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How to Use Valuation-Informed Indexing

I advocate Valuation-Informed Indexing. This investing strategy is the alternative to Buy-and-Hold.

Buy-and-Hold is rooted in the research of University of Chicago Economics Professor Eugene Fama and assumes that overvaluation is a logical impossibility; thus, it posits that investors need not change their stock allocations in response to price changes. Valuation-Informed Indexing is rooted in the research of Yale University Economics Professor Robert Shiller and assumes that valuations affect long-term returns; thus, it posits that allocation changes in response to big price changes are required of investors hoping to keep their risk levels roughly constant.

How to Implement a Valuation-Informed Indexing Strategy

The purpose of this guest blog entry is to explain how to implement a Valuation-Informed Indexing strategy.

It is not necessary to invest in more than two asset classes: (1) a broad index fund; and (2) an inflation-adjusted government bond. In the United States, we have Treasury Inflation-Adjusted Securities (TIPS) and IBonds; my understanding is that Real Return Bonds (RRBs) serve the same general purpose in Canada. My preference is to buy TIPS directly from the government rather than to own them in a mutual fund.

The purpose of the index fund is to generate portfolio growth. In the days before indexes, investors needed to research dozens of questions before making a stock purchase. Was the management of the company sound? Was the competition too strong? Was the pipeline of new products promising? For indexers, none of these questions matter. When you buy an index fund, you are buying a share of the productivity of the overall economy.

In the United States, that means that you are buying an income stream of 6.5 percent real per year. I don’t know the number that applies in Canada, but my guess is that it is in the same general neighborhood. If that return appeals to you, you are pretty much set. We now have available to us a means of tapping into the great earnings potential of stocks in an exceedingly simple way.

What’s Your Real Return?

There’s only one problem.

There is one important factor that can never be priced in to your purchase of an index fund — overvaluation. To overvalue a fund is to misprice it. Mispricing by definition can never be factored into the price you pay and must be considered separately.

Say that you pay two times the fair price for an income stream of 6 percent real. You obviously are not going to obtain an income stream of 6 percent with that purchase. Your return will not be $6 for each $100 you spend but $6 for each $200 you spend. Your income stream will be 3 percent real.

If you pay three times fair value (stocks were priced at three times fair value in the United States in January 2000), your return will be $6 for each $300 you spend. That translates into an income stream of 2 percent real.

If you pay one-half fair value (U.S. stocks were priced at one-half fair value in January 1982), your return will be $6 for each $50 your spend. That translates into an income stream of 12 percent real.

How do you know when stocks are being sold at a good price? You need to do two things: (1) determine the most likely 10-year return for your index shares; and (2) compare that return to the return you could obtain by investing in a super-safe asset class like TIPS or RRBs.

The Stock-Return Predictor: How Cheap Is Cheap?

I use The Stock-Return Predictor, a stock valuation calculator available at my web site, to identify the likely 10-year return on stocks. The calculator performs a regression analysis on the historical stock-return data dating back to 1870 to reveal the most likely 10-year return. For example, it reports that, when stocks are selling at the prices that applied in 1982, the most likely annualized 10-year return is 15 percent real. In contrast, when stocks are selling at the prices that applied in 2000, the most likely annualized 10-year return is a negative 1 percent real.

I follow a rule of thumb that the likely long-term return on stocks must be at least two percentage points higher than the certain return on the super-safe asset class for it to make sense for me to take on the volatility of stocks. At a time when stocks are offering a likely 10-year return of 3 percent real and TIPS (or RRBs) are offering 2 percent real, I would generally opt for TIPS (or RRBs). At a time when stocks are offering a real return of 6 percent real and TIPS (or RRBs) are offering 3 percent real, I would generally opt for stocks.

Valuations Are Relative

The analysis is not quite as simple as that, however. Other important considerations are: (1) the life goals you are pursuing that you need accumulated capital to pursue; (2) the amount of wealth you have accumulated over the years; (3) your risk tolerance; and (4) the return that can be obtained by investing in the super-safe asset classes at the time when you are making the allocation decision.

