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?