Valuation-Informed Indexing:
The Curious Case of the Market Price That Is Not the True Market Price

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by Rob Bennett

Valuation-Informed Indexers change their stock allocations in response to big swings in stock prices. It’s the sensible thing to do given Yale Professor Robert Shiller’s finding that valuations affect long-term returns. If valuations affect long-term returns, the risk/reward ratio for stocks is ever changing. The investor who sticks with the same stock allocation at all times is permitting his risk profile to go wildly off the mark of what he determined it should be at an earlier time. Buy-and-Hold makes no sense.

Most stock investors do not agree.

There must be a reason.

My sense is that the biggest reason is that investors think of Buy-and-Hold as a neutral choice. An objection that I often hear is that Valuation-Informed Indexing might generate better returns but that it sounds dangerous. The feeling is that it is safer to stick with a single stock allocation at all times than it is to make occasional changes. What if changes are made at the wrong time? What if the changes made are too big or too small?

It is of course true that those following a Valuation-Informed Indexing strategy can make mistakes. I don’t see that as being by itself much of an argument against this approach. Mistakes are possible in any life endeavor. The question is — Are mistakes more likely for those following a Buy-and-Hold strategy or for those following a Valuation-Informed Indexing strategy? If switching to Valuation-Informed Indexing increases the chances of making mistakes, that’s a legitimate argument against it. But what basis is there for an assumption that mistakes are more likely for those following a Valuation-Informed Indexing strategy than for those following a Buy-and-Hold strategy?

I believe that what is going on is that Buy-and-Holders have come to trust the market more than they trust themselves. They know that investors often become emotional over their investing choices and make just the wrong move at just the wrong time. That’s true. The Buy-and-Holders are right to question their own ability to make the right allocation shifts, in my assessment.

My view, however, is that we have no choice. Yes, we are emotional. Yes, we may make mistakes. Still, we have no choice but to invest our money and there is no way to avoid making decisions when doing so. We should try to inform ourselves. We should try to avoid the negative emotions. But ultimately we just have to face up to the reality that investing is sometimes difficult and make the best of the cards we are dealt.

The Buy-and-Holders don’t see it that way. It has become clear in my conversations with thousands of them that they believe they possess a secret weapon in the battle to avoid the reach of the investing emotions. They believe that, while they as human investors are prone to mistakes, the market as an independent non-emotional force is not. The way that Buy-and-Holders see it is that index-fund investors are buying a share of a market that over time generates strong returns and that, so long as they do not muck things up by questioning what the market tells them, things will work out in the long run.

I too have great confidence in markets. The difference between the Buy-and-Holders and me is that I hear the market to be saying something very different than what the Buy-and-Holders hear the market to be saying.

In January 2000, when the Dow was priced at near 12,000 and when the P/E10 value was telling us that the market was overpriced by a factor of three, was the market saying that the Dow was properly priced at 12,000? It was not. The market always reveals to us the proper price of stocks in two steps. First, it tells us the nominal price, which is only a temporary price. Then it tells us the adjustment needed in the nominal price to reveal the true, long-lasting market value.

The market doesn’t only generate nominal prices. It also generates P/E10 values. The extent of overvaluation or undervaluation present in the market is by definition not a factor considered in the nominal price. It is only by adding the two factors together (the nominal price and whatever adjustment the market is telling us is needed) that we can know what the market believes the true price to be.

Eugene Fama almost got it right. Fama believed that, because it is in each investor’s interest to exploit any anomalies in market pricing, the overall market was sure always to get prices at least roughly right. That makes sense. Fama’s mistake was in failing to stress to the investors who comprise the market what it is that they need to do to exploit pricing anomalies. We need to increase or lower our stock allocations in response to big price swings!

The market (that’s us!) does indeed very much want to be efficient and the market is providing us the information we need to make the market efficient. Our mistake in the Buy-and-Hold Era has been failing to engage in the exploiting behavior that is the only means by which market efficiency can be achieved. We need to stop looking at the nominal value generated by the market as the sole market message, accept that the P/E10 value generated by the market as well is also part of the story and then act pursuant to what the combination of those two bits of market-generated information tell us.

We need to increase our stock allocations a bit when the nominal market price drops below fair value and lower our stock allocations a bit when the nominal market price rises above fair value. When we persuade enough investors to do that, we will all enjoy — voila! — an efficient market! It is only by making all investors aware of the flaw in Fama’s initial formulation of how an efficient market is attained that we can achieve Fama’s dream of an efficient market in the real world.

Buy-and-Holders are right to place their confidence in the market. What they are failing to see today is that they are the market. They have a role to play in helping the market work its magic. During the Buy-and-Hold Era, they have been failing to play that role because of Fama’s mistake in thinking that the market is telling us what the true value of stocks is in one step rather than in two.

Rob Bennett often writes about behavioral finance. His bio is here.

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