Say that you will need to have money to help your daughter enter college in five years. You need to be more wary of the risks of stock investing than someone facing a different set of circumstances. Even if stocks are available at good prices, there is no telling how they will do in five years; statistically valid predictions can only be made for time-periods of 10 years or longer.

Your financial circumstances also influence your ability to take on the risks of suffering short-term losses. An investor with $10 million in accumulated wealth responds differently to a 50 percent loss than an investor with $1 million in accumulated wealth. The wealthy investor suffers a far bigger dollar loss. But the less wealthy investor is giving up more in terms of lost opportunities — $1 million is enough to finance a decent middle-class retirement but $500,000 is generally not thought to be enough.

You also need to consider the return that can be obtained by investing in the super-safe asset classes. TIPS were paying 4 percent real in 2000. They are not paying anything close to that today. If stocks were selling at the same price today as they were selling in 2000 (they are not), the scales would be tipped far more in the direction of stocks today than they were in 2000 because the alternative to stocks today would be offering a far less attractive value proposition relative to that offered by stocks.

P/E10 to Predict Returns

The valuation metric (P/E10 — the price of an index over the average of its last 10 years of earnings) used in The Stock-Return Predictor to identify the most likely long-term return is research-tested. It has worked well for the entire 140 years of U.S. stock-return history available to us. For example, research by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, reports that Valuation-Informed Indexing beat Buy-and-Hold in 102 of the 110 rolling 30-year time-periods now in the historical record.

Please understand, though, that while we now have the tools we need to make statistically valid predictions of the 10-year return of index funds, we are not able to make precise predictions. We can identify a range of possible returns and assign rough probabilities to each point on the spectrum of possibilities. But when the most likely 10-year return is 6 percent real, there is a 20 percent chance that the actual return will be less than 3 percent and a 20 percent chance that the actual return will be greater than 9 percent real.

Moreover, the investor needs to hold the stocks he buys for the 10 years that need to pass before effective predicting becomes possible. In those years, anything can happen. Stocks can perform well for one or two or three years starting from a time of insanely high valuations (this happened in 1997 and 1998 and 1999). Or they can perform poorly for one or two or three years starting from a time of insanely low valuations.

Shifting Probabilities in Your Favor

The smart Valuation-Informed Indexer prepares not only for the most likely outcome but for all other realistic possibilities. And the smart Valuation-Informed Indexer takes into consideration the emotional hit he will feel if he shifts to a low stock allocation because prices are high and stocks perform well for a few years or if he shifts to a high stock allocation because prices are low and stocks perform poorly for a few years.

He does this by avoiding dramatic valuation shifts. It is generally better to maintain at least a small stock allocation (perhaps 20 percent or 30 percent) even when stocks are selling at the insanely high prices that applied from 1996 through 2008. And it is generally better to avoid going with a stock allocation above 90 percent even when stocks are selling at prices so low that it is impossible to imagine a bad long-term outcome (perhaps your imagination is too limited!).

The idea behind Valuation-Informed Indexing is to shift the probabilities in your favor. Start thinking that our ability to predict stock returns is greater than it is and you will almost surely hurt yourself. Moderate allocation shifts always work. Extreme valuation shifts rarely do.

What Is Fair Value?

A P/E10 value of 14 is fair value for the U.S. market. About the lowest P/E10 value we ever see is 7 (half of fair value). A P/E10 value of 28 (double fair value) is insanely dangerous. Every time we have gone above 24 we have seen a stock crash and an economic crisis in the following years. The only time prior to the 1990s that we went to a P/E10 value of 33 we brought on the Great Depression. In the late 1990s, the P/E10 value rose to 44.

The idea behind the Valuation-Informed Indexing approach is to keep your risk profile roughly constant. You must be willing to change your stock allocation occasionally to be able to do this. But there is no need for frequent allocation shifts. An allocation shift is needed once every eight years or so on average.

