The How-To of Investing the Valuation-Informed Indexing Way

Step One of the How-To of Investing the Valuation-Informed Indexing Way — Come to a Realistic Appreciation of the Benefits of Indexing.

How-To of Valuation-Informed Indexing Indexing is an investing strategy, not a religion. The Valuation-Informed Indexing approach was developed for those who find the conventional indexing approach dogmatic and unrealistic. The first step to becoming a successful long-term indexer is developing an appreciation of the true benefits of indexing.

The primary benefit of indexing is that it provides an easy means to achieve a high level of diversification at low cost. That’s a powerful benefit. Those who suggest that indexing is the only rational way to invest (this includes John Bogle, founder of the Indexing Revolution) discredit indexing in the long-term by trying to make indexing something that it can never be.

Indexing is not the only rational way to invest. Picking individual stocks or investing in mutual funds makes all the sense in the world for investors with the time and skill needed to succeed at those investing approaches. Indexing is a great option for those of us who are not yet well-informed on what it takes to pick stocks or funds effectively or who just do not have the time to engage in the research work required to do so.

Buying the S&P 500 index permits you to obtain the returns generated by the S&P index. That’s great. That’s fine. Indexing is a breakthrough strategy. I wish that people like Bogle (a good number of his followers are more guilty of this than Bogle himself, to be sure) did not feel a need to oversell indexing and thereby to discredit it in the eyes of savvy investors.

Indexing is a fantastic strategy best employed in combination with other fantastic strategies.

Step Two of the How-To of Investing the Valuation-Informed Indexing Way — Determine the Extent to Which You Should Be Indexing.

If you have the time and skill needed to pick stocks effectively, you should be picking stocks. Those who pick stocks effectively generally will earn better returns in the long run.

Most of us do not possess the time and skill needed. Unless you are positive that you are one of the exceptional ones, you should index with most of your money. If you are new to investing, you almost certainly should index.

As you learn how investing works, you should gradually try picking stocks or funds. Picking stocks or funds is hard. There’s a big financial payoff available to those who pick stocks or funds effectively. But there’s a big price to be paid by those who kid themselves into thinking that they possess a greater level of expertise than they really do possess.

Get It Done
Start indexing and over time shift gradually to picking stocks and funds. Or, if you prefer, stick with pure indexing your entire life. There’s not a thing wrong with being a pure indexer your entire life.

There is something terribly wrong with kidding yourself into thinking that there is no benefit in learning how to pick stocks effectively. That sort of thinking is the product of an emotionally unhealthy defensiveness and narrowness and dogmatism. In the long term, that sort of thing will hurt you. The aim of the Valuation-Informed Indexing approach is to avoid the extremism that has caused the failure of the conventional indexing approach in recent years. Valuation-Informed Indexing is an indexing approach for the true long-term investor.

Step Three of the How-To of Investing the Valuation-Informed Indexing Way — Come to Appreciate the Benefits of Value Investing.

Many value investors see little appeal in indexing because they understand that they can earn higher returns by picking individual stocks effectively. Many indexers see little appeal in value investing because they have bought into the conventional indexer’s defensive dogma that picking stocks effectively is impossible. Valuation-Informed Indexing combines the benefits of value investing and conventional indexing for the benefit of those investors who want something from Column A and something from Column B.

The benefit of value investing is that it provides higher returns. This is a huge benefit in a secular bear market, when stock returns remain low for a long time. The benefit of indexing is that it is an easy no muss/no fuss approach. This is a huge benefit for the many middle-class investors who do not have enough free time to devote much of it to researching stocks.

The Valuation-Informed Indexer does not research stocks. He buys the S&P index (or some other broad index). How then does he avoid the terrible returns that the market as a whole has always dished out in the wild bear markets that inevitably follow in the wake of wild bull markets? He lowers his stock allocation at times of high valuations, putting the money into super-safe asset classes like Treasury Inflation-Protected Securities (TIPS), IBonds, or certificates of deposit (CDs). He thereby limits his losses during times when stock prices are headed downward, leaving him with more to invest in stocks when prices return to reasonable levels. In the long term, he can realistically expect to earn a return of at least 6.5 percent real, a return far in excess of the return available to the conventional indexer (who is forced to sell when prices are low as a result of overinvesting in stocks when prices are high).

Just Do It

The Valuation-Informed Indexer obtains a good measure of the benefits of value investing without having to do the work required of value investors. He does not obtain the full benefit of value investing, to be sure. He obtains higher returns than the conventional indexer while engaging in far less research than the non-indexing value investor. For some investors, this is the best of both worlds.

Step Four of the How-To of Investing the Valuation-Informed Indexing Way — Choose a Reasonable Valuation-Assessment Tool.

