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How a Valuation-Informed Indexer Chooses His Stock Allocation

Beyond Buy-and-Hold #83

For background on Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

The P/E10 level is 18. Treasury Inflation-Protected Securities (TIPS) are paying 2.5 percent real. What is the best stock allocation?

The Stock-Return Predictor tells us that the most likely annualized 10-year return on the purchase of a broad stock index made when the P/E10 level us 18 is 3.92. There’s an 80 percent chance that the 10-year return will be better than 0.92 and an 80 percent chance that it will be worse than 6.92.

Those numbers tell you what you need to know to make an informed decision. They do not provide you with a one-size-fits-all solution.

The likely return on stocks (3.92 percent real) is better than the certain return on TIPS (2.50 percent real). But is it sufficiently better to justify going with a high stock allocation? My view is that it is not.

With TIPS, you know exactly what you are getting. With stocks, there is uncertainty. My view is that I should be compensated for being willing to take on that uncertainty of return. As a general rule, I am not inclined to invest heavily in stocks unless the most likely return for stocks is at least two percentage points higher than the return available with a super-safe asset class. In this case, that test is not met. So I would not be inclined to go with a high stock allocation.

That said, I don’t think that a zero stock allocation generally makes sense in these circumstances. The likely stock return is higher. And it is possible that the stock return will be as high as 7 percent. There’s no chance that you are going to get a 7 percent return on the TIPS. It’s important to keep in mind that much of the “risk” of stocks in these circumstances is on the upside. So long as you obtain a return of 2.5 percent real from stocks, you are better off in stocks. And the odds are about two in three that the stock return will beat the TIPS return.

What to do?

A likely portfolio allocation in the current investment environment

I might go with a stock allocation of 50 percent. If the stock return really does end up beating the TIPS return, you end up happy. If the downside risk of stocks becomes a reality, you are only earning the lower return on half of your savings. Since the odds are strong that the return on stocks will be 1 percent or higher, even a worst-case scenario will not be too awful.

Personal considerations need to be taken into account.

Say that you are five years from retirement and earning a return of only 1 percent would leave you short of your retirement savings goal and a return of 2.5 percent would permit you to hit the target. In that case, the TIPS look more attractive. The TIPS are certain to get you to where you want to be. The stocks probably will, but might not. In those circumstances, I might go with a 30 percent stock allocation rather than 50 percent.

But it’s a mistake to think that only retirees get upset when their investments do not deliver the expected returns.

Say that you are 30 years old, expecting to buy a house within five years and need to earn a return of 2.5 real on your savings to have enough to be able to afford a down payment on a house in a few years. In these circumstances, you face investing realities not that different from those faced by the near-retiree. You of course would prefer a return a good bit higher than 2.5 percent real. But the pain associated with earning a return less than that is great enough that you probably should invest more heavily in the certain-return TIPS than in the possibly better/possibly worse-return stocks.

Investors need to be concerned about Risk at any age

The conventional advice is that only near-retirees need to be worried about the risk of stocks. It’s not so. Any investor who has a need for a portfolio of a certain size within ten years or so needs to take the uncertainty of the return on stocks into account. Most of us are in those circumstances. Some of us may need money to buy a house. Some of us may need money to start a business. Some of us may just not be able to cope with seeing our portfolio values stop rising for five or ten years.

The most important question is — How low of a stock return can you tolerate without feeling pressure to sell stocks?

If there is a chance that earning only 1 percent on stocks for 10 years would cause you to abandon stocks, you shouldn’t be heavily invested in stocks. The Return Predictor tells you the returns stocks will provide for those who hold their stocks for at least 10 years. All bets are off if you fail to satisfy the qualifier.

What if the P/E10 value were 12 instead of 18?

Then my advice would be very different.

Buy stocks when the P/E10 value of 12 and the most likely annualized 10-year return is 8.15 percent real. In that case, the edge over TIPS paying 2.5 percent real is so great that you simply must be heavily invested in stocks.

My thought is that that is the case even for the near-retiree. You don’t get many opportunities to earn an annualized 10-year return of 8 percent real. By taking on the risk of stocks when the odds are in your favor, you can earn sufficiently high returns that you will be able to afford to go with a much lower stock return in years when the differential between the stock return and the TIPS return is not as great.

Logic of course dictates an allocation shift in the opposite direction when the P/E10 level is 32 rather than 12 or 18. At that valuation level, the most likely annualized 10-year return is 0.21 real and the best return you can realistically even hope for is 3.21 percent real. It makes no sense to take on the risky-ness of stocks in exchange for the pleasure of earning a lower return than what is available risk-free from TIPS, or, in a best-case scenario, earning only a slightly higher return than the return that is available risk-free from TIPS.

Rob Bennett is a fan of the book Unexpected Returns. His bio is here .

 

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( Photo from Flickr by Helico )

2 Responses to How a Valuation-Informed Indexer Chooses His Stock Allocation

  1. Such a pracitcal and thoughful discussion about asset allocation and valuation. Rob, I would be interested knowing what your asset allocation would be today with TIPS Real 10 year yield actually negative?!

  2. Thanks for your kind words, Ken.

    Personally, I am at a zero stock allocation. I am in TIPS and IBonds paying 3.5 percent real. So the low yield that applies for TIPS purchased today doesn’t affect me.

    If I were in more typical circumstances, I would be going with a stock allocation of something between 30 percent and 50 percent. At 30 percent, your risk is minimal. Even a 50 percent price drop only causes a loss of 15 percent of portfolio value. At 50 percent, you would see a loss of 25 percent of portfolio value with a 50 percent price drop. That’s serious. So I think of that as a high-end allocation for the circumstances we are in today.

    There is never one allocation that we can identify as the precisely right one. We cannot predict what returns sequence is going to pop up and that is a big factor. So the best we can do is to identify a range of possibilities and suggest that people place themselves somewhere in that range.

    The key thing that people need to take away is that that range of possibilities is not a constant. The range of possibilities CHANGES with changes in valuation levels. So the range might be from 30 percent to 50 percent at one time and then from 40 percent to 60 percent at another time and then from 50 percent to 70 percent at another time and then from 60 percent to 80 percent at another time and then from 70 percent to 90 percent at another time and then from 80 percent to 100 percent at another time.

    I hope that helps a bit.

    Please take care.

    Rob

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