By Rob Bennett
Rob Bennett is the author of “Passion Saving: The Path to Plentiful Free Time and Soul-Satisfying Work,” and writes the Financial Freedom Blog. He writes extensively on Valuation-Informed Indexing at his www.PassionSaving.com web site, which features The Stock-Return Predictor calculator, a calculator that reveals the value proposition associated with purchases of the S&P500 Index made at various valuation levels (based on a regression analysis of the historical stock-return data).
Stay the Course!
How many times have you heard that bit of advice? Probably hundreds. It is John Bogle’s favorite admonition to investors.
Have you ever stopped to think what it means?
The idea of Staying the Course sounds great. No investing strategy is going to pay off unless you possess the courage to stick with it through challenges. Investors who Stay the Course are stable, consistent, unshakable.
More than one way to stay the course
Most indexers interpret the phrase as an argument for sticking to a single stock allocation. We determine our stock allocations by performing an analysis of risk and return. Stocks are a high-risk/high-return asset class. An investor chooses a 60 percent stock allocation as the result of a determination that a 70 percent stock allocation would be a bit too risky and a 50 percent stock allocation would provide a bit too low of a long-run return. We all aim to be like Goldilocks and identify the stock allocation that is not too hot and not too cold but “just right.”
The trouble is — the stock allocation that is “just right” today may not be “just right” tomorrow.
Do you believe in the Efficient Market Theory? If you do, you may want to turn to another article for your investing advice at this point. I do not believe in the Efficient Market Theory. I do not believe that stock prices are in some mystical sense always efficient or correct or good or right. I believe that stock prices are sometimes far too low, sometimes far too high, and usually somewhere in the middle of the two extremes.
If you, like me, believe that it is possible for prices to be too high, then you should not be sticking with the same stock allocation in your effort to Stay the Course. For investors like us, changes in prices are causing the course to always be in motion. Risks are greater at times of high prices and long-term returns are lower.
If a 60-percent stock allocation was just right when you elected it during a time of moderate prices, it cannot possibly be just right today, a time of super-high prices (my valuation tool is P/E10, the price of an index over the average of the past 10 years of earnings). For an investor like you to Stay the Course, you need to lower your allocation when prices get to where they stand today, perhaps to 30 percent. Only when prices return again to moderate levels will a 60 percent allocation again be just right for you.
I call this approach to investing Valuation-Informed Indexing. I believe in indexing because I see it as a great way to lock in the overall market return without having to spend lots of time researching individual stocks. Given the long-term returns that have historically been provided by investing in a broad U.S. index, the return obtained by locking in the market return seems plenty appealing enough to me. I don’t believe for 10 seconds that it would be realistic for me to expect to see those sorts of returns for an investment made at today’s prices (we are now at a P/E10 level of 25), however. I have learned from life experience that when it sounds too good to be true, it’s usually because its too good to be true. I don’t believe in banishing that rule from mind when it comes time to make investing decisions.
What sort of long-term return do I expect the S&P index to provide starting from today’s prices? That’s a good question better explored in a separate article. I’ll say this much here, though. There have been three times in the history of the U.S. market when the P/E10 number reached today’s levels. The average drop in the value of the index on those three occasions was 67 percent (that’s from Robert Shiller’s “Irrational Exuberance” book). That’s too risky for a guy like me, a guy who at times of moderate prices might want to go with a stock allocation of about 60 percent.
How about zero stocks then? Is that the answer?
I don’t think so, at least not for the typical investor. I don’t believe that anyone knows how stocks are going to perform in the next year or two or three or four. If stock prices zoom in the short term and you have nothing invested in them, my guess is that you may come to feel regret in your decision to go with so extreme an allocation. Another way of saying it is that, while the risk/return ratio is not nearly as good as it would be if stocks were at moderate prices, it is not so bad as to justify a zero stock allocation.
The goal of a Staying the Course investor is to maintain roughly the same risk profile in your personal portfolio while Mr. Market sends the risk profile for the S&P as a whole through dramatic up and down swings. For today, that means not sticking with your 60 percent allocation and not dropping to a 0 percent allocation, but going with something in the middle of those two extremes, perhaps 30 percent.
Do I believe in Staying the Course? Conceptually, I do. Stability should indeed be the goal of the long-term investor. But I don’t believe in this bit of advice in the way in which it is usually advanced by Bogle. It’s not stability of the stock allocation that should be the aim. It’s stability of the risk/reward profile that you seek. Staying the Course in a meaningful way requires changing your stock allocation to reflect changes in the risk/reward ratio accomplished through changes in the price level of the index in which you are invested.
Stay the Course — Yes!
Stick with the same stock allocation at alll price levels — No!
The Stock-Return Predictor:http://www.passionsaving.com/stock-valuation.html
Financial Freedom Blog: http://www.passionsaving.com/the-financial-freedom-blog.html