By Rob Bennett
The Buy-and-Holders say that it is a bad idea to practice price discipline (long-term market timing) when buying stocks. Valuation-Informed Indexers say that it is required for investors seeking to keep their risk profile constant over time. Both strategies are advertised as being rooted in science. Can we perform a study to check which one is right?
Studies have been performed. In fact, I co-authored one with Wade Pfau. Wade was very surprised by what we found. He wrote that: “What you see in the top part of the graph for each year is the amount of wealth accumulated after 30 years for someone following Buy-and-Hold against someone following Valuation-Informed Indexing….Valuation-Informed Indexing provides more wealth for 102 of the 110 rolling 30-year periods while Buy-and-Hold did better in 8 of the periods. I will take steps in my final paper to test a wide variety of assumptions about asset allocation, valuation-based decision rules, whether the period is 10, 20, 30, or 40 years, lump-sum vs. dollar-cost averaging, and so on, and to show that the results are quite robust to changes in any of these assumptions.” He observed that: “The findings for ‘market timing’ are so robust anyway, that it hardly matters how we do it.” And he concluded by stating simply that: “Yes, Virginia, Valuation-Informed Indexing works!”
Not quite. It settles it for me. But most investors are less than impressed by how Valuation-Informed Indexing has been trouncing Buy-and-Hold for 150 years of stock market history. The question that they have re a stock investing strategy is: “What have you done for me lately?” Stocks are today priced at two times fair value. So the answer for investors who look only at the numbers on their portfolio statement is that Buy-and-Hold has done pretty darn well. Stock returns have been dramatically sub-par for the past 19 years. But they were of course insanely good for the four prior years and very good for a nice stretch of time prior to that. So the last 19 years of sub-par returns don’t bother the majority of investors all that much. The overall story is that Buy-and-Hold performs well enough over the long term, super at some points in time and okay in most others.
And Valuation-Informed Indexing requires that investors go with low stock allocations when stocks are priced as they are today. I recommend a 30 percent stock allocation for the typical investor today. The super-safe asset classes are today offering very low rates of return. Most Buy-and-Holders turn up their nose at those low rates of return, worrying that they would miss out on the higher returns generally offered by stocks if they were to switch strategies.
My response to those concerns is that a small positive return is better than a large negative one. A return to fair-value CAPE levels would translate into a 50 percent price drop. And, once the irrational exuberance psychology is broken, prices usually drop not to fair-value levels but to levels of one-half that. That would mean a price drop of 75 percent from today’s levels. A small positive return looks positively juicy in comparison.
But of course I cannot say with certainty that prices will ever drop that low. And predictions that a dramatic price drop will come soon have a poor track record in recent years. Robert Shiller warned investors in July 1996 that those who stuck with their high stock allocations would live to regret it within 10 years. We have seen 23 years of sand pass through the hourglass since that pronouncement and most Buy-and-Holders are happy that they tuned it out.
So the case is not crystal clear one way or the other.
There’s only one question that matters - are stock price changes caused by a rational assessment of economic developments or by swings in investor psychology? If price changes are caused by a rational assessment of economic developments, you can trust the numbers on your portfolio statement - they are rooted in economic realities. If price changes are caused by swings in investor psychology, they cannot be trusted to report accurately your accumulated wealth. Investor psychology can change on a dime and most of your life savings can be transformed into so much cotton candy to be blown away in the wind.
Advocates of both strategies claim that they are rooted in research. And there is indeed research that purports to support both strategies. But those who believe in the strategies have as much confidence in studies performed by those on “the other side” as a fan of the Red Sox baseball team has in the opinion of a fan of the Yankees as to whether a member of the Red Sox was safe or out on his attempted steal of second base.
True science is rooted in testable hypotheses. Can we test the hypotheses on which these two investment strategies are rooted?
Buy-and-Hold is rooted in an assumption, the assumption that investors are engaged in the rational pursuit of their own best interests. There has never been any data advanced showing this assumption to be valid. You either believe it or you don’t. Buy-and-Holders believe in their strategy as a matter of faith.
And it is not possible to test the hypothesis behind Valuation-Informed Indexing in an entirely satisfactory way either. We can say that stocks have always performed as if prices were being set by swings in investor psychology. But it can take 40 years for an irrational exuberance/irrational depression cycle to complete itself and we only have 150 years of good data available to us. So there are only four complete (or nearly complete) cycles available for review. So we cannot say with a level of confidence that is suitable for true science that stocks will continue to perform in the future as they always have in the past. There is not enough data available to us to examine to prove the point conclusively.
I believe that Valuation-Informed Indexing is the future. But I do not believe that dogmatism is justified at this point in the proceedings.
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