Valuation-Informed Indexing Cuts the Risk of Stock Investing by 60 Percent

Beyond Buy-and-Hold #98

I often make the point that Valuation-Informed Indexing is far less risky than Buy-and-Hold. John Walter Russell’s research showed that investors who take price into consideration when setting their stock allocations reduce risk by 80 percent. Wade Pfau’s research used a different methodology to show that investors who take price into consideration when setting their stock allocations reduce risk by 70 percent. Either way, the risk reduction is huge.

I thought I would try a third way of measuring the effect through use of The Investing Strategy Tester.

The Strategy Tester lets us compare how different strategies perform over a 30-year time-period. It provides the full range of results that can apply presuming that stocks perform in the future at least somewhat as they have always applied in the past. And it assigns rough probabilities to each of the possible outcomes.

Risk and its affect on your investment strategies

Risk is uncertainty. Risk is not knowing what is going to happen to your portfolio down the line.

My thought is that we could compare the size of the range of 30-year outcomes for a Valuation-Informed Indexing strategy with the size of the range of 30-year outcomes for a Buy-and-Hold strategy. The smaller the size of the range of outcomes, the less uncertainty there is for the investor. The smaller the size of the range of outcomes, the less risk there is for the investing strategy.

I presumed that the investor starts with $10,000 in his portfolio and adds $10,000 to it each year for 30 years. I also presumed that the investor could earn a return of 3 percent real in a non-stock investment class. I had the Buy-and-Hold investor go with a 60 percent stock allocation. I had the Valuation-Informed Indexer go with a 90 percent stock allocation when prices are low, a 60 percent allocation when prices are moderate, a 30 percent allocation when prices are high and a zero percent stock allocation when prices are insanely high.

Here’s the graphic that the calculator produces (please click to enlarge):

Risk reduction graph
Risk reduction graph

Here’s the table of numbers that the calculator produces (please click to enlarge):

Risk reduction chart
Risk reduction chart

The green bars are identifying the range of results that will apply in best-case scenarios (outcomes that have only a 20 percent chance of turning up). The point at which the blue bars and the yellow bars meet identifies the most likely outcome. The red bars are identifying the range of results that will apply in worst-case scenarios (outcomes that have only a 20 percent chance of turning up).

At the end of 30 years, the Buy-and-Holder has a range of possible outcomes extending from a best-case portfolio value of $1,086,755 and a worst-case portfolio value of $566,032. That’s a range of $520,723.

At the end of 30 years, the Valuation-Informed Indexer had a range of possible outcomes extending from $1,586,980 to $611,916. That’s a range of $975,064.

Wait!

The range in possible outcomes for the Valuation-Informed Indexer is a lot larger than the range of possible outcomes for the Buy-and-Holder. RIsk is GREATER for the Valuation-Informed Indexer!

No?

No.

The range of possible outcomes really is greater for the Valuation-Informed Indexer. In that sense, it could be argued that making the shift to Valuation-Informed Indexing increases risk.

But you come to that conclusion only if you use a crazy definition of risk. It’s not really true that uncertainty equals risk. You don’t increase risk by opening up the possibility of obtaining better results. A better definition is that risk is the possibility of obtaining a poor result.

Say that you are looking at things from the standpoint of a Buy-and-Holder. Your range of outcomes extends from $566,032 on the low side to $1,086,755 on the high side. What is it that you are worried about when you worry about risk? You are worried that you will obtain a result near the lower end of the range of possible outcomes. If you could insure that you would obtain a 30-year result somewhere in the numbers covered by the blue bar or the green bar, you would have reduced risk dramatically.

Making the shift to a Valuation-Informed Indexing strategy does that!

The investor following a Buy-and-Hold strategy has a 50 percent chance of having a portfolio value of $764,115 or less at the end of 30 years. The Valuation-Informed Indexer has more than an 80 percent chance of enjoying a portfolio value of greater than $764,115 at the end of 30 years.

If you have reduced the odds of a bad outcome from 50 percent to something less than 20 percent, you have reduced the risk of stock investing by more than 60 percent. The calculator gives a result in tune with the findings of Russell and Pfau — it shows that Valuation-Informed Indexers endure far less long-term investing risk than Buy-and-Holders.

Rob Bennett writes about the rarely voiced realities of investing today. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

( Photo from Flickr by Helico )

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