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Today’s guest post comes to us from Rob Bennett. Rob created the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here.
I recommend Valuation-Informed Indexing, an investing strategy in which the investor goes with one stock allocation at times of moderate prices (perhaps 60 percent), a higher stock allocation at times of low prices (perhaps 90 percent), and a lower stock allocation at times of high prices (perhaps 30 percent). This strategy permits investors to obtain far higher returns at greatly diminished risk. Investor heaven!
Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, has posted preliminary research showing that “Valuation-Informed Indexing provides more wealth [than Buy-and-Hold] for 102 of the 110 rolling 30-year periods” in the historical record. The purpose of this Guest Blog Entry is to answer the obvious question: Given how simple and powerful this concept is, how is it that it has remained undiscovered until now?
The overall story is a highly encouraging one. All signs are that we stand today on the threshold of the greatest advance in our understanding of how stock investing works in history.
It was in the 1960s that academics began studying investing in a systematic way. The first big advance was achieved by University of Chicago Economist Eugene Fama. Fama discovered that short-term timing (changing your stock allocation with the expectation of seeing a benefit for doing so in a year or two) never works. The second big advance was achieved by Yale University Professor Robert Shiller. Shiller discovered that long-term timing (changing your stock allocation in response to big price swings with the understanding that you may not see a benefit for doing so for as long as 10 years) always works.
Had we discovered both things at the same time, we would all be Valuation-Informed Indexers today. It makes zero sense to stay at the same stock allocation at all times if the value proposition for stocks is a wildly variable thing. A regression analysis of the historical stock-return data shows that the most likely annualized 10-year return in 1982 was 15 percent real while the same number in 2000 was a negative 1 percent real. There is obviously no single stock allocation that makes sense for any investor in both sets of circumstances.
The reason why we got on the wrong track is that Shiller’s research was not available at the time the Buy-and-Hold concept was being developed. Fama’s research showed that short-term timing does not work. He of course wanted to offer an explanation for that finding. It is the explanation that was put forward (not the research findings themselves — which have stood up to scrutiny for many years) that caused all the trouble.
Fama’s explanation was that the market is “efficient.” This means that investors collectively take into consideration all factors bearing on what stock prices should be. That is indeed one plausible explanation for why short-term timing does not work. If the stock price is always set properly, all price changes are caused by unforeseen economic developments. No investor, no matter how smart, can gain an edge by predicting things that cannot be predicted.
While Fama’s explanation is a plausible one, it is not the only plausible one. Another perfectly good explanation of why short-term timing doesn’t work comes at things from an opposite perspective.
What if the process by which stock prices are set is almost entirely inefficient? What if the primary driver is investor emotion and economic developments have little to do with it (except to the extent to which they set off emotional reactions)? It’s not possible for any investor, no matter how smart, to predict the direction of investor emotion, an inherently irrational phenomenon.
Fortunately, there is way to test which explanation is the right one.
If Fama’s explanation is right, overvaluation is a meaningless concept. An efficient market is a properly priced market. But Shiller’s research shows that valuations predict long-term returns. Overvaluation and undervaluation are both meaningful concepts. Market prices are not set rationally in response to economic developments but through the influence of irrational investor mood swings.
But wait. The market must be efficient in the long term. The very purpose of a market is to set prices properly. If the market were never at least largely efficient, it would collapse. So what we have is a market that is highly inefficient in the short term and highly efficient in the long term.
This changes everything.
If the market is efficient both in the short-term and in the long-term, Buy-and-Hold is the perfect strategy. The only way to capture the high returns of stocks is to be heavily invested in them and, since there is no way to predict returns, the only thing to do is to remain heavily invested in stocks at all times.
However, if the market is inefficient in the short term and efficient in the long term, Buy-and-Hold is the worst of all possible strategies. If the market is always in the process of moving in the direction of efficiency, long-term returns are highly predictable. The last thing you want to do is to maintain a high stock allocation when the market is insanely overpriced and in the process of returning to fair value prices.
We now have the advantage of both the wonderful insights of Fama and of the wonderful insights of Shiller. We need to combine them into a model for understanding for the first time how stock investing really works. The strategy that combines both insights is Valuation-Informed Indexing. Valuation-Informed Indexers disdain short-term timing but always practice long-term timing as needed to keep their risk profiles roughly constant.
If this economic crisis brings on the questioning of Buy-and-Hold that launches a national debate on the true realities of stock investing, we may someday look back at it as the best thing that ever happened to us. Imagine that!
How about you all? Have you ever tried Valuation-Informed Index Fund investing? What’s your take on how it will work out?
Share your experiences by commenting below!
***Photo courtesy of http://farm1.static.flickr.com/105/310847464_bcfbde894a.jpg