9 Rules For Exercising Price Discipline When Buying Stocks - Part 1

by: ValueWalk

Originally Published July 12, 2016

By Rob Bennett

Recent columns have described the five calculators (The Stock-Return Predictor, The Retirement Risk Evaluator, The Investor's Scenario Surfer, The Investment Strategy Tester and The Returns Sequence Reality Checker) that I developed (with John Walter Russell and Sam Parler) to help investors appreciate the how-to implications of Robert Shiller's "revolutionary" (his word) finding that valuations affect long-term returns. Shiller showed that we all should be exercising price discipline when buying stocks. The calculators were designed to provide guidance on how to apply this powerful theoretical insight in the practical realm.

This column and the next two offer nine rules that I have developed by making use of the calculators in the 11 years since the first one was developed.

Rule #1: To Practice Short-Term Timing Is Guesswork, To Practice Long-Term Timing Is To Exercise Price Discipline.

The term "market timing" is an obscenity to the ears of most informed investors. But the reality is that the research that we once believed showed that market timing is a bad idea only shows that short-term timing (changing one's stock allocation because of a belief that one knows where stock prices are headed over the next year or two) does not work. Shiller was the first researcher to test long-term timing (changing one's stock allocation in response to a big shift in valuations with an understanding that this may not produce benefits for as long as 10 years) and he showed that long-term timing always works.

Short-term timing doesn't work because stock price changes are determined primarily by changes in investor emotion, and changes in investor emotion are unpredictable. Long-term timing is price discipline. It is the ultimate purpose of a market to get prices right and so long-term timing must work. The market would collapse if there were not forces causing prices eventually to return to fair-value levels. So we know with certainty that there will be downward pressure on prices when valuations are high and upward pressure on prices when valuations are low.

All of the calculators (which are rooted in the historical return data going back to 1870) illustrate this point. For example, the Return Predictor identifies a range of possible returns that apply for stock purchases made at any of the various P/E10 value. There are different ranges that apply at 10 years out, at 20 years out and at 30 years out. But no predictions whatsoever are supplied for five years out. The data simply does not support such predictions. At that time period, returns are essentially random. It is only with the passage of 10 years of time that the short-term unpredictability is overcome by long-term predictability and statistically significant predictions can be made.

The Buy-and-Holders achieved a huge advance when they discovered that short-term predictions don't work. Unfortunately, their breakthrough was misinterpreted. It is every bit as important to be sure to practice long-term timing as it is to be sure to avoid practicing short-term timing. To engage in short-term timing is to engage in a costly (because of transaction fees) waste of mental energy. To engage in long-term timing is to engage in price discipline, the thing that makes all markets work. The core message of all five calculators is that long-term timing is as good as short-term timing is bad.

Rule #2: Long-Term Predictions Are Of Huge Value.

Many investors are not impressed by the 35 years of peer-reviewed research showing that long-term predictions always work. There is great interest in short-term predictions - experts in this field continue to offer them on a daily basis despite the mountain of research showing that they don't work because the demand for short-term predictions is insatiable. Oddly, the interest in long-term predictions - the type that can be made effectively - is limited. The five calculators show the great value of long-term predictions.

The Retirement Risk Evaluator makes the point in a most compelling way. It was once believed that the safe withdrawal rate is a constant number - 4 percent. Shiller's research showed that risk is variable and that, thus, the safe withdrawal rate can drop to a number as low as 1.6 percent at times of high valuations and rise to a number as high as 9 percent at times of low valuations. For a retiree with a $1,000,000 portfolio, that's the difference between living on $16,000 per year and living on $90,000 per year. No small difference!

It is the first ten years of a retirement that determine whether it will succeed or not. A retirement portfolio that experiences big losses in its early years suffers from more than just the nominal losses - it also gives up the many years of compounding that would otherwise have been enjoyed on those amounts. Once a retirement has seen at least decent returns for 10 years or so, it has enjoyed enough compounding that this effect has been greatly diminished. So knowing the risk of a price crash turning up in those first ten years is critical. The odds of seeing a lasting price crash are very high when valuations are high and very low when valuations are low. It is not possible to assess the chances of retirement success without taking the valuation level that applies on the day the retirement begins into account.

Rule #3: Bull Markets Hurt Investors Who Are Building Their Portfolios While Helping Those Who Are in the Process of Cashing Them Out.

The Return Sequence Reality Checker shows that investors who are adding to their portfolios each year should cheer on bear markets and boo bull markets. Bull markets cause prices to increase, which means that investors are not able to buy the same amount of stocks with their limited investment-purchasing resources. Bull markets are a plus only for those who are selling stocks to finance their retirements.

Disclosure: None.