To invest in a valuation-informed way, you obviously need a tool to assess valuation levels. I advise that you not use P/E1, which is the most commonly cited valuation assessment tool. It’s hardly a mystery why “studies” using P/E1 often produce such strange results. P/E1 compares today’s price to today’s earnings; if earnings are at a temporary high, that produces an artificially low valuation number; if earnings are at a temporary low, that produces an artificially high valuation number. I view it as a scandal that there are still today big-name investing “experts” who cite P/E1 as if the P/E1 number were a meaningful indicator of valuation levels.

I believe that the best indicator is P/E10. This indicator compares this year’s price with the average of the past 10 years of earnings, thereby diminishing the effect of any temporary earnings highs or lows. Some use Tobin’s Q. Some use the Gordon Equation. Some use an approach to employing P/E1 in which they compare the P/E1 value that applied at one point in the economic cycle with the P/E1 value that applied at a similar point in the economic cycle that takes place years later (this is an alternate means of dealing with the problem of temporarily high or low earnings figures that allows for comparison of apples with apples and oranges with oranges).

Robert Shiller, the author of Irrational Exuberance,  reports on recent P/E10 values at his web site. The P/E10 value reported for November 2007 (this article was posted in December 2007) is 27.

To gain a sense of what the various P/E10 values signify, please take a look at The Stock-Return Predictor (see tab to the left of this page). The Predictor tells us that the most likely 10-year annualized real return for stocks purchased at a P/E10 value of 27 is 1.10 percent. You can do better than that by investing is far safer asset classes.

Practical Investing Advice

Step Five of the How-To of Investing the Valuation-Informed Indexing Way — Learn How Successful Investors Time the Market.

All investors following the Valuation-Informed Indexing strategy need to take a look at the article at the “Valuation-Informed Indexing” section of the site entitled “Market Timing — What Works and What Doesn’t.” The short version of the story is that you should forget about short-term timing, counting on changes that you make in your stock allocation in response to price swings paying off in one year or three years or five years.

Long-term timing works, however. Long-term timing is changing your stock allocation in response to price swings with no expectation of seeing a payoff for up to 10 years. Please check out The Investor’s Scenario Surfer (see tab to left) to gain a sense of how great a difference long-term timing makes in the long term. It often takes 10 years for valuation-informed allocation shifts to pay off. Once they do, however, the compounding returns effect kicks in. The financial gain at the end of 30 years is often in the hundreds of thousands of dollars; in some cases, it is in the millions. This is a benefit that those seeking financial freedom early in life do not want to pass up!

Step Six of the How-To of Investing the Valuation-Informed Indexing Way — Avoid Frequent Allocation Shifts.

I have received several e-mails in which community members have expressed frustration that the general news media does not regularly report on shifts in the P/E10 value. I agree that it is unfortunate that this important long-term indicator is not more widely reported. The other side of the story is that you do not need to hear frequent updates of the P/E10 number to engage in a successful Valuation-Informed Indexing strategy. You should not be changing your allocation every year or every two years or every three years. It is not hard to imagine circumstances in which you would not need to change your allocation for 10 years or longer.

One of the risks with this investing strategy is that those following it might be tempted to engage in an excessive number of allocation shifts. If a few shifts in allocation produce long-term gains in the hundreds of thousands of dollars, then even more shifts will bring you to financial freedom in no time at all, right? Not right. Our tools for assessing valuations are not precise enough to justify saying that small changes in the P/E10 value are significant. It makes all the sense in the world to change your allocation when the number goes from 14 to 20. It does not make sense to change your allocation when the number goes from 14 to 16, in my assessment.

Do be sure to change your stock allocation when prices shift dramatically. But please aim not to overdo it.

Step Seven of the How-To of Investing the Valuation-Informed Indexing Way — Avoid Extreme Bets.

Investing Is Boring
I refer to the P/E10 value of 20 as The Red-Alert Danger Zone. It is foolhardy (in my view) to remain at the same stock allocation when the P/E10 value goes above 20 that you elected for yourself when prices were normal (a P/E10 value of 14 or 15). But guess what can happen to stock prices if you get entirely out of stocks when they go to these dangerous price levels? They can rise even higher. A lot higher. The P/E10 value could go from 20 to 40 (the highest P/E10 valuation ever hit was 44, the number that applied in January of 2000, the end of the largest bull in the history of the U.S. market).

I recommend always hedging your bets. Maintain a small stock allocation (perhaps 30 percent) even when prices are at absurd highs. Hold back from going with 100 percent stocks even when prices are at mouth-wateringly low levels (any P/E10 value below 12 is mouth-watering).

I can see making an exception when the P/E10 level goes above 30 or below 8. It’s important to keep in mind, though, that short-term price moves are unpredictable. Take too big a bet that prices are headed down just because they are absurdly high and you could be feeling a lot of remorse during the 10-year time-period that you might have to live through before your long-term expectations come to fruition.

