Alternative Investing Strategy --
Why Valuation-Informed Indexing?

This article offers brief responses to ten alternative investing strategy questions, explaining why the conventional indexing approach has a lot to offer, why the conventional indexing approach also leaves a lot to be desired, and why Valuation-Informed Indexing fulfills the promise of the indexing revolution.

Alternative Investing Strategy Question #1 -- Is the PassionSaving.com web site a pro-indexing site or an anti-indexing site?

It is neither. This site reports on what the Financial Freedom Community has discovered about how middle-class workers can win financial freedom early in life. We have found that index investing can be a big plus in many circumstances. We have also found that indexing as usually practiced today is a gravely flawed investing strategy. The aim of the PassionSaving.com site is to tell both the positive and negative sides of the indexing story, and to encourage changes in how indexing is practiced to make it a more effective and realistic investing strategy for long-term buy-and-hold investors. I see Valuation-Informed Indexing as the alternative investing strategy of today and the conventional indexing strategy of tomorrow.

Alternative Investing Strategy Question #2-- What’s good about indexing?

Indexing is simple. Most middle-class investors have limited time to devote to investing research. The simplicity of indexing has great appeal to them. Practiced in reasonable ways, indexing has the potential to generate highly appealing long-term returns. It may be that those who take the time to engage in extensive research of individual stocks will obtain better results than indexers. But there are good reasons for believing that indexers can obtain 80 percent of the benefits obtained by the world’s best investors by putting forward only 20 percent of the researching effort. For the typical middle-class investor, indexing appears to be a solid choice.

Alternative Investing Strategy Question #3 -- Is there a downside to indexing?

Yes. Many advocates of indexing have become highly dogmatic in their claims for it as a result of the success indexing has seen during the Bull Market we experienced during the 1980s and 1990s. Many indexing enthusiasts argue that investors should practice only indexing and rule out consideration of picking individual stocks or investing in mutual funds that do not provide ownership in a broad U.S. market. Many indexing enthusiasts also argue investors should maintain the same stock allocation at all times, regardless of changes in valuation levels. These are extreme positions. This site argues that each investor should determine for himself or herself how best to put the benefits of indexing to use.

Alternative Investing Strategy Question #4--How did you come to discover the Valuation-Informed Indexing approach?

Valuation-Informed Indexing is the product of discussions held at a number of Financial Freedom Community discussion boards. The discussions started with a post that I put to a Motley Fool board in which I asked whether changes in valuations should be considered in the determination of safe withdrawal rates. That post was put forward on May 13, 2002, and has come to be known as “The Post Heard Around the World” as it led to the most long-lasting and controversial series of personal finance discussions ever held on the internet, the discussions collectively referred to as “The Great Safe Withdrawal Rate Debate.” Those discussions proved beyond any reasonable doubt that the value proposition of a stock purchase changes dramatically as valuations move from moderate levels to high levels. Thus, in order to maintain the same risk level, an investor practicing indexing must adjust his stock allocation percentage in response to changes in valuation levels.

Alternative Investing Strategy Question #5 -- Isn’t that a form of timing?

Yes, it is a form of timing. There is a good bit of historical stock-return data showing that short-term timing does not work. There is also a good bit of historical stock-return data showing that long-term timing does work. Changes in valuations cause the probabilities associated with various outcomes to shift. In the short-term, there are too many factors influencing stock outcomes for the probabilities to assert themselves. It takes at least 10 years for the probabilities to assert themselves with some force, and more precise predictions of stock returns become possible only over longer time-periods.

Alternative Investing Strategy Question #6 -- Are you saying that you can predict today what sorts of returns the S&P index will provide in 10 or 20 or 30 years?

Yes. It is not possible to predict future stock returns with precision. But it is possible to use the historical data to determine the range of stock returns that will likely apply, presuming that stocks perform in the future much as they have in the past. It is also possible to assign rough probabilities to various points on the spectrum of possibilities. At the time this article was written (May 2006), the historical stock-return data shows a most likely 10-year annualized real return for the S&P index of 1 percent. It shows a worst-possible return of a negative 5 percent (the odds of this return coming to pass are less than 1 in 20) and a best possible return of 6 percent (again, the odds are less than 1 in 20 ). At the end of 30 years, the most likely return is 5.3 percent, the worst possible return is 3.3 percent, and the best possible return is 7.3 percent.

Alternative Investing Strategy Question #7 -- How should investors practicing Valuation-Informed Indexing be putting the message of the historical data to use in development of their asset-allocation strategies?

They should be lowering their stock allocations at times of high valuation (when the payoff from stock investing is lowest and when the risks associated with stock investing are greatest) and they should be increasing their stock allocations at times of low valuation (when the payoff from stock investing is greatest and when the risks associated with stock investing are lowest). More detailed guidance is offered in articles posted to the “Investing for Humans” section of the site.

Alternative Investing Strategy Question #8 -- Do you know for certain that those who change their stock allocations in response to changes in valuation will do better in the long term than those who do not?

We don’t know this for certain. We do know that common sense tells us that we should be lowering our stock allocations when the value proposition for a stock purchase is diminished. We do this in our purchases of all other types of assets, do we not? For example, we try to cut back on driving when the price of gasoline goes through the roof. Applying the same sort of thinking to purchases of the income streams provided by stocks is just common sense applied to the investing area. On top of that, the historical stock-return data shows that this approach worked well in the past. And the best-informed investing experts (people like William Bernstein, Scott Burns, Rob Arnott, and John Walter Russell) have confirmed the key principles on which the Valuation-Informed Indexing approach is built.

John Bogle, founder of the Indexing Revolution, talked about the effect of changes in valuations on long-term stock returns in a recent speech (which I view as offering support for our alternative investing strategy of Valuation-Informed Indexing).

Alternative Investing Strategy Question #9 -- Is it fair to say that you reject the buy-and-hold approach to investing?

To the contrary. Our community discussions show that it is far harder to walk the buy-and-hold walk than it is to talk the buy-and-hold talk. The key to successful buy-and-hold investing is forming reasonable expectations of the long-term returns that one’s investments are likely to generate. Investors who do not take the effect of valuations into account are likely to be surprised when stock prices fall to the extent that the historical data indicates they are likely to fall. The better informed an investor is about how stocks truly perform in the long-term, the more likely he is to practice buy-and-hold investing successfully.

Alternative Investing Strategy Question #10 -- Are you saying that Valuation-Informed Indexers will not be tempted to sell when stock prices fall?

They will no doubt be tempted. My hope and my belief is that, because their stock allocations will be smaller, the temptations felt by Valuation-Informed Indexers to sell will not be as great as those experienced by many others. Our four years of discussions show that middle-class investors are done in by buying stocks when prices are high and selling stocks when prices are low. The path to long-term investing success is doing just the opposite. The historical data provides Valuation-Informed Indexers with a source of objective insights that can be employed to counter the influence of the nonsense heard on television, in speeches, and in magazine articles. The investment advice heard in Bull Markets is almost always too bullish, and the investment advice heard in Bear Markets is almost always too bearish. The key to long-term investing success is avoiding the traps set for bulls and bears and forming realistic expectations rooted in an understanding of how stocks have always performed in the past.