Valuation-Informed Indexing Is the Future of Investing

By Rob Bennett

You have recently been sent to Earth from your home planet of Mars and know nothing of what people here have for years been saying about stock investing in the papers and magazines and web sites. You have some money to invest. You have only had time to do enough research to learn a single important fact about stock investing: The average long-term return in the U.S. market is 6.5 percent real.

What do you do? You follow a Buy-and-Hold strategy. You put most of your money in stocks and count on the long-term realities to pay off for you. You make an effort to tune out the short-term noise. You stick with stocks for the long run.

That’s where most of us stand today. We know one important and true thing about stock investing: Stocks are unpredictable in the short term but they always do well for those willing to wait long enough.

What if that didn’t work?

Now say that you have time to do enough research to learn a second important fact: Throughout history, stocks have always provided strong intermediate-term (10 or 15 or 20 years) returns when priced at fair value or less and have always provided poor intermediate-term returns when priced at the sorts of valuation levels that have applied from 1996 forward.

Now what do you do? You don’t follow Buy-and-Hold anymore. You follow a modified form of Buy-and-Hold, a form of Buy-and-Hold that we might call Buy-and-Hold 2.0.

You still make an effort to tune out the short-term noise and to stick with your strategies for the long run. But you keep in mind that it is not only the distant long run (30 years out) that you need to be concerned about. How stocks do in 10 years and 15 years and 20 years matters too.

A bankable alternative

Knowing two important facts about how stock investing works, you don’t practice Buy-and-Hold. You practice Valuation-Informed Indexing. That’s the investing strategy that I recommend in this column. That’s the investing strategy that I believe will replace Buy-and-Hold.

Buy-and-Hold is rooted in a belief that obtaining the average stock return is good enough. The average stock return is 6.5 percent real. That’s indeed plenty good enough for most reasonable people. So what’s not to like about Buy-and-Hold?

What’s not to like is that someone who cannot swim and is six feet tall is not going to do well in a pool that on average has a depth of five feet if he happens to be placed in the section that has a depth of twelve feet. Because Buy-and-Holders choose their stock allocations based on how stocks perform on average, the strategy works well so long as stocks are selling at average prices and the average return or better is likely to turn up within 10 or 20 years. That was the situation we saw from 1974 through 1995, the years when Buy-and-Hold became popular.

Buy-and-hold doesn’t account for over-valuation

The trouble comes when prices rise to insanely high levels, as they did in 1996. Stocks purchased at times of insanely high prices don’t provide average returns in the intermediate term but returns far less than average, so much less that it is a rare middle-class investor who can endure sticking with a high stock allocation for the full length of such time-periods.

Stocks were priced so high in 2000 that the most likely 10-year return was a negative number. Those who start saving at age 25 and hope to be able to retire at age 65 have only four decades in which to accumulate the $1 million or so in assets they will need to do so. Let 10 years go by without enjoying any benefits of compounding whatsoever and you greatly diminish the odds that you will make it.

Valuation-Informed Indexers don’t give up those years. We invest heavily in stocks during the years when the intermediate-term return for investing in stocks is solid. So we enjoyed all the great returns experienced from 1974 (when Buy-and-Hold was popularized by the publication of Burton Malkiel’s A Random Walk Down Wall Street) through 1995. But we lowered our stock allocations in 1996, when stock prices got so dangerous that far safer asset classes offered a more appealing long-term value proposition. We will increase our stock allocations again when valuations drop to levels where the intermediate-term return is likely to be strong, according to how stocks have always in the past performed starting from various price levels.

Valuation-Informed Indexers enjoy the rewarding side of stock investing the great returns without having to take on the scary side the price crashes that can wipe out decades of saving in a few years. High returns combined with low risk That’s investor heaven!

And there’s nothing even a little bit complicated about it. You consider price when buying everything else you buy in this Consumer Wonderland of ours, do you not? You wouldn’t dream of buying a computer or a camera or a cucumber or a comic book without taking the price at which it is selling into consideration. The idea behind this new investing strategy is that you should follow the same practice when buying stocks.

Take Buy-and-Hold and delete the Get Rich Quick element incorporated by The Stock-Selling Industry for marketing purposes (a recent Wall Street Journal column observed that the “myth” that long-term timing doesn’t work is a “hoary old chestnut [that] keeps the clients fully invested”) and you’ve got Valuation-Informed Indexing. That’s the future of investing.

Rob Bennett is the creator of The Stock-Return Predictor and “The First Retirement Calculator that Gets the Numbers Right.”. Rob is also the owner and creator of A Rich Life. a blog that aims to put the personal back into personal finance. Rob developed the Passion Saving approach to money management as well as the Valuation-Informed Indexing investing strategy, both of which are described on his blog.

( Photo courtesy of Christopher Chan )