This post is from an evangelist of an investment method called valuation-informed indexing (VII). The post compares and contrasts that method with the more traditional buy-and-hold method, talks about the potential impact on retirement, and points out that investors have a choice about how much risk they want to take on.

Investing research affects the lives of millions in intensely personal ways. We don’t get a second chance to decide on an investing strategy. Most of us have available to us about 40 years (from age 25 to age 65) to finance our retirements. The trouble is, there are millions who will be learning very late in life that they do not have nearly the amount of resources they need to finance a secure middle-class retirement.

Why? Because of their investing strategy.

The predominant strategy

Buy-and-Hold is an investing strategy in which the investor generally stays at the same stock allocation at all times. (An investor’s “stock allocation” is the percentage of their entire investment portfolio that is invested in stocks, compared with the percentage held in bonds, cash, real estate, etc.)

Buy-and-Hold is rooted in the research of University of Chicago Economics Professor Eugene Fama. Fama showed that short-term timing (changing your stock allocation because of a belief as to where prices will be in another year or so) never works. That research has stood the test of time.

All signs are that short-term timing really does not work. The problem with Fama’s research is that the way he wrote up his finding was to say that “timing doesn’t work” rather than specifying that it is only short-term timing that doesn’t work.

Enter Shiller

In 1981, Yale University Economics Professor Robert Shiller showed that long-term timing (changing your allocation because of a big shift in valuations with an understanding that you
may not see benefits for doing so for as long as 10 years) always works and is always required. Shiller was the first to test this.

Prior to Shiller’s 1981 research most people believed in an “efficient” market. That essentially means that stocks are always priced properly. The idea is that there are millions of investors seeking to take advantage of anomalies in pricing and, if one was discovered, it would be exploited for profit and thereby eliminated almost immediately.

Shiller showed that this is not so. He showed that investing is not a rational endeavor (as Fama theorized) but an emotional endeavor. He showed this by demonstrating a strong correlation between the P/E10 value (a valuation metric) that applies in the current day and the return obtained by investors 10 years in the future. There is not a statistically
significant correlation in the short term (one year or so). But there is a strong correlation at 10 years and at 15 years and at 20 years. There should be no correlation if the market is efficient.

If the market were efficient (rational), stock prices would play out in the form of a random walk. They don’t. Overvaluation and undervaluation are real and meaningful phenomenon, according to Shiller’s research.

Underlying beliefs affect actions

When you buy an index fund, you are buying a tiny share of ALL the stocks within that fund. The benefit of indexing is that the investor obtains a high level of diversification. Indexers are not counting on the success of any one particular company.

Valuation-Informed Indexing (VII) is the same as Buy-and-Hold Indexing except for one point. Valuation-Informed Indexers aim to maintain the same risk level at all times rather than the same stock allocation.

Buy-and-Holders believe that stock investing risk is constant. That’s why they believe in staying at the same stock allocation at all times. Valuation-Informed Indexers believe (based on Shiller’s findings) that risk is variable — risk increases when valuations rise and diminishes when valuations drop. So Valuation-Informed Indexers CHANGE their stock allocations in response to big valuation shifts.

(This MPRA paper shows that investors can reduce risk dramatically by practicing long-term timing or can earn much higher returns while taking on the same amount of risk.)

The strategies in action

An investor’s stock allocation is the percentage of his total portfolio that is in stocks. An investor with a $100,000 portfolio and a 60 percent stock allocation has $60,000 in stocks and $40,000 in non-stock asset classes.

A Buy-and-Holder might go with a 60 percent stock allocation at all times while a Valuation-Informed Indexer would go with 90 percent stocks when valuations are low, 60 percent stocks when valuations are moderate and 30 percent stocks when valuations are high.

My understanding

My understanding of how stock investing works differs from the conventional understanding in only one respect. I say that stocks are like anything else that can be purchased with money. They offer a great deal at some prices (valuations), a good deal at other prices and a poor deal at yet other prices. PRICE MATTERS. That’s the VII concept in two words.

The U.S. market has provided an average long-term return of a little over 6 percent real for 140 years now. A Buy-and-Holder would say that investors should always own primarily stocks because no other asset class offers that high a return on a consistent basis. I say (based on a regression analysis of the 140 years of historical data available to us) that the most likely annualized 10-year return in 1982 (when prices were very low) was 15 percent real and that the most likely annualized 10-year return in 2000 (when prices were very high) was a negative 1 percent real.

