Valuation-Informed Indexing Is the Future of Investing
By Rob Bennett
You have recently been sent to Earth from your home planet of Mars and know nothing of what people here have for years been saying about stock investing in the papers and magazines and web sites. You have some money to invest. You have only had time to do enough research to learn a single important fact about stock investing: The average long-term return in the U.S. market is 6.5 percent real.
What do you do? You follow a Buy-and-Hold strategy. You put most of your money in stocks and count on the long-term realities to pay off for you. You make an effort to tune out the short-term noise. You stick with stocks for the long run.
That?s where most of us stand today. We know one important and true thing about stock investing: Stocks are unpredictable in the short term but they always do well for those willing to wait long enough.
What if that didn?t work?
Now say that you have time to do enough research to learn a second important fact: Throughout history, stocks have always provided strong intermediate-term (10 or 15 or 20 years) returns when priced at fair value or less and have always provided poor intermediate-term returns when priced at the sorts of valuation levels that have applied from 1996 forward.
Now what do you do? You don?t follow Buy-and-Hold anymore. You follow a modified form of Buy-and-Hold, a form of Buy-and-Hold that we might call Buy-and-Hold 2.0.
You still make an effort to tune out the short-term noise and to stick with your strategies for the long run. But you keep in mind that it is not only the distant long run (30 years out) that you need to be concerned about. How stocks do in 10 years and 15 years and 20 years matters too.
A bankable alternative
Knowing two important facts about how stock investing works, you don?t practice Buy-and-Hold. You practice — Valuation-Informed Indexing. That?s the investing strategy that I recommend in this column. That?s the investing strategy that I believe will replace Buy-and-Hold.
Buy-and-Hold is rooted in a belief that obtaining the average stock return is good enough. The average stock return is 6.5 percent real. That?s indeed plenty good enough for most reasonable people. So what?s not to like about Buy-and-Hold?
What?s not to like is that someone who cannot swim and is six feet tall is not going to do well in a pool that on average has a depth of five feet if he happens to be placed in the section that has a depth of twelve feet. Because Buy-and-Holders choose their stock allocations based on how stocks perform on average, the strategy works well so long as stocks are selling at average prices and the average return or better is likely to turn up within 10 or 20 years. That was the situation we saw from 1974 through 1995, the years when Buy-and-Hold became popular.
Buy-and-hold doesn?t account for over-valuation
The trouble comes when prices rise to insanely high levels, as they did in 1996. Stocks purchased at times of insanely high prices don?t provide average returns in the intermediate term but returns far less than average, so much less that it is a rare middle-class investor who can endure sticking with a high stock allocation for the full length of such time-periods.
Stocks were priced so high in 2000 that the most likely 10-year return was a negative number. Those who start saving at age 25 and hope to be able to retire at age 65 have only four decades in which to accumulate the $1 million or so in assets they will need to do so. Let 10 years go by without enjoying any benefits of compounding whatsoever and you greatly diminish the odds that you will make it.
Valuation-Informed Indexers don?t give up those years. We invest heavily in stocks during the years when the intermediate-term return for investing in stocks is solid. So we enjoyed all the great returns experienced from 1974 (when Buy-and-Hold was popularized by the publication of Burton Malkiel?s A Random Walk Down Wall Street) through 1995. But we lowered our stock allocations in 1996, when stock prices got so dangerous that far safer asset classes offered a more appealing long-term value proposition. We will increase our stock allocations again when valuations drop to levels where the intermediate-term return is likely to be strong, according to how stocks have always in the past performed starting from various price levels.
Valuation-Informed Indexers enjoy the rewarding side of stock investing — the great returns — without having to take on the scary side — the price crashes that can wipe out decades of saving in a few years. High returns combined with low risk — That?s investor heaven!
And there?s nothing even a little bit complicated about it. You consider price when buying everything else you buy in this Consumer Wonderland of ours, do you not? You wouldn?t dream of buying a computer or a camera or a cucumber or a comic book without taking the price at which it is selling into consideration. The idea behind this new investing strategy is that you should follow the same practice when buying stocks.
Take Buy-and-Hold and delete the Get Rich Quick element incorporated by The Stock-Selling Industry for marketing purposes (a recent Wall Street Journal column observed that the ?myth? that long-term timing doesn?t work is a ?hoary old chestnut [that] keeps the clients fully invested?) and you?ve got Valuation-Informed Indexing. That?s the future of investing.
Rob Bennett is the creator of The Stock-Return Predictor and ?The First Retirement Calculator that Gets the Numbers Right.?. Rob is also the owner and creator of A Rich Life, a blog that aims to put the “personal” back into “personal finance”. Rob developed the Passion Saving approach to money management as well as the Valuation-Informed Indexing investing strategy, both of which are described on his blog.
