Want to try a different way to invest in the Stock Market?

Beyond Buy-and-Hold #8

The How-To of Valuation-Informed Indexing

By Rob Bennett

Say that you agree that you need to take valuations into consideration when setting your stock allocation. How do you go about doing so?

The first thing that I do is to check out The Stock-Return Predictor, a calculator at my web site that performs a regression analysis of the historical stock-return data to reveal the most likely 10-year return on stocks purchased at any specified valuation level. Here?s a link:

http://www.passionsaving.com/stock-valuation.html

To get an idea of how the calculator works, try plugging in the P/E10 levels that applied at different times in recent history and seeing what the Return Predictor tells you about the likely 10-year return for stocks purchased at those times. In 1982, the P/E10 level was 8; the calculator tells you that the most likely 10-year return was an annualized 15 percent real. In contrast, the P/E10 level was 44 in 2000 and the most likely 10-year return was an annualized negative 1 percent real.

Testing against the alternatives

You next need to look at the return being provided by the super-safe asset classes (IBonds, Certificates of Deposit and Treasury Inflation-Protected Securities). If stocks are not likely to give you a significantly higher return than a virtually risk-free asset class, why take on the risk of investing in them? My rule of thumb is that I will only invest heavily in stocks when the 10-year return is at least two percentage points better than the return being provided by the super-safe asset classes.

Please understand that valuations are not the only factor you need to take into consideration when setting your stock allocation. The Buy-and-Holders will tell you that there are three factors that should be considered:

  1. your financial circumstances (a 50 percent loss hurts a lot more for someone who barely has enough to retire on than it does for someone with millions to spare);
  2. your life goals (you might want to take on more risk if your goal is to retire early and you might want to take on less risk if you are close to retirement age); and
  3. your risk tolerance (not all of us respond to losses in the same way).

Valuation-Informed Indexers agree that these factors must be considered. We just add a fourth factor — how pricey stocks are at a given time — to our list of considerations.

You could make frequent allocation changes if you wanted to. The value proposition for stocks changes slightly each time valuations change. So one way to play it is to make a modest adjustment in your allocation at the end of each year. Say that your determine that the best stock allocation for someone in your circumstances at a time of fair valuations (a P/E10 level of 14) is 70 percent stocks. Then you might go to 80 percent stocks if the P/E10 level fell to 12 and to 60 percent stocks if the P/E10 level rose to 16.

But it?s also entirely possible to do far better than you could hope to do following a Buy-and-Hold strategy while making only rare changes in your stock allocation. As a general rule, one allocation change each 10 years or so is required. Stocks were either low-priced or reasonably priced or only somewhat highly priced for the entire time-period from 1975 through 1995. An allocation of 70 percent would have made sense for that entire time-period. And stocks were insanely overpriced for the entire time-period from 1996 through 2008,. An allocation of 20 percent would have worked for that entire time-period.

Long-term horizons to the rescue

The key to getting Valuation-Informed Indexing to work for you is giving up your short-term focus. If you look at results obtained for a year or two or three or four as proof that a strategy is working or not working, this strategy is not for you. Valuation-Informed Indexing often underperforms Buy-and-Hold for short time-periods. For example, Buy-and-Hold did far better in the time-period from 1996 through 1999. This is not a bug! This is just the way it goes. What works in the short-term is often not what works in the long-term. Buy-and-Hold is a short-term strategy that is marketed as a long-term strategy. Valuation-Informed Indexing is a true long-term strategy.

I have a second calculator at my site, ?The Investor?s Scenario Surfer? that will help you experience how this strategy plays out in real-world scenarios. The calculator asks you to choose a stock allocation for each year of a 30-year return sequence that is randomly chosen but that is a realistic possibility given what we know about how return sequences have always played out in the past. At the end of the 30 years, you will be able to compare the results you obtained by making valuation-informed choices with the results you would have obtained from rebalancing. My experience is that Valuation-Informed Indexing beats Buy-and-Hold in about 90 percent of the scenarios tested, sometimes by very large amounts.

The pattern is that Buy-and-Hold can remain even with Valuation-Informed Indexing or even go ahead of Valuation-Informed Indexing for a good number of years but sooner or later the Reversion to the Mean phenomenon (even John Bogle acknowledges that Reversion to the Mean is an ?Iron law? of stock investing) pulls Valuation-Informed Indexing ahead. Once it goes ahead, the compounding returns phenomenon causes the edge gained by the valuation-informed investor to grow larger and larger over time. It is only when the quirkiest and most unlikely return sequences happen to pop up that Buy-and-Hold can produce good results (and given how unlikely these return sequences are, I think it is fair to say that the enhanced returns are being obtained by taking on more risk).

It is the Reversion to the Means phenomenon that makes Valuation-Informed Indexing so effective. Most strategies relying on market timing involve so much guesswork that the odds of them coming through are not great. Because Valuation-Informed Indexing relies on an ?Iron Law? of stock investing, it almost always produce better returns for those investors patient enough to wait for the phenomenon to kick in. Then it?s just a question of letting enough time to pass for the compounding returns phenomenon to transform a small edge gained by taking an almost certain bet into something substantial.

Do you think you’d like to give Valuation Informed Indexing a try?

Rob Bennett?s favorite personal finance book is Your Money or Your Life. His bio is here.

5 Responses to Want to try a different way to invest in the Stock Market?

  1. Interesting strategy Kevin. I really like your idea of checking the market P/E to get a quick gauge of where we are. Have you read “the little blue book that beats the market”? I used that system for a couple years with excellent results (then spent the money on getting married, heh). The gist is to look for low P/E stocks with a very high return on capital.

    Awesome you made calculators for your site by the way.

  2. Thanks for sharing your thoughts, Deacon.

    This is Rob. It’s actually me who writes this jibber-jabber. Kevin is kind enough to run the column at his site each Wednesday.

    I haven’t read “The Little Book” but I have heard good things about it from people I respect. The book is on my Wish List at Amazon. I have gotten so immersed in the investing stuff in recent years that I find I need to get away from it at night. So I no longer read books about personal finance before going to bed. Now it’s usually novels or the Alfred Hitchcock Mystery Magazine or stuff about Dylan or the Beatles. I need a break from this stuff from time to time. But I do hope to read that book someday. The premise certainly makes sense.

    The calculators were developed jointly by John Walter Russell and myself. John did all the statistical work. My role was to ask lots of annoying questions and just generally slow things down and muck things up. I thought that arrangement worked well! Those who have an interest in learning more about Valuation-Informed Indexing should check out John’s site — http://www.Early-Retirement-Planning-Insights.com. There’s tons of original research there on every investing question you can imagine and it’s all valuation-informed.

    John’s efforts were heroic. He worked this stuff full time for eight years, never receiving a dime of compensation for his efforts. That’s community! John died last October and his site was transferred to me. I miss the guy every single day. I look forward to the day when his work gets the recognition it merits.

    Rob

  3. Sorry about that Rob, Kevin. I’m always so careful to look for the by-line and somehow this one was invisible to me last night.

    That’s really awesome you’re able to carry on John’s work and give it new life Rob. Thanks for sharing this strategy and calculators!

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