time-period. There’s a sense in which one might fairly label him a “scaredy cat.” But his intent was not to avoid risk, it was to take the steps necessary to allocate his risk-taking in the most efficient manner over the course of his investing lifetime. If Shiller’s Nobel-prize-winning research is legitimate research, we will be seeing in the not-too-distant future a number of years in which the CAPE level will be below the fair-value CAPE level of 16, just as we have seen in recent times many years in which it was above that threshold. In those days, the Valuation-Informed Indexer will be going with a higher stock allocation than the Buy-and-Holder (perhaps 90 percent). What is the antonym of the term “scaredy-cat”?

Ordinarily, the antonym would be “risk-taker.” But it is not exactly right to say that the Valuation-Informed Indexer is more willing to take on risk than the Buy-and-Holder. The difference lies in the different understanding of what makes stocks risky. For the Buy-and-Holder, it is economic uncertainty that causes stock risk. Stock price changes are caused by economic developments and we cannot know in advance how economic developments are going to play out. So there is always risk attached to placing one’s money in stocks. And, importantly, that risk is constant. Stock prices are not predictable. Market timing doesn’t work.

What Makes Stocks Risky?

The Valuation-Informed Indexer has a different understanding of what makes stocks risky and thus a different understanding of how to allocate his risk-taking over the course of an investing lifetime. For the Valuation-Informed Indexer, it is shifts in investor emotion that play the primary role in determining stock prices. Thus, stock prices are to a large extent predictable, market timing always works and risk waxes and wanes. It does not make sense for an investor to stick with the same stock allocation at all times. The strategically smart thing to do is for the investor to go with a higher stock allocation when the risk of investing in stocks is small and with a lower stock allocation when the risk of investing in stocks is large. Following this practice, the Valuation-Informed Indexer is able to earn a much higher return from investing in stocks over the course of a lifetime while employing the same average stock allocation.

The great thing about investing in this way is that price changes do not come as surprises. Valuation-Informed Indexers do not worry about the effect of economic developments on stock prices because they do not imagine this effect to be terribly significant; most price changes are caused by shifts in investor emotions. If stock prices were to fall hard over coming months, it would not worry me in a personal sense (although it would cause me some concern re the effect that it would have on our nation). I am expecting a price crash in the not-too-distant future because of today’s high valuation levels. Things that one is expecting to see happen do not scare one.

I would not be afraid to invest in stocks after a price crash. I have just as much confidence that stocks will perform well starting from a low CAPE level as I have that they will perform poorly starting from a high CAPE level. And I would not be concerned that the price crash was due to some economic issue that might not yet be resolved. It is shifts in investor emotion that cause price changes, not economic developments. I wouldn’t feel able to say when prices would start moving upward any more than I today feel able to say when prices will begin moving downward. But when the CAPE level was low I would feel confident that the long-term direction of stock prices would be upward.

Rob’s bio is here.