Beyond Buy-and-Hold #86
The last 30 years of academic research shows that long-term investors MUST change their stock allocation in response to big shifts in valuation levels. That’s why I favor Valuation-Informed Indexing over Buy-and-Hold strategies. Stocks are riskier at times of high valuations. Thus, investors who stick with a single stock allocation at all times thereby permit their risk profile to get wildly out of whack. There’s one complication. Short-term timing doesn’t work. That is, you cannot expect to see good results immediately following your switch to the Valuation-Informed Indexing approach. You might lower your stock allocation when prices rise to insanely high levels and then stocks might do well for another two or three years. Or you might increase your stock allocation when prices fall to juicy low levels and then stocks might do poorly for another two or three years.
Why investors resist this strategy
This worries investors. I have readers of my columns ask me all the time — “Rob, WHEN should I lower my stock allocation?” People want to know what stock allocation is appropriate for each P/E10 level. People are nervous about making allocation changes. They want to be sure to get this right. Many decide that, in the event they cannot be 100 percent sure to get their allocation changes right, they will not make any allocation changes. Chill. You need to make the allocation changes. You don’t need to get them 100 percent right. The key to long-term investing success is making those allocation changes. Get them roughly right and you will be far, far ahead of the Buy-and-Holders who aren’t making allocation changes at all. I have a calculator at my site called “The Investment Strategy Tester” that helps us to analyze this sort of question. The calculator permits you to compare the performance of four strategies over a 30-year time-period. It runs thousands of return sequences that are true to the patterns we have seen return sequences follow for the 140 years for which we have historical return data available to us and reports the percentage chances of various outcomes for each of the four strategies.
Testing various strategies
For each of the four strategies I tested, the starting portfolio size was $10,000 and I made a $10,000 contribution to the portfolio in each of the 30 years. I assumed a return of 3 percent real for assets not invested in stocks. And I assumed that stocks were selling at the beginning of the 30 year time-period at fair-value prices. For Portfolio A, I assumed that the investor went with a 60 percent stocks Buy-and-Hold strategy. For Portfolio B, I went with 100 percent stocks up to a P/E10 level of 12, with 80 percent stocks up to a P/E10 level of 20, with 30 percent stocks up to a P/E10 level of 25, and with 0 percent stocks at higher P/E10 levels. For Portfolio C, I went with an 80 percent stock allocation up to a P/E10 value of 18, with a 50 percent stock allocation up to a P/E10 value of 24, with a 20 percent stock allocation up to a P/E10 value of 30, and with 0 percent stocks at higher P/E10 levels. For Portfolio D,I went with 90 percent stocks up to a P/E10 value of 15, with a 60 percent stock allocation up to a P/E10 value of 22, with 30 percent stocks up to a P/E10 value of 26, and with 0 percent stocks at higher P/E10 values. At the end of 30 years, the best possible portfolio values (of the thousands of return sequences tested) were: (1) $1,099,483 for Portfolio A; (2) $1,694,214 for Portfolio B; (3) $1,406,696 for Portfolio C; and (4) $1,552,589 for Portfolio D. The worst possible portfolio values were: (1) $565,000 for Portfolio A; (2) $634,000 for Portfolio B; (3) $594,000 for Portfolio C; and (4) $634,000 for Portfolio D. The most likely portfolio values were: (1) $767,021 for Portfolio A; (2) $1,041,945 for Portfolio B; (3) $901,278 for Portfolio C; and (4) $1,001, 408 for Portfolio D.
Don’t sweat the small stuff!
If you change your stock allocation in response to big valuation shifts, you will earn far higher returns while taking on dramatically reduced risk and you will be able to retire years sooner than your friends following Buy-and-Hold strategies. It’s not the particular Valuation-Informed Indexing strategy you choose that makes the difference. The biggie is that you be sure to tune out the Get Rich Quick garbage pushed by Wall Street and be certain not to remain at the same stock allocation when stock prices change dramatically. It’s not precisely how you avoid Buy-and-Hold that matters so much, it’s that you are certain to avoid it somehow.
Rob Bennett believes that Buy-and-Hold has failed and writes about the alternative investing strategy “Valuation-Informed-Indexing”. 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.
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