A Truly Simple Way to Invest in Stocks

Beyond Buy-and-Hold #26

Most people acknowledge that valuations affect long-term returns and therefore that the idea of adjusting your stock allocation in response to big price swings (Valuation-Informed Indexing) makes a good bit of sense. An objection that I often hear, however, is that Buy-and-Hold is more simple.

Most middle-class investors lead busy lives and find little appeal in the idea of spending their nights and weekends studying investing. So the criticism that the new approach is the more complicated approach should be taken seriously. If Buy-and-Hold really is more simple, Buy-and-Hold possesses an important edge.

I don?t think Buy-and-Hold is more simple than Valuation-Informed Indexing. I think Valuation-Informed Indexing is by far the more simple investing strategy.

Why simplicity is so important

The key to making an investing strategy work in the real world is sticking with it for the long term. If you don?t possess a complete understanding of your strategy, you are likely to abandon your strategy at the worst possible time for doing so. Simplicity is not just a nice thing in an investing strategy. It is imperative for those who want their strategies to work in the real world.

There is a surface sense in which Buy-and-Hold is more simple. With Buy-and-Hold, you make a one-time determination of what your stock allocation should be and then stick with that choice forever. It can fairly be said that there is a certain simplicity that follows from never needing to revisit the question of what your stock allocation should be.

The approach that offers surface simplicity brings into play many deep and long-lasting complexities, however.

A basic problem that plagues many of today?s middle-class investors is that they do not possess a good understanding of how investing works. I believe that much of the confusion we all feel is rooted in our effort to convince ourselves that it is not necessary to take price into consideration when buying stocks.

We all buy lots of goods and services. We all consider price when making purchases of every thing we buy except stocks. It would actually be more simple to consider price when buying stocks too. Then we could put the many years of experience we all enjoy buying hundreds of goods and services to work helping us understand how to buy stocks.

By adopting a completely opposite rule for stock-buying (Buy-and-Holders go so far as to argue that taking price into consideration when buying stocks is a bad thing when they assert that timing doesn?t work), we confuse ourselves about how stock investing works. Our confusion generates all sorts of unnecessary complexities.

Knowing how much you can afford to spend on cars and houses and vacations becomes far more complex when you follow a Buy-and-Hold strategy. Valuation-Informed Indexers reduce their stock portfolio numbers for the effect of overvaluation (wealth that is the product of overvaluation is only temporary and not lasting wealth). So we can plan our financial affairs properly.

Buy-and-Holders cannot.

Stocks were priced at three times fair value in January 2000. The Buy-and-Holder who believed that he possessed $300,000 in stock wealth possessed only $100,000 in lasting stock wealth. How could someone who misunderstood his financial circumstances to that extent make good decisions about what sort of house to buy or what sort of car to buy or what sort of vacation to take? Getting all those things wrong for many years (stock prices remained at insanely dangerous levels from January 1996 through September 2008) adds a good bit of complexity to one?s life.

Buy-and-Holders become excited over bull markets because they treat the temporary wealth generated by them as real. Valuation-Informed Indexers don?t because they count only real gains (and not gains that are attributable solely to market mis-pricings) as real. Stock investing becomes a far less complex pursuit when you avoid the emotionalism that comes to dominate all investing decisions during out-of-control bulls.

Valuation-Informed Indexers also avoid the intense emotionalism that comes to dominate in bear markets. We go with lower stock allocations when stocks are priced to crash. So we don?t see our hopes for comfortable retirements going up in smoke as stock prices make their inevitable way back to fair value. Non-emotional investing is simple investing.

If most investors became Valuation-Informed Indexers, bull markets (and the bear markets and economic crises that follow from them) would become logical impossibilities. That would mean no more big jumps in the unemployment rate! And no more political debates about huge economic stimulus packages! And no more worrying about Fed pronouncements and hyper-inflation and deflation and all that sort of thing. Again, the simple path is the path that recognizes the need for investors to know the true non-inflated value of their stock holdings at all times.

How many allocation shifts are needed to achieve all this good stuff? One every 10 years or so.

That tiny bit of effort generates a whole big bunch of simplicity over an investing lifetime. To say that it?s more simple to ignore valuations than to take them into account is like saying that it is more simple to ignore brushing your teeth than to take on the small bit of complexity involved in taking care of your teeth and thereby avoiding all the complexities that follow from failing to do so.

You want to go with the investing strategy that is the most simple in the long run.

Rob Bennett believes that simple investing is smart investing. His bio is here.

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