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Is It Possible to Get “Stuck” at a Low Stock Allocation as the Market Takes Off?

Beyond Buy-and-Hold #97

Valuation-Informed Indexers don’t stay at the same stock allocation at all times, like Buy-and-Holders. They aim to keep their risk profile roughly constant by going with higher stock allocations when prices are low and risk is low and by going with lower stock allocations when prices are high and risk is high. The academic research shows that investors following the new strategy earn far higher returns while taking on much less risk and can thus expect to be able to retire five to ten years earlier than their friends following Buy-and-Hold strategies.

Some see a potential problem.

Valuation-Informed Indexers acknowledge that short-term timing doesn’t work. The Buy-and-Holders really are right that there is no way to effectively predict where stock prices will be in a year or two or three.

The penalty for getting it wrong

What happens if an investor drops to a low stock allocation at a time of high prices but prices never drop? As prices rise higher and higher, the Valuation-Informed Indexer is less and less inclined to buy stocks. So, in these circumstances, the Valuation-Informed Indexer might get locked out of stocks for a long time, giving up the high returns he needs to finance his retirement.

Could it happen?

Yes and no.

It can never happen to someone who understands why Valuation-Informed Indexing works. But the lock-out is potentially a real pitfall for those who possess only a surface understanding of the concept.

Why Valuation-Informed Indexing works

The key to making Valuation-Informed Indexing work for you is appreciating WHY it is that short-term return predictions never work and yet long-term return predictions always work. The reason is that short-term prices are determined by investor emotion while long-term prices are determined by economic realities. If you get that, you will not be freaked out when Valuation-Informed Indexing does not seem to be working for a time and you will possess the fortitude necessary to reap the strategy’s long-term benefits.

In the early 1990s, the P/E10 level hit 20. That’s high. It’s not insanely high, as were the P/E10 levels we saw from 1996 through the price crash of 2008. But it’s high enough to be somewhat dangerous. There’s virtually no risk to owning stocks when the P/E10 level is 15. There’s risk at 20. So a lot of Valuation-Informed Indexers lowered their stock allocations in the early 1990s.

Those who weren’t happy owning stocks with the P/E10 level at 20 experienced a long wait before they again felt comfortable owning stocks. We didn’t see a P/E10 level below 20 again until early 2009.

That’s the sort of thing the critics of Valuation-Informed Indexing have in mind when they cite a possible lock-in effect that could keep you out of stocks for years. It’s a real enough phenomenon.

Avoiding the “lock-in” affect

You don’t have to permit yourself to be hurt by it, however! The lock-in effect can be avoided.

The key lies in understanding WHY you lower your stock allocation at times of high prices. It’s not that you think you can guess when a price drop is coming. You cannot do this! Valuation-Informed Indexers are in complete agreement with Buy-and-Holders re this one. Short-term timing doesn’t work!

We lower our stock allocations at times of high prices in an effort to keep our risk profiles roughly constant. It is failing to engage in market timing that is the truly risky move.

So —

You don’t go to a zero stock allocation when the P/E10 level rises to 20. You might want to lower your stock allocation a bit when that happens, perhaps going from a 90 percent stock allocation to a 60 percent stock allocation. But there’s no call to change your stock allocation dramatically when the change in the risk to which you are exposing yourself is not dramatic.

Guess what?

If you lowered your stock allocation from 90 percent to 60 percent in the early 1990s and then from 60 percent to 30 percent in 1996 (when the P/E10 level rose above 25), you’re now ahead of the game and positioned to go farther ahead of the game with the next price crash. Allocation changes like that make sense. That’s why they always work (or at least they always have for the 140 years for which we currently have return data).

Buy-and-Holders are fighting the last war

Buy-and-holders advanced our understanding of how stock investing works in a big way when they discovered that short-term timing never works. As a result, they can’t help becoming emotional about ALL forms of market timing. They hear the word “timing” and a bell goes off in their brain telling them that the idea being considered is bad, bad, bad.

No.

There’s nothing whatsoever bad about long-term market timing. It is by engaging in long-term market timing that you take price into consideration when buying stocks. How could taking the price of the thing you are buying into consideration when buying it ever turn out to be a bad thing?

Follow a Valuation-Informed Indexing strategy with the mindset of a Buy-and-Holder and you might indeed suffer the lock-in effect warned of by a good number of our Buy-and-Hold critics. Come to understand why Valuation-Informed Indexing always produces better risk-adjusted results in the long term and you won’t even be tempted to make the extreme moves that the Buy-and-Holders worry you will make if you abandon their rigid insistence that you always stay at the same stock allocation regardless of how insanely high prices go.

Rob Bennett has written about what it takes to become an intelligent investor. 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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