Beyond Buy-and-Hold #94
The academic research shows us that investors who fail to lower their stock allocations when prices rise to insanely high levels pay a very big price. Not only do they see a wipeout of their accumulated savings of a lifetime. The loss of those savings leaves them with little money to invest in stocks when prices are again reasonable. So investors following research-based strategies earn higher returns for many years to come. And then for decades into the future they earn compounding returns on the higher returns.
What keeps us from lowering stock allocations
Something holds us back from lowering our stock allocations when it is most critically important that we do so. What is it?
One factor is the low returns available on non-stock asset classes at times when large numbers of people become doubtful of the claims that Buy-and-Holders make about stocks.
Treasury Inflation-Protected Securities (TIPS) and IBonds were paying returns of 4 percent real at the top of the bubble. That’s an amazing return for a risk-free asset class to be paying. But few of us took advantage of the deal. We hadn’t yet suffered the stock crash. So many of us who have become skeptical of Buy-and-Hold strategies in recent years were enthusiastic about them at the time.
Lots of investors opened their minds to alternative investment classes after the crash. But most ended up sticking with stocks because the returns on non-stock asset classes have fallen so low that we cannot imagine being able to finance our retirements with such investments.
This way of thinking about things is short-sighted
First, you need to ask yourself why it is that the returns provided by non-stock investment classes has dropped so hard. Entities trying to interest investors in non-stock asset classes had to make an incredible offer to entice them back in the late 1990s and early 2000s. Stocks were so popular that it took returns of 4 percent real or close to it to persuade people to part with their stocks.
That isn’t the case today. Lots of people are looking for an alternative to stocks today. We are seeing the law of supply and demand at work. It is not reasonable to expect to see the same sorts of returns on non-stock asset classes that were available in early days.
It does not follow that the deals available are not worth snapping up.
You always have to compare the value proposition available from an asset class with the value proposition available at the same time from other asset classes. TIPS or IBonds or certificates of deposit (CDs) are not a bad deal when they are paying a return of 1 percent real or even 0 percent real so long as shifting a portion of your money to them permits you to earn a higher return at less risk on your overall portfolio.
Lower risk is a form of return
Say that CDs are paying a return of zero percent. That doesn’t sound terribly appealing. Considered in isolation, it is NOT appealing. But if that 0 percent return permits you to hold onto most of your money during a time when we are recovering from a bubble, it can help you attain a far higher long-term lifetime return by insuring that you will have more assets to invest in stocks when they are again available for sale at reasonable prices.
I entered numbers into The Strategy Tester to compare four scenarios: (1) a scenario in which an investor sticks with an 80 percent stock allocation no matter how insanely high prices go and earns 4 percent real on the portion of his portfolio not in stocks; (2) a scenario in which an investor sticks with an 80 percent stock allocation no matter how insanely high prices go and earns 0 percent real on the portion of his portfolio not in stocks; (3) a scenario in which an investor follows a Valuation-Informed Indexing strategy (going with a higher stock allocation when prices are reasonable and a lower stock allocation when prices are insanely high) and earns 4 percent real on the portion of his portfolio not in stocks; and (4) a scenario in which an investor follows a Valuation-Informed Indexing strategy and earns 0 percent real on the portion of his portfolio not in stocks.
The most likely 30-year balance for the Buy-and-Hold portfolio (assuming a $10,000 portfolio to start and then a $10,000 contribution each year) with a 4 percent return for the non-stock asset class is $924,637. That’s better than the most likely 30-year balance for the Buy-and-Hold portfolio with a zero percent return for the non-stock asset class — $794,481.
But that difference is not as great as the difference that comes from being willing to shift out of stocks when prices are insanely high.
The most likely 30-year balance for the Valuation-Informed Indexing portfolio with a 4 percent return for the non-stock asset class is $1,087,520. The most likely 30-year balance for the Valuation-Informed Indexing portfolio with a zero percent return for the non-stock asset class is 965,206.
You’ll enjoy an earlier retirement following a Valuation-Informed Indexing strategy and earning 0 percent on your non-stock investments than you will following a Buy-and-Hold strategy and earning 4 percent real on your non-stock investments!
You of course want to get the best return on your non-stock asset class that is available. But please don’t let low returns on non-stock asset classes dissuade you from moving out of stocks at times when stocks are dangerous overpriced. That’s missing the big picture. You want to protect your money when stocks are priced for poor performance so that you can invest heavily in stocks when stocks are priced for good performance.
Rob Bennett writes about new ideas in asset allocation management. 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.