Stocks provide great returns. There’s really only one thing wrong with this investment class. It’s the risk! Lots of middle-class people feel that they must invest in stocks to have any realistic hope of attaining a good retirement but live in fear of the stock crashes that can wipe out the accumulated savings of a lifetime in a few years. If only there were a better way!
Like all of the most powerful ideas, the new way of stock investing that I will describe here is rooted in something so simple that it will amaze you that you and thousands of others did not think of it before. Please don’t let that sway you. This checks out. I’ve been studying the new approach (Valuation-Informed Indexing) for nine years and I have put it before tens of thousands of people, both experts in the field and regular people. None has yet identified a significant flaw.
The idea is — to buy stocks in the way you buy everything else you buy.
Say that you were buying a car. Or a camera. Or a computer. Or a comic book. How would you go about it?
Most of us follow a two-step process. First, we determine which car or camera or computer or comic book is the right one for us. Then we check around to get a good price. No reasonable person would question this procedure. No reasonable person would say that we should buy the car or camera or computer or comic book at any price whatsoever. Taking price into consideration is always a plus. Right?
So why don’t we do that with stocks?
Stocks sell at all different sorts of prices. Sometimes they sell at fair value. Sometimes they sell at half of fair value. Sometimes they sell at double fair value.
Do we buy more stocks when stocks are well priced and fewer stocks when stocks are poorly priced? Most of us do not. Most of us follow some form of a Buy-and-Hold strategy, a strategy in which we stick with the same stock allocation at all times.
Does that make sense?
It doesn’t. Not according to the historical stock-return data going back as far as we have records.
The historical data says that Buy-and-Hold is the one thing that never works. The historical data says that it’s the way we go about buying everything we buy other than stocks that would work best when buying stocks too. The historical data says that we should be going with a high stock allocation when stocks are priced well and with a low stock allocation when stocks are priced insanely high (as they have been for most of the time-period from 1996 forward).
Lots of studies have been done testing whether this is so. All say the same thing. All say that price matters when buying stocks, just as it does when buying anything else. One of the best I’ve seen is a study recently done by Wade Pfau, an Associate Professor of Economics at the National Graduate Institute of Policy Studies in Tokyo, Japan.
Pfau compares the results for Valuation-Informed Indexing with the results for Buy-and-Hold for 110 rolling 30-year periods going back to 1870. He finds that: “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.” And the “more wealth” was in a good number of cases significantly more wealth. Look at the chart at that link!
It’s not just that Valuation-Informed Indexing provides far higher returns. The kicker is that it does so at dramatically less risk. Do you know how many lasting stock crashes there are in the historical record? Four. Do you know how many caused significant losses for Valuation-Informed Indexers? Zero. Lasting stock crashes only take place starting from times of insanely high prices. It is only Buy-and-Holders (investors who have been persuaded not to lower their stock allocations even when prices reach insanely high levels) who suffer serious losses during stock crashes.
Which means that they have less money to invest in stocks when prices are reasonable again! Which explains why Valuation-Informed Indexers beat Buy-and-Holders even at times when stocks are not priced to crash! Sometimes the best offense is a good defense.
I know your question.
If this is so great, why isn’t everyone already following this approach?
Let’s return for a moment to our discussion of cars and cameras and computers and comic books. If you were in the car business and you had somehow persuaded millions of your customers that cars were worth buying at any price imaginable, would you want the word to get out that this was nonsense?
You wouldn’t. You would want to keep the realities hushed up. The academic research has been showing for 30 years now that valuations affect long-term returns. The Stock-Selling Industry has continued spending hundreds of millions promoting Buy-and-Hold. It’s a good deal for them. Just not for you!
It’s not just me who says that. If you don’t trust me on this one (after all, you hardly know me), would you trust the Wall Street Journal? Brett Arends recently wrote in the Wall Street Journal that: “For years, the investment industry has tried to scare clients into staying fully invested in the stock market at all times, no matter how high stocks go…. It’s hooey…. They’re leaving out more than half the story.”
I just told you the other half of the story. You don’t want to be going with the same stock allocation at all times. You want to go with a far higher stock allocation when stocks are priced reasonably than you do when they are priced insanely high (as they have been for most of the time-period from 1996 forward).
But listen — The Stock-Selling Industry is not going to be any too pleased with me for my having spilled the beans regarding this one. Could we try to keep this one just between you and me? I don’t want any of those fellows getting angry with me. Those guys are multi-millionaires!
Rob Bennett created the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here.