When the P/E10 value is 7, it is virtually impossible for it to drop any lower. Stock prices must eventually return to fair value for the market to continue to function (the primary purpose of a market is to set prices properly). If the P/E10 value remains at 7, you would earn a return of 6.5 percent real for any money invested in stocks at that price. If the P/E10 value moves in the direction of fair value, your return would be better than that. So it is almost impossible to imagine a way you could lose on stocks purchased at so low a price.

The converse is true when stocks are selling at the sorts of prices that have applied from 1996 forward (except for a few months in early 2009, when we dropped down to moderate price levels for a short time). When stocks are selling at a P/E10 level of 24 or higher, the best possibility is that they might remain at that P/E10 value for a few years and that you would earn a return of 6.5 percent real. The more likely possibility is that the price will crash within few years and you will see big losses. The long-term probabilities are very much against investors buying stocks at such high prices.

Asset Allocation Strategy

The most simple strategy is probably the one that calls for a stock allocation of 30 percent stocks at times when the P/E10 value is above 21, 60 percent stocks when the P/E10 value is between 12 and 21, and 90 percent stocks when the P/E10 value is below 12. Pfau tested a 30/60/90 stock allocation strategy.

Valuation-Informed Indexing increases your long-term return dramatically. It is a virtual certainty that the Valuation-Informed Indexer will go ahead of the Buy-and-Holder sooner or later because Buy-and-Holders get killed in crashes and we all are certain to experience crashes at some point in our investing lifetimes. Once the Valuation-Informed Indexer goes ahead, it is almost impossible for the Buy-and-Holder to catch up because both strategies call for high stock allocations at times when stocks are priced to provide good returns. And, once the Valuation-Informed Indexer gains an edge, the compounding returns phenomenon continually increases the value of that differential over the remaining years of the investor’s lifetime.

But the primary purpose of strategy is not to increase returns. The primary aim is to limit risk. Please examine the discussion of how Valuation-Informed Indexing limits risk put forward by Pfau in this Bogleheads Forum thread (the highlight is the chart set forth in the post put forward on February 28 at 9:45 pm).

What do you think of valuation-informed indexing?

Comments

  1. Rob Bennett

    Thanks for not giving up on the idea too quickly, Sustainable. Lots of people experience difficulty with this. I don’t think it is because it is complicated in any way. I think the problem is that it is just so different from Buy-and-Hold that it takes some time to get your head around it.

    The encouraging aspect of this is that the thing that makes VII had to understand at first suggests HUGE potential for us all to invest far more effectively in the future than any group of investors has ever been able to invest in the past. What we are talking about here is a way to predict stock returns that really works (the academic research shows that there has never yet in 140 years been a time when this did not deliver much higher returns at greatly reduced risk). Risk is uncertainty. When we make stock returns predictable, we are transforming stocks into a non-risky asset class.

    That’s pretty darn exciting.

    Rob

  2. Sustainable PF

    Glad to see this getting spelled out in a straight forward way Rob. I have to admit in our conversations I was a bit lost but posting in this manner is helping me to understand a bit better.

  3. Sustainable PF

    Well it sure seems to make sense as you put it here.
    I found the spreadsheet to be a bit confusing as well, both in terms of USING it but also UNDERSTANDING the outputs.
    What you have written here seems easy enough. Look at 10yr stock value, compare against threshold above RRBs/TIPS, purchase the one that makes the most sense.

  4. Rob Bennett

    There are obviously many people who have a hard time understanding this. My guess is that most people have similar questions. It helps if we can get those out on the table and see whether I am able to give answers that make any sense or not.

    I am certainly grateful for your interest and your patience. My experience with some others is that there will be a moment when it all just clicks into place. I obviously want to say what needs to be said to facilitate the click experience. It helps me when people identify what it is that doesn’t add up for them. One of the problems that I have is that I have been working on this for so long that it has become second nature to me. However, I very much get it that it is not at all second nature to many others.

    Rob

  5. My Own Advisor

    Good post Rob, but I wonder, is this approach making things more complicated than need be?

