Shiller Quantified What Was Previously Thought to Be Non-Quantifiable

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Shiller quantified what was previously thought to be non-quantifiable. That’s the advance. That’s the breakthrough. That’s the revolution.

Every investor with sense has always known that stock prices were affected both by rational factors (economic developments) and by emotional factors (investors getting overly optimistic or overly pessimistic and sending prices to places not justified by the economic realities. In pre-Shiller days, the trouble was that there was no way to determine how much of the current price was real and how much was emotional mumbo jumbo. The Buy-and-Hold concept was essentially an admission of defeat. The idea was — we cannot know how much emotion is affecting the price so we will just stay at a high stock allocation at all times and hope for the best.

Now we know what we need to know!

The fair-price CAPE level is 17. So, if the CAPE is somewhere near 17, you are good going with a high stock allocation. Stocks offer a strong return. So why not?

If the CAPE goes a little above 17, it’s the same deal. Stocks still offer a strong return at 18 and 20 and 22. So why not stay with your high stock allocation? You might want to go with something a little lower at 22. But not too much lower. Risk is greater at 22 than it is at 17. So it would make sense to take something off the table. But the same research that shows that long-term timing always works shows that short-term timing never works. So you don’t want to overreact.

But 25? 30? 40?

You lower your stock allocation at those price levels if you are a thinking investor. Risk is dramatically different at those price levels than it is when stocks are priced reasonably. So, if you want to keep your risk profile constant over time (you should), you need to lower your stock allocation to have any hope of doing so. That’s the Valuation-Informed Indexing magic. That’s what it’s all about.

Stock allocation according to CAPE level

I could list every CAPE level and tell you what stock allocation I would go with when that CAPE level applies. But I am not going to do that. I don’t think that it would serve much purpose. For several reasons.

One, you always need to take your personal circumstances into consideration. I went to a zero stock allocation in 1996. I have always recommended that the typical investor keep some money in stocks even when prices are insanely high because there is no telling what prices are going to do in the short term and it can mess with your mind for you to see prices rise quickly at a time when you are on the sidelines. But I was counting the days until I would have enough money saved to be able to leave my corporate employment and launch my internet writing business. I couldn’t afford to suffer significant losses because of my personal circumstances. So I went to zero. I very much think that I did the right thing. Prices skyrocketed from 1996 through 1999. But there was a real risk that they could collapse at any time. It was important to me that I not suffer big losses at that time, So I think I did the right thing to take what the CAPE value of the day told me about the riskiness of the stock market into consideration when setting my stock allocation.

Two, we don’t have enough historical data available to us to make precise recommendations. We have 150 years of data. That sounds like a lot. But it takes about 40 years to complete a full bull/bear cycle. So there are only three complete bull/bear cycles on record. That’s not enough to permit us to get too cute with this stuff. We know a lot. We should be grateful for how much we know and we should put what we know to good use. But we should also recognize that there is a lot that we would like to know that we do not know and act with some humility in the face of that reality.

Three, no matter how smart I am (and I am not super smart), I have only one mind and one set of life experiences to draw upon in making assessments re these matters. You would get a fuller picture by hearing what thousands of people with reasonably good minds and reasonable mixes of experiences have to say. Insist that every internet site be opened to honest posting re the peer-reviewed research! Then you will get better advice for free on the internet than what I could offer you in this article. The purpose of the article is to make the case that every site be opened to honest posting re the research. Once that breakthrough is achieved, we will all benefit from the explosion of sound advice that will follow.

Definitely do not stick with the same stock allocation at all price levels! That much I can say for sure.

And definitely do not get too cute with your allocation changes. We don’t know enough to permit extreme allocation choices. I feel confident re that one too.

If you make moderate allocation changes (60 percent when stocks are priced reasonably, 30 percent when prices are insanely high, 90 percent when prices are insanely low), you will see most of the benefits that the Shiller revolution promises to all of us. You don’t need to fret about it beyond that.

Rob’s bio is here.