Step Eight of the How-To of Investing the Valuation-Informed Indexing Way — Customize This Advice.

People often ask me: “What stock allocation do your recommend at today’s price levels?” For the typical investor, I recommend a stock allocation of about 30 percent when the P/E10 level is 27. Please keep in mind, though, that you are not a typical investor. You are you. For you, a very different stock allocation might be best.

If you are in circumstances in which you cannot afford a big price drop for even a small percentage of your portfolio, you might want to go with an allocation a good bit lower than 30 percent. That’s fine. If you know how to pick stocks well, you might be able to overcome the drag on stock returns that affects most investors at times of such high prices. In those circumstances, a significantly higher stock allocation might make good sense. There is no one rule.

All of the considerations that come into play when conventional indexers are setting their stock allocations come into play when Valuation-Informed Indexers are setting their stock allocations. The big distinction is that Valuation-Informed Indexers do not rationalize sticking with an allocation when the risk/reward correlation changes dramatically. Stocks are risker when prices are high and stocks provide smaller long-term returns when prices are high. So Valuation-Informed Indexers quite naturally elect to go with smaller stock allocations until prices return to normal.

Step Nine of the How-To of Investing the Valuation-Informed Indexing Way — Think Through the Cause of the Rationalizing Employed By Conventional Indexers.

Learning How to Invest

To stick with a stock allocation after prices change dramatically makes no sense. I say that not to hurt the feelings of those who follow the conventional indexing approach. I say it because it is so obviously so and because so few investing “experts” are willing to say it in terms clear and plain and bold and understandable enough for most middle-class investors to get the message.

The conventional approach to indexing is irrational.

That’s my claim. I do not believe that the people who follow the conventional approach are in a general sense irrational people. I have talked with thousands of conventional indexers and my experience has been that most of them are smart and kind and good and interesting people. Why is it that some of them (not most, in my assessment, but a not insignificant number) go berserko when the topic of discussion turns to investing strategies?

It’s because investing is primarily an emotional endeavor and only secondarily a rational one. People are scared to put their money at risk and, when people are scared, they react with defensiveness to questioning of ideas they have come to adopt to keep the fear at bay. Conventional indexers have been persuaded by advocates of the Efficient Market Theory that it is a good idea not to engage in any form of market timing. Yet their common sense tells them that long-term timing must work; how could it not? The result is that they are suffering from a good bit of emotional angst and honest reports of what the historical stock-return data says about the effect of valuations on long-term returns make them feel uneasy and in some cases even angry.

What does this have to do with the how-to of investing for those following the Valuation-Informed Indexing strategy? It’s an overriding consideration, one that should be kept in mind during contemplation of any aspects of the decision-making process.

If investing were primarily a rational endeavor, there would not be any need for a distinction between the conventional approach to indexing and the valuation-informed approach. In a world in which investing was a rational endeavor, there would be no “experts” arguing that valuations should be ignored and there would be no middle-class investors listening to anyone sufficiently off the beam to suggest that this might be a reasonable idea. The case for taking valuations into account is overwhelming.

The reality in the year 2007, however, is that this investing strategy is controversial. There are more investors today ignoring valuations than there are paying attention to valuations (otherwise we wouldn’t be at the valuation levels we are at today, would we?). Awareness of that strange reality should influence every investing choice you make.

Please take a moment now to to ask yourself an important question: Do the arguments in this article make sense to you? If the answer is “yes,” please check them out carefully before permitting them to influence your investing decisions. If the answer is “no,” please bid a fond adieu to the investing articles at this site and seek another one better suited to your needs.

My point here is — you’ve got to go with your common sense. No bull market can count more than common sense. No bear market can count more than common sense. No expert can count more than common sense. No historical data can count more than common sense.

Talkig Over Investing Ideas You are the one who needs to live with the investing results you obtain from your decisions. If the arguments informing those decisions do not make sense to you, you are not going to be able to stand the heat when it comes (the heat arrives someday for followers of all possible investing strategies). If this stuff does not make sense to you, you simply must take your leave of it.

I wrote this article in December 2007. You might be reading it five years later. The realities might be very different today from what they were when I wrote the article. If you take Step Nine seriously, you will be able to figure out how to proceed under the new realities. If you failed to integrate the ideas put forward in this article into an overall investing philosophy informed primarily by common sense, you might not be able to do so.

Think about it. Does it make sense? If yes, move ahead slowly. If not, jump off the tracks before you get hurt; if it does not make sense to you, it does not make sense for you.

Step Nine is not theoretical. Step Nine is the most practical of the nine steps. Some of us view it as a Godsend finally to have an investing strategy available to us that adds up, that makes sense. Others do not enjoy a click experience when hearing about this one. Valuation-Informed Indexing is not for everybody.