Why stock allocations matter

Since the long-term return is so different in those two sets of circumstances, investors should go with very different stock allocations at the two different times. A 90 percent stock allocation makes sense when the long-term return is 15 percent real. A 30 percent stock allocation makes sense when the long-term return is a negative number.

Shiller showed that long-term stock returns (but not short-term stock returns) are
PREDICTABLE. That’s the big advance.

An index fund should be expected to provide a return of 6 percent real if purchased at fair prices. If prices are two times fair-value, that cuts the long-term return in half (to 3 percent real). If prices are three times fair-value, that cuts the long-term return into a third (to 2 percent real.). If prices are half of fair-value, that doubles the long-term return (to 12 percent real).

People will lose large portions of their retirement money in days to come because they don’t know this. If people knew this, stock prices would be self-regulating. Each time prices got too high, people would sell stocks because they wouldn’t be offering a good enough deal anymore. That would bring prices back down to fair-value levels. So long as people know that price matters, we can never have huge amounts of overvaluation or undervaluation.

The Buy-and-Holders persuaded investors that there is no need to consider price when buying stocks. That essentially took the brakes off the car. When large numbers of people stop paying attention to price, prices just keep going up and up and up until they reach crazy levels. (Investors are essentially voting themselves raises when they increase the price of stocks beyond the 6.5 percent real annual increase justified by the economic realities.)

Past performance

In 2000, stocks were priced at three times fair value. That was $12 trillion in overvaluation.
Shiller showed that overvaluation always leaves the market in the long term. So he was able to predict the 2008 crash in his book Irrational Exuberance, published in March 2000.

We gave up SOME of that $12 trillion in the 2008 crash. But we have never once in history seen a secular bear market end until the P/E10 level drops to 8 (that’s half of fair value). We always go BELOW fair value because investors are depressed to see their Pretend Gains disappear. A drop to 8 is a 65 percent drop from where we stand today.

It was the high stock prices of the late 1990s that caused the economic crisis. The Buy-and-Holders believe that all the bull market gains were real. Shiller showed that bull market gains (any gains in excess of the 6.5 percent real gains supported by the economic realities) disappear in time. When $12 trillion worth of Pretend Gains leaves the economy, $12 trillion of spending power leaves the economy. People don’t have money to buy as many houses or cars or sweaters or bananas. Tens of thousands of businesses fail and millions of workers lose their jobs.

Impact on retirees

If Shiller is right, the investing strategies followed by 90 percent of the population are much more risky than they realize. People don’t want to hear that they may lose large portions of their retirement money in days to come.

The safe withdrawal rate (SWR) is the highest percentage that a retiree can take out of his portfolio each year with virtual certainty that the portfolio will survive 30 years (which would get him to age 95 if he retired at 65). Since the Buy-and-Holders believe that risk is stable, they believe that the SWR is always the same number (4 percent). Since Valuation-Informed Indexers believe that risk varies with changes in valuation levels, we believe that the SWR VARIES (it was 1.6 percent in 2000 but it was 9.0 percent in 1982).

Investors who retired in 2000 thinking that the SWR was 4.0 percent (giving those with $1 million portfolios $40,000 to live on each year) have been taking out far more than they can afford to take out if the SWR was really 1.6 percent (permitting them $16,000 to live on each year).

Numerous big-name publications (including the Wall Street Journal and the Economist magazine) have acknowledged that the 4 percent withdrawal claimed as “100 percent safe” is in fact not at all safe when valuations are high. But none of the old studies have been corrected. If the recent research is valid, MILLIONS of retirements will fail in days to come.

What to do about the problem

Many top-name people acknowledge the problem. The trouble is figuring out what to do about it. If people come out today and acknowledge that the retirement studies used by millions got the numbers wildly wrong, the millions of people who relied on those numbers are obviously going to be very upset. The other side of the story is that people will be even MORE upset if they learn only when their retirements fail that the numbers were wrong all along and that many people knew this and didn’t tell them.

If we were open with investors and explained to them that stocks offer a poor long-term value proposition when they are overpriced, they would act in their self-interest and keep stock prices at least sane. We hurt ourselves in a very big way by borrowing so much from our future selves. We didn’t know how things worked in the past, so there was nothing we could do about it (when, for example, the bull market of the 1920s caused the Great Depression).

But now we have available to us the research we need to end a great deal of human misery. My view is that we all should be working together to get the word out and to help people learn what they need to learn to earn far higher returns while greatly reducing stock investing risk. My advice to investors is to consider the possibility that most of the investment advice that you hear is rooted in research that may not be nearly as sound as you have been led to believe.