The Five Big Benefits of Valuation-Informed Indexing
I’ve been arguing for nine years now that the Buy-and-Hold investing strategy needs to be updated. Buy-and-Hold was developed to reflect lessons learned from the academic research of the 1960s and 1970s. A key premise of this model, that investors do not need to change their stock allocations in response to big price swings, is rooted in the research of University of Chicago Economics Professor Eugene Fama. But Fama’s research was discredited 30 years ago.
Yale Economics Professor Robert Shiller showed in 1981 that valuations affect long-term returns. If valuations affect long-term returns (there is now a mountain of follow-up research backing up Shiller’s 1981 finding), the value proposition of stocks is a variable and not a constant thing. Thus, investors should not be staying at the same stock allocation at all times but changing their stock allocations in response to big price swings. Those who fail to do so are permitting their risk profiles to swing wildly. It is only by changing our stock allocations in response to big price shifts that we can keep our risk levels roughly constant.
I call this new approach Valuation-Informed Indexing. Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, recently posted at his blog preliminary research showing that it works well. Pfau found that: “Valuation-Informed Indexing provides more wealth for 102 of the 110 rolling 30-year periods” in the historical record.
Combined with the message delivered by Brett Arends in a recent Wall Street Journal column that the only reason why experts have been so slow to pick up on the implications of Shiller’s research is that “for years the investment industry has tried to scare clients into staying fully invested in the stock market at all times no matter how high stocks go” and that “they are leaving out more than half the story” and that Buy-and-Hold has been revealed as “hooey,” I believe that the time has come for the launching of a national debate on the true realities of long-term stock investing.
Set forth below are five reasons why I view Valuation-Informed Indexing as the investing strategy of the future.
1) Higher Returns
Having less money in stocks when they are priced to crash (a regression analysis of the historical stock-return data showed that stocks were in 2000 priced to provide a likely annualized 10-year return of a negative 1 percent real) leaves you with more money to invest in stocks when prices are moderate or low. You lose less at times of high prices (the only bad time to own stocks) and you gain more at times of low prices (both because you have more money to invest after suffering smaller losses and because Valuation-Informed Indexers go with higher stock allocations at times when stocks are offering mouth-wateringly high long-term returns [in 1982, stocks were priced to provide a likely annualized 10-year return of 15 percent real!)];
2) Less Risk
The most important implication of Shiller’s research is that the inherent riskiness of stocks is greatly overstated. To say that valuation levels affect long-term returns is to say that valuation levels predict long-term returns (not precisely, but to a significant extent). Risk is uncertainty. To the extent that long-term returns can be predicted, stocks are not risky. A statistical analysis shows that 78 percent of the 20-year return of an index fund is determined by the valuation level that applies at the beginning of the 20-year period. Only 22 percent is due to factors that cannot be known by the investor at the time the investment is made.
3) Better Emotional Balance
Valuation-Informed Indexers do not become elated by price jumps or depressed by price drops. Why? Because every upward price movement has its downside (it lowers the most likely long-term return from that point forward) and every downward price movement has its upside (it increases the most likely long-term return from that point forward). The stock portfolio of a Valuation-Informed Indexer is adjusted for the effect of overvaluation or undervaluation and thus increases at a steady pace over time rather than jumping wildly up and down in tune with the manic-depressive mood swings of Mr. Market.
4) True Long-Term Focus
Buy-and-Hold purports to be a strategy for long-term investors. The reality, however, is that most Buy-and-Holders pay almost as much attention to the short-term ups and downs as stock investors have since the beginning of time. The reason is that Buy-and-Hold posits that price changes are the result of economic developments. Investors who believe that short-term economic developments are affecting their retirement hopes can hardly expect to honour vows not to pay attention to what is going on in the economy. Shiller’s research suggests that the primary driver of short-term price changes is investor emotion. Thus, short-term economic developments are of little consequence to the Valuation-Informed Indexer. By encouraging a thought process in which the short term truly doesn’t matter, the new strategy helps investors tune out the short-term noise not just in theory but in reality.
5) Enhanced Money Management Abilities
Stocks were priced at three times fair value in January 2000. That means that an investor with a stock portfolio nominally worth $300,000 possessed lasting wealth of only $100,000. Millions spent more on houses, cars and vacations than they would have if they had known their true financial status. Valuation-Informed Indexers discount the nominal value of their portfolios for the extent of overvaluation present in the market and thus are better able to manage their non-investing financial affairs.