    To play the devil’s advocate, what I mean is, most investors wouldn’t understand half of what you are discussing. Wouldn’t they be better off to simply buy a bond ETF like CLF, CBO, XSB or XBB (just to name a few) or a bond mutual fund (higher fees aside) and keep that product for 30 years instead of worrying about thresholds and the like.

    Sorry to be a pain here.

  6. Rob Bennett

    You’re not being a pain even a tiny bit, My Own Advisor. You’re asking an intelligent and an important question.

    I think that middle-class people need to be in stocks. Bonds do not pay returns that are high enough. Each point of added return is a very big deal when you look at the effect over the course of an investing lifetime (60 years or so). Give up 1 point of return and consider the compounding effect on that and your chances of being able to finance a decent retirement go way down.

    The investing approach MUST be simple, though, or it will not work for the majority of middle-class investors. So any significant complexity is a big problem.

    I don’t believe that Valuation-Informed Indexing needs to be even a tiny bit complicated. You could go with a 25/50/75 approach. Your non-stock money would be in an inflation-protected bond. You would need to make about one allocation shift each 10 years. What could be more simple?

    The investor should not need to worry about thresholds. Once we all accept that valuations affect long-term returns (and that Buy-and-Hold can thus never work in the long run), the media would be reporting on these thresholds on a daily basis. We now see the DOW and the S&P numbers reported all the time. Why not just add a note that “at today’s valuation levels, stocks are extremely dangerous and most middle-class people should limit their stock allocations to 25 percent or less?” That would do the trick.

    They have something like that when I go to the beach at Cape May, New Jersey. They have a green flag for when all is well, a yellow flag for when the surf is rough, and a red flag for when no one is permitted in the water. We should have the same thing for stocks. We should not be telling people that it is okay to stay at the same stock allocation at all times. We should be warning them that it is dangerous to do so.

    The full reality is that, once we establish such a warning system, we will never again see another bull market or another bear market. All overvaluation and undervaluation is irrational. If we permitted ourselves to talk openly about the realities of stock investing, both bulls and bears would become logical impossibilities. We all WANT to invest effectively, there is not one person alive who invests with the aim of losing his or her money in a crash. Crashes come about because we engage in self-deception and self-deception becomes impossible once we encourage our fellow community members to set us straight when they see us doing crazy stuff.

    My view is that the thing that makes stock investing so complex is all the emotional drama that goes with it. We get all excited in bulls thinking that now we are on our way to a good retirement even though much of the money in our portfolio is sure to disappear in a few years. And we get all depressed when the money disappears because now we cannot figure out how we are going to make it. Why not just report the numbers accurately at all times? Take away the crazy ups and you also take away the crazy downs. Then you can count on the numbers in your portfolio statement as representing something real. That’s truly simple investing, in my assessment.

    If we permitted fully honest and fully accurate posting on every aspect of stock investing everywhere on the internet, stocks would go up in price by 6.5 percent real each year (that’s the gain justified by the productivity of the U.S. economy — the number is Canada is probably in the same general neighborhood). Could anything be more simple than a stock market that goes up by a predictable amount each year? This is easily within our grasp today. We just need to start putting this new communications medium to use for the benefit of the middle-class investor.

    The reason why no one ever did this before is that we didn’t have the research needed to know what we know today until 1981 and Buy-and-Hold has been too popular to challenge in the years since. But Buy-and-Hold becomes less and less popular as the economic crisis it caused worsens. So this is the logical next step. The only complicated aspect I see to this is the part where we have to get the Buy-and-Hold advocates to acknowledge having made a mistake. I will acknowledge that that one has proven to be enormously complicated — beyond belief!

    But even there, all of these people want to help people invest more effectively. That’s why they got into this field in the first place. So they will be cool with all this once it becomes clear to them that it really is going to happen. I think that the thing holding it up is that some don’t quite believe that we could ever make such a huge advance, so they are waiting to see how things play out. We are going to make the advance. As the crisis worsens, there’s going to come a time when we all are going to come to the conclusion that we really just don’t have any choice anymore.

