Brett Arends included a throwaway line in an article he wrote for the Wall Street Journal in 2010 that I thought was so important that I included the article in the “Links That Matter” section of my site. He said: “Valuation is by far the most important issue for investors.”
Those of us trying to help people to become better investors need to emphasize this point. It’s true. Valuations matter most. And that’s not so just by a little bit. Valuations are 80 percent of the game. If you get valuations right, you can mess up on every other point and you still are likely to be a highly effective investor. if you mess up on valuations, you can get everything else right and you are still likely to come up losers.
Here’s a graphic that tells the tale:
The first color bar at each year-mark shows the possible returns for a portfolio of $100,000 when the starting-point valuation level is one-half of fair value. The second bar shows the results when the starting-point valuation level is fair value. The third shows what happens when the starting-point valuation level is high, as it is today. The fourth shows what happens when the starting-point valuation level is insanely high, as it was for most of the time-period from 1996 through 2008.
The green portion of the bars shows the 20 percent of the best possible results. The red portion of the bars shows the 20 percent of the worst possible results. The most likely result is the point at which the blue portion of the bar meets the yellow portion of the bar.
At every year mark, the first color bar (the one that applies when stocks are priced at one-half fair value) provides fantastic results. The most important thing in stock investing is not to get spooked by price crashes into selling. How can an investor getting the results we see under the first color bar ever get spooked?
He has a 20 percent chance of doubling his money in five years. In ten years, he is certain to have doubled his money (the worst possible result is that the $100,000 portfolio rises in value to only $200,000). At fifteen years, he is likely to have quadrupled his money (the blue portion of the bar meets the yellow portion of the bar near the $400,000 mark). At 20 years, he has a 30 percent chance of seeing his initial $100,000 turned into $600,000. At 25 years, he has a good chance of owning a portfolio worth $800,000. And at 30 years, he may have a portfolio worth $1 million or more.
The worst possible portfolio value at 20 years is $400,000. The worst possible portfolio value at 30 years is $600,000. These are all good results; there are no bad results. This is risk-free stock investing. It’s the great starting-point valuation that made these results possible.
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Contrast that with the poor investor who put his $100,000 into stocks at a time when the P/E10 value was 32. He has a chance of seeing no gain at all at 5 years out and at 10 years out and even at 15 years out. Going 5 or 10 or 15 years without a gain is discouraging. It is investors who invest in stocks at those sorts of price levels who end up selling and thus never realize the long-term gains for which stocks have become famous.
At 30 years out, this investor is likely to have seen his $100,000 turned into $400,000. But that’s after sweating through lots of years of losses or small gains. And that $400,000 doesn’t compare to the $900,000 value that applies for the investor who made his investment at a time of low valuations. The best result for the high-valuations investor is a portfolio value of $600,000, half of the best-possible portfolio value that applies for the low-valuation investor.
Stock investing is a valuations game.
Do you want to know the biggest problem with the conventional stock investing advice? It addresses everything but valuations.
You’ll see articles that talk about how to pick stocks. It doesn’t matter all that much. You’ll see articles that talk about how to choose a mutual fund or an index fund. it doesn’t matter all that much. You’ll see articles that talk about short-term timing. it doesn’t matter all that much. You’ll see articles that talk about where the economy is headed. It doesn’t matter all that much.
What matters is valuations. That’s 80 percent of the game.
So why don’t the experts talk more about valuations?
Tell people that valuations matter and they get mad at you because most of us are hoping at times of high valuations to persuade ourselves that our portfolio values are real. People trying to sell you stuff don’t make sales by getting you mad at them. So the most important story in stock investing goes widely unreported.
Most of what you hear about stock investing is nonsense. And it hurts you. Because the more time you spend thinking about nonsense, the less time you have to focus on the one thing that matters more than all the other factors put together — stock valuations.