Home Stocks Practicing Valuation-Based Market Timing Permits an Investor to Go With Higher Stock Allocations

Practicing Valuation-Based Market Timing Permits an Investor to Go With Higher Stock Allocations

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Love stocks?

Want to go with the highest stock allocation that makes sense for someone in your circumstances?

You need to look into valuation-based market timing. It’s the stock investing strategy for those who truly love stocks.

The idea behind valuation-based market timing

The Buy-and-Holders don’t see it that way. They understand that Valuation-Informed Indexers (investors who practice valuation-based market timing) lower their stock allocation when stocks are priced at the crazy high prices that apply today. That’s so. The idea behind valuation-informed strategies is to keep one’s risk profile constant over time, to Stay the Course in a meaningful way. Robert Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns suggests that an investor who goes with a 60 percent stock allocation when stocks are priced reasonably might want to drop to a 30 percent stock allocation today.

That means less stocks! That’s an anti-stock move! Right?

No. Not even a tiny bit right.

The same logic that tells a valuation-informed investor to lower his stock allocation today tells him to increase it when prices are insanely low, as they probably will be for some time in the days following the next price crash. The investor who is going with a 30 percent stock allocation today might be going with a 90 percent stock allocation then.

Valuation-Informed Indexing is not an anti-stock strategy. It is a risk-minimization strategy. The thing that makes stocks risky is the investor emotionalism that produces irrational exuberance. By going with a lower stock allocation at times when risk is off the charts and a higher stock allocation when risk is minimal, Valuation-Informed Indexers are able to own as much stocks as Buy-and-Holders while exposing themselves to much less risk.

Now –

Wait a minute.

What if the valuation-informed investor is happy to expose himself to as much risk as a Buy-and-Holder? In that case, he could buy more stocks than the Buy-and-Holder. The one big negative of the stock investment class is that stocks are a high-risk asset. The research that I produced with Wade Pfau shows that investors who are open to engaging in valuation-based market timing can thereby reduce their stock investing risk by nearly 70 percent. Reducing risk by that much permits the investor to go with an allocation strategy calling for more stocks than the 30 percent/60 percent/90 percent plan that permits the valuation-informed investor to match the lifetime stock allocation of the Buy-and-Hold investor.

Minimizing risk is a good thing

How much more stocks you will own is of course up to you. Some valuation-informed investors like the idea of reducing risk by nearly 70 percent and elect not to own more stocks than their Buy-and-Hold friends. The point is that minimizing risk is a good thing and taking Shiller’s amazing research findings into consideration when investing in stocks permits one to do that. The investor can choose to just reduce risk or to reduce risk a bit and also to increase stock ownership a bit and thereby to increase lifetime returns a bit. Adopting a research-based approach is all upside and no downside. It’s investor heaven.

It’s hard to persuade many investors of this at times like today, when the lure of irrational exuberance has influenced all discussions of stock investing. But the first word in the term “irrational exuberance” should clue you in to what is going on. The idea that price discipline is not every bit as important when buying stocks as it is when buying any other good or service available for sale is absurd. If you are careful not to overpay when buying a car, over the course of a car-buying lifetime you will end up with more money in your pocket. You can elect to direct that money to the purchase of other goods and services or to the purchase of more cars. We would not describe someone who got a good deal on the purchase of a car as being “anti-car” because he spent less. He could purchase more cars with his savings over the course of a lifetime. The smart car buyer is pro-car! So it is with the smart stock buyer as well.

Buying fewer stocks when they are priced as they are priced today will permit you to buy more stocks when stocks are selling at discount prices, which they will be soon in the event that the stock market continues to perform in the future anything at all as it has always performed in the past. Price discipline is the thing that makes markets work. When price discipline fades, markets become dysfunctional. Today’s stock market is dysfunctional. Your stock allocation should reflect that important reality.

Rob’s bio is here.

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