Another great post from the OutOfYourRut crew. I love the analogy of being six foot tall in a pool with an average depth of five feet. I have a couple of points:
— Carl Richards (BehaviorGap) points out that average is not normal – especially in the stock market. People will find themselves in 12 feet of water a lot more than they might think.
— Price is relative. Value matters (especially in investing). Unfortunately American society (in general) knows the price of everything but the value of nothing. That is why people will pay $35 for a designer shirt from an outlet that is only worth $20. They will pay it because the outlet sells the shirt for 50% off a super-inflated price of $70.
— Last point – The flip side of equities to most investors (bonds) also runs in cycles and those cycles don’t always match up nicely with equity valuation cycles. There are times where you could be jumping from the frying pan into the fire. Alternative strategies may be your best bet in these situations (like now).
Thanks for your kind words, John.
Unfortunately American society (in general) knows the price of everything but the value of nothing.
We can change this! For years we have been telling people that there is no need for them to lower their stock allocations when stock prices go to insanely dangerous levels. What if we stopped?
We’ve been destroying our economy with this Buy-and-Hold stuff. It’s like beating your head against a wall over and over and over again. The only good thing you can say about it is that it sure feels good to stop doing it! We’re not quite there yet, but I see grounds for some optimism. My view is that we will someday look back at this economic crisis as the best thing that ever happened to us because it will open our minds to the changes we need to make to bring on the greatest period of economic growth we have ever seen.
That’s what I tell myself in these dark days, in any event!
Rob
The flip side of equities to most investors (bonds) also runs in cycles and those cycles don?t always match up nicely with equity valuation cycles.
This is a great point. I believe that we need to reexamine all of our fundamental beliefs about stock investing, including the one that the two basic asset classes are stocks and bonds.
I think a better combination is stocks and Treasury Inflation-Protected Securities (TIPS). They complement each other perfectly. I go with stocks when the long-term value proposition for stocks is good. And I go with TIPS when it is not.
When stocks are safe, you want to be going with stocks. And when stocks are not safe, you want to be going with something where you can be sure to preserve your assets until stock prices are reasonable again. That’s not bonds. But TIPS do the job well.
Stocks are the highest-risk asset class. And TIPS are essentially risk-free. So they counter each other perfectly. Bonds have risks of their own (primarily inflation) which make them a less-than-perfect counter to stocks.
Rob
Rob – I think your point about “the price crashes that can wipe out decades of saving in a few years.” is one of the most significant points.
The buy-and-hold idea of holding through (and investing in) all kinds of markets maybe painfully simple to execute, but it does so at least partially by keeping us fully exposed to an overpriced market. So right now a lot of investors may be in a better position than they were in during the spring of 2009, but how many of the same people are ahead of where they were in the spring of 2000 when they were fully invested.
The fact that you’re fully invested in a market top means you’re also fully exposed to a crash. And we’ve had two of them since 2000!
Fundamentally, one of the best ways to make money is not to lose it, and that’s where buy-and-hold fails.
We knew someone once who had a tie rack (tie portfolio) loaded with old ties. When questioned about all the old and outdated ties in his tie portfolio, he stated, “Eventually, these old ties will make a comeback and I will be in style again.”
The essence of this man’s message is that he didn’t care about being in style, but there was another underlying truth in what he said. Fashion is cyclical. If he bought and held a given portfolio of ties for a sufficient length of time, he would once again experience the uptick of being in style and in the mainstream of fashion thought and the fashion police would quit badgering him to jump on the latest fashion train.
If fashion is cyclical, what else is cyclical? Human behavior? If human behavior is cyclical (seasonal), how does this manifest itself in market activity?
If we applied the buy and hold strategy to farming (a seasonal or cyclical activity) how successful would we be at farming? Would we have the optimum crop production for the investment of our time, energy, and seed money? How many farmers do you see continuing to plant and irrigate in the winter time? How many farmers attempt harvesting their crops in the spring?
If we want optimum returns on our investment dollars, we need to understand the investment season we are in. We don’t want to be planting our investment dollars in the equivalent of winter nor do we want to attempt financial harvest in the spring. We also need to consider the global aspects of human behavior. If Chile can grow grapes in our winter season, we need to consider if certain global financial markets or sectors have their unique seasons.
If one doesn’t know what financial season they are in, how can they know when to plant, what to plant, when to harvest, or when to rest?
A buy and hold strategy ignores the seasonality of nature and human behavior. To every thing there is a season, and a time to every purpose under the heaven…Ecclesiastes 3:1
The buy and hold strategy does have, however, a couple of useful purposes. First, it provides a ready and continuing market for Wall Street insiders to unload their harvest. Secondly, it provides investors who would rather spend their energies hoping for better returns a methodology for doing so.
