Investors Who Ignore Valuations Are Like Overeaters Who Ignore the Risk of Heart Disease

————————————————————————————————————————
Welcome to My Personal Finance Journey! If you are new here, please read the “About” or “First-Time Visitor” pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
————————————————————————————————————————

valuation informed indexing safe withdrawal rates retirement passive investing investing strategy investing guest posting buy and hold

Click here to enter my free $196 giveaway for a chance to win 5% of My Personal Finance Journey blog income and give another 5% to a charity of your choosing! Deadline to enter is January 31st, 2012.


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!

Investors Who Ignore Valuations Are Like Overeaters Who Ignore the Risk of Heart Disease

Jacob (the owner of this blog) and I have had a number of good conversations about my belief that indexers need to move from the conventional Buy-and-Hold approach to indexing (under which the investor stays at the same stock allocation at all times) to the Valuation-Informed Indexing strategy (under which the investor changes his stock allocation in response to big valuation shifts in an effort to keep his risk profile roughly constant. Jacob does not endorse Valuation-Informed Indexing. But, he finds it worthy of further examination. You can read his take here.



The Risks of Ignoring Market Valuations in Your Investing Strategy

The difference between Jacob (and the vast majority of investors) and me is that I view valuations as not just another factor to consider in adopting an investing strategy, but rather as the the most important factor by far. The trouble that I have persuading people of the merit of the new approach is that the importance of valuations varies greatly. In every investor’s lifetime, there are time-periods in which valuations are close enough to fair value that it makes little practical difference whether investors consider valuations or not. Investors can go many years without suffering any penalty for failing to consider valuations. 

Then, everything can suddenly change. One day, the investor wakes up to find himself going with a high stock allocation at a time of insanely high valuations and the insanely high level of risk that applies at such times. Over the next 20 years (in every case in history in which valuations have gone to two times fair value, it has taken that long for stocks to begin providing good long-term returns again), he loses so much of the accumulated wealth of a lifetime that he delays his retirement by many years.

The valuations problem (lack of paying attention to valuations that is) in the stock market is like the heart disease problem for those of us who eat too much and exercise too little. Physicians often tell their overweight patients that they could extend their lives dramatically by making a few common-sense lifestyle changes. 

The patients often tune out the advice because they have never suffered any serious negative effects from overeating. Then comes the heart attack. 


Why I Started Paying Attention to Stock Market Valuations – Safe Withdrawal Rates During Retirement

I learned about the importance of valuations by studying safe withdrawal rates. The safe withdrawal rate is the percentage amount of a portfolio that a retiree may withdraw each year with virtual certainty that the retirement will survive 30 years, presuming that stocks perform in the future much as they always have in the past. 

For many years, financial planners told their clients that the safe withdrawal rate (SWR) for a high-stock portfolio is 4 percent. That is, someone retiring with $1 million at age 65 can take out $40,000 each year to live on with no worries that he will run out of money even if he lives to 95. 

I am the person who discovered the error in the old approach to calculating SWRs — the conventional methodology contains no adjustment for the valuation level that applies on the day the retirement begins. Numerous big names in the field have confirmed my findings in the 10 years since I put forward a series of posts at a Motley Fool discussion board showing that in reality, the SWR can drop to a number as low as 2 percent or rise to a number as high as 9 percent. 

Please take a look at a sobering report recently posted at the Raddr’s Early Retirement and FinancialStrategy Board. The report examines how a retiree who placed his faith in the conventional retirement studies for a retirement beginning at the top of the bubble is doing today. Please scroll down to the update put up on January 1, 2012 to read some words that I believe will drive home to you why I view it as imperative that those investing in stocks never take their eye off the valuations ball.

Raddr examines the numbers and concludes that: “The poor retiree’s real net worth has dropped nearly two-thirds (from $1,000 to $367) in only 11 years, and he is now withdrawing about 11 percent of his portfolio per year, which is a recipe for disaster even if the market heads up big-time from here. It looks like his portfolio very likely will fail in the next decade and is virtually certain to fail in the 30-year time frame which was touted as “100 percent safe” by many respectable market gurus and financial planners just a decade ago.”

There are too many retirement portfolios dying an early death as a result of our decision as a society not to engage in the serious discussion that this critically important topic very much merits. 

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!  

***Photo courtesy of http://farm1.static.flickr.com/41/127076756_efb656e584.jpg

Comments

  1. Rob Bennett says:

    Jacob:

    You are the best!

    There are two things that make me happy in every interaction I have with you:

    (1) You are just about the fairest guy on Planet Earth. You don't patronize me by pretending to agree with things re which we are not truly in agreement. But I never feel insulted after reading your caveats or criticisms re Valuation-Informed Indexing. You are thoughtful and helpful and practical in your comments. It's not easy to pull that off as consistently as you do; and

    (2) You go to a lot of trouble to develop your own take on the issues you address. You put as much effort into writing comments on my guest post as it would have taken for you to write a full post yourself. That obviously helps me develop my thinking process. My hope and belief is that it helps all of your readers. In my eyes, the biggest benefit of this new communications medium is the community aspect and you are someone who doesn't just talk the community talk but goes to a lot of trouble to walk the community walk.

    Your kind and intelligent approach has added a nice measure of cheer to my Wednesday morning!

    Rob
    My recent post VII #75 — Bogle’s Crazy, No-Good, Terrible, Mixed-Up 15 Percent Rule for Tactical Asset Allocation

  2. I value companies, partnerships, closely-held comps, options, etc. as my job, and it amazes me how many people ignore what we say and think we are way off! I definitely think valuations should be considered.
    My recent post The classes that I'm taking and how I need to try harder

  3. This approach seems to be equivalent to adding a managed beta component to the classic long beta and long bond components of a retirement account. With the managment based on Shiller PE or something similar. I think it's a good idea overall, since there's good historical evidence that sort of management outperforms. It does create complexity though.
    My recent post Guest Post on Las Vegas Tips at Budgeting The Fun Stuff

  4. Jacob, I'm at a similar life stage as you (I'm 25). I find Valuations Informed Investing very important and was surprised to see that valuations have deviated so far from the historical average for nearly our entirely lives! This puts us at a time when we are able to take the most risk (when we have the most time to recover, the most Human Capital, and the least financial capital invested) yet valuations tell us that we should be invested in equities with only a small portion of our portfolio.

  5. I want your feedback on my approach. I’ve built a glide path based on my age and the weighted average of my expected contributions that gets more conservative as I get older.
    I’ve built another glide path dependent on only the current PE10 ratio of the S&P. I simply weight my value of my ‘confidence’ in either curve at a given value (say 40%), and then my target Asset Allocation will be 60% based on my age glide path, and 40% based on the Valuations. With this calculation, at age 25, my target asset allocation will vary between 90% equities and 60% equities depending on valuations. My goal is to keep ‘risk’ relatively constant, though I imagine that my definition of risk is different than most
    Of course, every individual would have their own glide path for both the age based and the valuation based strategy – not different from the typical passive investor.

    • Wow Marlowe! A very fascinating approach – mixing both passive investing with asset allocation and VII. Very nice idea. I haven't done a detailed analysis about how that would play out, but I think it would be worth investing some time in to do the backtesting and determine how it would have played out over the past 20 years.
      My recent post Long Term Life Insurance

Speak Your Mind

*

CommentLuv badge