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The following is a guest post by Rob Bennett. Rob has recorded numerous podcasts on how to invest wisely, addressing such topics as market timing, diversification, and dollar cost averaging. His bio is here if you are interested in reading more!
The Risks of Ignoring Market Valuations in Your Investing Strategy
Why I Started Paying Attention to Stock Market Valuations – Safe Withdrawal Rates During Retirement
How about you all? Do you consider market valuations in putting together your long term investing strategy and asset allocation? Why or why not? Do you feel that ignoring market valuations in your investing strategy exposes you to unmanageable levels of risk?
What do you feel is a safe rate to withdrawal your money during retirement?
Share your experiences by commenting below!
Jacob’s Thoughts – Listed below are my random thoughts as I was reading this article.
- Great post here, Rob! Your articles always get me thinking about what I do in my investing strategy and seeing if there are any places for improvement.
- @ The conventional approach to indexing / passive investing that I support -
- In the article above, Rob mentions that the conventional approach to indexing involves an investor staying at the same stock allocation at all times.
- While this is generally the strategy that I follow and promote, there is one big specification that I want to make clear before we proceed to other points in this discussion.
- While I do advocate staying at the same stock allocation regardless of market valuations, I absolutely do not recommend staying at the same stock allocation regardless of the life stage you are in. In my opinion, this is far too risky.
- Instead, what I advocate is assessing your cash needs for the coming years, your tolerance for risk, your age, life status, etc, and then set a fixed income / stock asset allocation from there based on your tolerance for risk and time to retirement.
- My belief is that by rebalancing your portfolio periodically, you can properly manage your risk and exposure to stocks.
- For example, just because right now at age 26, my asset allocation is 75% equity / 25% fixed income, that doesn’t mean that it will be at those same levels when I am 55.
- Got it? Right! Let’s proceed with some other fascinating aspects of this discussion.
- @ Why I haven’t yet been persuaded of adopting Valuation Informed Indexing -
- As Rob mentioned in the post, I have done an in-depth analysis comparing the performance of the Valuation Informed Indexing approach to my passive investing approach over the past 20 years.
- From this analysis, I found that since the market has been overvalued from a historical perspective for the past 20 years, Valuation Informed Indexing (VII) had the investor shy away from stocks during this time.
- Because of this, passive investing outperformed VII during the time period, although VII showed much less risk / standard deviation of portfolio value.
- In addition to the under-performance I saw from my analysis of VII, I felt that as an investor, I probably wouldn’t have the will-power to stick to the VII strategy.
- If you’ve done much reading about investing strategies, you’ve probably heard that one of the most devastating things that someone can do is bounce around to different approaches, following whatever advice happens to be given to you. While I’m not saying that VII is some shady penny stock newsletter/tip, I feel it would keep me too far from the performance of the market that I might not keep to the plan.
- Just think for a second - would you really be able to hold to only investing 30% of your money in stocks during the late 90′s through 2008 if you are trying to aggressively save money for retirement? It’s likely that most people would not be able to stick to this plan.
- Nevertheless, I do hope that we can one day tweak the VII strategy in such a way that I can become convinced enough to switch. As I mentioned in my analysis post, I really do believe it has potential since VII provides a concrete numerical system (using PE10 values, which keeps emotions from getting in the way) and so effectively reduces risk / standard deviation.
- @ The current PE10 ratio
- Just out of shear curiosity, I wanted to check what the current PE10 (valuation indicator) value was, since I hadn’t checked it since I finished my VII analysis in June of 2011.
- According to Robert Shiller’s data, the current PE10 is 20.75. This is down from 23 during June 2011, so this means that the markets are slightly less overvalued. If the PE10 goes below 20, VII dictates moving to a slightly more stock aggressive “base” asset allocation. During this time, the market has gone up overall ~2%.
- @ The issue of safe withdrawal rates and providing income for retirement -
- (I will preface this section by saying that I know much less about safe withdrawal rates during retirement than I do about the investing / nest egg accumulation phase – probably due to my age).
- The concerns about safe rates of withdrawal for providing income during retirement are well-founded in my opinion, as this is a serious issue to consider.
- In particular, if you had a high-stock allocation portfolio at the time of retirement, I do agree with the fact that you would do well to consider market valuation (because your all-stock nest egg could drastically decrease) when thinking about rates of withdrawal.
- However, I personally do not believe people should have a high stock allocation portfolio at the time of retirement in the first place.
- If you follow life-stage asset allocation advice set forth in books such as A Random Walk Down Wall Street, in your mid 50′s, you would have only 55% of your retirement funds in stocks + real estate. In your late sixties and beyond, you would only have 40% in stocks + real estate. The rest would be in ‘more stable’ investments like bonds and cash.
- By having the majority of your money in secure investments, you actually don’t need to rely on your stock holdings for your current income.
- Personally, the way I plan to attempt to structure my retirement income is lock in a guaranteed source of monthly payments through an annuity so that it is absolutely certain that I won’t run out of money. Then, any money I have invested in stocks, bonds, and cash will be separated from the income source.
- By doing this, I could simulate how people still in the working stage of life have an income source separated from their investments.
- Overall, if you are using an annuity or another instrument to lock in your retirement income, I do not believe that you need to consider market valuations in your nest egg withdrawals or investment strategy (reasoning would be similar to that used above) during retirement. You are simply wanting to attempt to grow some of your money for your later retirement years and large purchases.
- However, what if you don’t have enough saved up to lock in a guaranteed annuity retirement income and will definitely need to withdrawal the money now/later from your limited stock allocation to cover everyday living expenses? Should market valuations be considered with how quickly or slowly you withdrawal your retirement savings? Should you use Valuation Informed Indexing in your investment strategy?
- This is a much more complex set of questions, and I’ll have to do some more research and come back to you all in a future post about this!
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