Steven and Debra – The tie analogy is interesting. Of course it really doesn’t apply to stocks, since many of the companies that “go out of style” also go out of business! And I think your point about seasonality is critical. Buy-and-hold assumes certain constants that really don’t exist outside of theory and computer models. Personally, I don’t think timing the market is reliable (nor does the average investor have the time, skill or tools do do so) but there is a time to be in the market, and most definately a time to be out.
If you could have sold anywhere near the last two stock market peaks (2000 and 2007) and just waited out the market, your long term returns would have been dramatically better than with buy-and-hold.
A buy and hold strategy ignores the seasonality of nature and human behavior.
I am grateful for your comment, Steven and Debra. I saw the link to Weston Price at your web site. My wife is a huge fan of Weston Price. I feel that to some extent I am trying to do for investing what Weston Price does for food.
There’s a book titled “Stock Cycles” that discusses seasonality of stock prices in a compelling way. There’s an analogy that the author draws in the Introduction that left a mark on me (I hope I get the description of it here roughly right working solely from recollection of a book I read many years ago).
He talks about how astrology was once viewed as a science. In the days when this was so, we did not have the science we have today, of course. People did not know why there were a times when it was a good idea to plant certain crops and times when it was not. But they very much needed to know! Having those crop come up or not was the difference between being able to eat and not being able to eat.
The people who were working astrology put out planting guides based on the location of the stars that were essentially calendars that helped the farmers know when the seasons were going to turn. They didn’t really know the WHY of what they were saying. But there was practical value in what they were saying. So they were respected. And over time astrology morphed into what we think of today as more serious science.
The important thing to get from this is that we humans are always in the process of learning stuff. We do not know it all today! Our state of understanding how investing works is primitive.
The Buy-and-Holders taught us a great deal. I don’t take that away from them for two seconds. My problem with them is that they have closed their minds to new thinking. Buy-and-Hold has become dogmatic. And dogma is not justified in this field.
There ARE seasons in investing. This is absolutely right. And we need to let that in and learn about it and become better informed and more confident by doing so.
We need to take what we learned from Buy-and-Hold and add what we have learned in the days since Buy-and-Hold first became popular. Then we will really have something.
Until it comes time to learn even more!
Rob
If you could have sold anywhere near the last two stock market peaks (2000 and 2007)…
I’d like to add a wrinkle here if that’s okay, Kevin.
What you are saying here is so. Knowing to sell at those times would have given the investor a big edge. I presume that everyone agrees with that. What causes controversy is the question of whether it is possible to know in advance when we are at a peak. The Buy-and-Holders say “no.” The short-term timers say “yes.”
I am not a Buy-and-Holder or a short-term timer. I am not saying “yes” or “no” in the way that the Buy-and-Holders and short-term timers use those words.
I am saying that the odds of a price crash increased dramatically in 1996, which is when stock prices first went to insanely dangerous levels. I am saying “yes” in the sense that I am saying that stocks are more dangerous at some times than they are at others and that I believe people should adjust their stock allocations accordingly. However, I am saying “no” in the sense that I don’t believe that it was possible to know in advance whether the crashes were going to come in 1996 or 1997 or 1999 or 2000.
A Valuation-Informed Indexer would have lowered his stock allocation in 1996, he would not have waited until 2000. That bothers some people. Some say “Well, I would have missed out on the gains of 1996 and 1997 and 1998 and 1999.” That’s so. That’s part of the deal. That’s how it works.
I don’t think it is possible with any precision to know when a crash is coming. All you can do is look at the odds that apply and go with the stock allocation that makes sense given the odds. But I am also saying that that leaves you far, far ahead in the long run. If you invest with the odds on your side for your entire lifetime, you will have times like 1996 through 1999 when you fall behind the Buy-and-Holders but you will end up in the end being able to retire a good number of years sooner.
Having the odds on your side at all times pays off big time in the long run even though there will be short periods of time (like 1996 through 1999) when having the odds on your side will not pay off immediately. Having the odds on your side translates into obtaining higher risk-adjusted returns in the long run. It is a sure thing. But it is not something that always pays off quickly. It can take 10 years for this to pay off. People who don’t like that aspect of this cannot follow this path. It will not work for them.
All of the confusion that we see in discussions of this strategy comes from a failure to distinguish what works in the short term from what works in the long run. This aspect of the thing throws people again and again and again and again. Valuation-Informed Indexing is strictly a long-term strategy. I do not say that it will produce good results over any specified short-term time period. But there has never been any time in the historical record when it has not paid off big time for those willing to stick with it for the long run.
Rob
Rob,
There are some parts of our portfolio that have the characteristics of the ‘buy and hold’ strategy, but in some seasons they are considered more as insurance, or hedge positions, and allocated accordingly. In some seasons the allocations of those insurance positions are increased to represent both insurance and investment positions.