    Anyway, I really am grateful for your question, My Own Advisor. If this is too complicated for the middle-class investor, it’s of no value. The entire idea here is to develop something simple enough for the average middle-class investor and anything even a little complex just won’t do it. I think there is some perceived complexity here but I think that is only because we are not hearing these ideas being spread through the media on a daily basis. When these ideas are being communicated as often as the Buy-and-Hold ideas have been communicated in recent decades, I don’t think anyone will be seeing this as complicated anymore.

    We take price into considered when buying everything else we buy. Doing so when we buy stocks too is the most natural and sensible and simple thing in the world. At least that’s my (inevitably at least somewhat biased!) take.

    Rob

  7. Rob Bennett

    I need to make one more (brief!) point re the complexity/simplicity question.

    There is no need to get the stock allocation precisely right. When your proper stock allocation is 25 percent, you will do just fine if you are at 20 percent and you will do just fine if you are at 15 percent. Our use of numbers to illustrate points is not intended to suggest that investing is an exact science.

    What we don’t want to see is people who should be at 20 percent stocks going with a 70 percent stock allocation. That’s what Buy-and-Hold did to a lot of people when it went unchallenged for a good number of years.

    Rob

  8. Wow Rob, you’re turning up in more places these days! I’d advise anyone reading this post to give it deep consideration. Rob is writing a series of posts on VII at my site, and it’s clear that he’s done his research and done some deep thinking.

    Most of us want an investment strategy that’s “fire-and-forget”, but that’s mostly a fantasy. That should be self evident from the fact that we’ve eperienced two major stock market crashes in the past ten years.

    It’s time for a different way to look at investing, and Rob is on to something here.

  9. Rob Bennett

    Thank you for those exceedingly kind words, Kevin.

    Yes, my name has indeed been showing up at more sites in recent months. I’d like to comment briefly on that reality because I think it is a matter of some importance to the future of the Personal FInance Blogosphere.

    Every reader of our blogs wants to invest effectively. Every one of us bloggers wants to help his or her readers to achieve that goal. We are all in this together. We are all friends.

    I think it’s fair to say that everyone who knows even a little bit about my history has at least a sense of what I am getting at here.

    I’ve got the hand of kindness outstretched to everyone. My aims are positive, life-affirming ones. For every single person involved.

    We solve our problems by talking about them. It’s the only way the humans have ever come up with. There is no other way.

    Discovering a better way to invest is 100 percent good news for all of us. There is not even a tiny bit of bad in it for anyone. We all need to focus on that and get about the business of figuring out the best way to manage the transition.

    Love is the answer.

    People don’t talk like that much in the investing field, do they? You know what? That’s the problem!

    Investing is a human endeavor. When it comes to any project involving the humans, love must be present or things are going to go off track. There are no exceptions.

    I hope that in coming days we will all be able to focus more and more on the positive stuff going on all around us and become gradually less and less tied to some old ways of doing things that at one time seemed to make sense but which have been revealed over time to have been somewhat less than perfect in some of the particulars.

    My thanks to all those (this group very much includes my good friend Balance Junkie!) who have made my increased visibility of recent months a reality. It’s when we get to the other side of the Big Black Mountain that the real fireworks (the good kind!) begin.

    I can’t wait. And I believe that every single one of us is going to feel the same once we collectively work up the courage it will take to get from where are today to where we all deep in our hearts want to be tomorrow.

    Rob

  10. Monique

    Good Day to you Mr. Bennett,

    I’m come from the Philippines, pretty new to the world of investing in terms of in practice. I read your articles with regards to VII for the past 2 weeks and I have to say that I’m very interested about it.

    I have some concerns with regards investment products available in my home country which the majority of them are actively managed and there are only 4 are index tracker funds (2 of them tracks the local index benchmark, one is a bond index and the other is a dollar bond index fund)

    Is it possible for me to apply VII with these funds?

  11. FranklinMu

    I see there’s a lot of talk about valuation-informed investing now in the blogs. I don’t really understand it but like many ex-Bogleheads, I’m coming around to Rob’s approach.

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