We don’t advocate the use of ‘timing’ for our insurance position. That would be a little like starting and stopping homeowner’s insurance coverage on the basis of the current fire danger. Fire danger can be external or internal and we need our insurance to protect from both. Homeowner’s insurance or investment hedge positions are where the ‘buy and hold’ strategy works best with increases or decreases in allocation depending on a change in risk profile, or seaonality, and our investment goals.
If your investment ideas can do for investing what Weston Price’s ideas did for food, you’ve got our attention.
Rob – I agree, it isn’t possible to be able to time the market with any precision. That being said, there is common sense, which we all have, and that should tell us that big gallops in stock prices (or any prices) increase risk and call for caution.
At a minimum, if investors did what you’re saying, by lowering stock allocations at points where prices are dangerously high, they’d lock in the gains they’ve already made and limit exposure on the downside.
Greed, it seems, is the main driver in the markets when they reach such heights. In my business, I saw many, many people who were close to 100% in stocks in the late 90s and 2000. That’s falling in love with an investment vehicle, and that may be the most dangerous investment philosophy of all.
If your investment ideas can do for investing what Weston Price?s ideas did for food, you?ve got our attention.
The comparison is that a lot of the illnesses of today have been caused by big corporations who determine what gets put into our food and even what we are able to learn about what gets put into our food. I am a journalist by trade. I don’t object is people eating processed foods. I see that as being up to them. But I believe strongly that the media should be an independent voice and should be telling the straight story re how processed foods have hurt us all in many ways. I am a big believer in the power of information to enhance people’s lives.
We have known that Buy-and-Hold (as it is promoted by The Stock-Selling Industry) does not work for 30 years now. Buy-and-Hold is rooted in the academic research and the research showing that the initial ideas were mistaken (no crime there, we all make mistakes) was published a long time ago. The media should have been telling us about this! That’s the job!.
The Wall Street Journal recently ran an article pointing out why we have not been told. The “myth” (that’s the word used in the article) that long-term timing does not work “keeps the clients fully invested.” That’s what it is all about. The reason why we are told that we should always be heavily invested in stocks is that the commissions on stocks are bigger than the commissions on alternative investment classes. Buy-and-Hold has brought in hundreds of millions in profits for The Stock-Selling Industry while setting back the retirements of middle-class people by many years or in some cases even decades. The media has generally failed to tell the story. The free market cannot long survive unless we do something to turn the situation around.
My hope is to set up a number of web sites and blogs and discussion boards that would permit middle-class investors to learn the realities of stock investing, not the b.s. that is pushed by The Stock-Selling Industry and by the conventional media. We need a place where we can talk things over among ourselves and learn what really works without intervention of those with a profit interest to push only one asset class.
I see that as being similar to what Weston Price does. They are teaching people things about nutrition that should be common knowledge but that some of the huge food processing companies do not want us to know about. We need to take matters into our own hands both in the food area and in the investing area.
I see the movement toward Valuation-Informed Indexing as being as much a political movement as an investing movement. It is about getting out of this economic crisis (which was caused by the reckless promotion of discredited investing strategies). It is not for just conservatives or for just liberals. It is for both. The same of course is true of the food issue. I know both liberals and conservatives who are fervent supporters of the work that Weston Price does. It is about giving people information they need to live better lives.
Sorry for the long response. This one is an emotional hot button for me. I am a big believer in Free Speech.
Rob
Rob,
What are you and your family doing for dinner this Sunday? We could probably spend hours talking with you that would seem like seconds. Actually, we are in the process of moving and the movers will be here Tuesday to pick up our belongings. Therefore, we’ve got to light a fire and will give you a raincheck on the dinner :-).
Your comparison of the food conglomerates to the wall street boyz is spot on. What is interesting, is that some of the same names surface in both groups and the mainstream media appears to be on both their payrolls.
An important factor to all this, as you suggest, is alternative education, but we also recognize that the primary societal tipping point will arrive when individuals begin assuming more personal responsibility for where they are currently and where they want to go in the future.
We’ve enjoyed the chat and hope to pick it up on the other side of our move.
P.S. – Kevin, the dinner invite and brainstorming session is extended to you also. We think it would be a hoot!
We?ve enjoyed the chat and hope to pick it up on the other side of our move.
That sounds wonderful. I look forward to the day when we can get that historic dinner date put together (a few good and determined people can move mountains, I understand).
You brought a good bit of cheer to my Friday morning, Steven and Debra (and Kevin).
Rob
Everyone is a market timer you decide when to buy and you decide when to sell. Dollar cost averaging is actually a form of market timing – instead of buying everything at a single point in time and selling at another time, you are buying at intervals, betting that the average price is lower than the price at a single point in time.