Valuation-Informed Indexing - A Long-Term Investing Approach
Submitted by Guest on April 18, 2011 - 15:06
As part of our intention to show you different long-term stock market investing strategies, here is a guest post by Rob Bennett on the Valuation Informed Indexing approach.
When people talk about Trend Investing, they are generally making reference to medium-term trends. Trend Investors try to figure out where stock prices will be in the next six months or the next year and then to position themselves to take advantage. I employ a different kind of Trend Investing, Long-Term Trend Investing. I call this approach “Valuation-Informed Indexing.” Valuation -Informed Indexing could fairly be described as a mix of Trend Investing and Buy-and-Hold.
The benefit of Buy-and-Hold is that it is simple. You invest in the market as a whole. The market as a whole has always provided good returns in the long term. You count on that continuing to happen.
There’s one big flaw to Buy-and-Hold, however. When stocks are overpriced, it can take a long, long time for investors to obtain the average long-term return of 6.5 percent real. The Buy-and-Hold advocates don’t like for investors to learn how long it can take for the average long-term return to apply.
Avoid waiting 25 years for good returns
How does the idea of waiting 25 years to see a good return on your money sound to you? If you don’t have 25 years to sit around waiting for the long-term to arrive, you might want to consider taking a pass on Buy-and-Hold.
Investing with the trends would do the trick. It can he hard to pull that off, however. You need to know a lot about investing to know which way to move and when to do so.
That’s not a problem with Valuation-Informed Indexing. With Valuation-Informed Indexing, you go with the trend -- but you go with the long-term trend, not the short-term trend. Valuation-Informed Indexers lower their stock allocations when prices reach insanely high levels and increase their stock allocations when prices reach insanely low levels.
For example, a Valuation-Informed Indexer might go with a 30 percent stock allocation at times of high prices, a 60 percent stock allocation at times of moderate prices and a 90 percent stock allocation at times of low prices.
Do you know how often that works?
It always works. We have historical stock-return data available going back to 1870. That’s 140 years. For that entire time-period, Valuation-Informed Indexing has provided investors with far higher returns than Buy-and-Hold at greatly reduced risk.
It’s not just that Valuation-Informed Indexing always has worked. The better news is that we know that it will always continue to work in the future. Why? Because it must work. If this strategy ever stopped working, the market would collapse.
Stock prices can be two or three times fair value
Stock prices rise to insanely high levels because investors like to vote themselves raises. Stocks were priced at three times fair value at the top of the last bull market. That means that every investor was pretending that the value of his stock portfolio was worth three times what it was really worth.
Those with $100,000 in wealth were pretending that they possessed $300,000 in wealth, those with $200,000 in wealth were pretending that they possessed $600,000 in wealth, and so on. Is it any wonder that that upward price trend remained in place so long? Stock price gains caused by overvaluation look like free money to the investors causing them!
But elementary logic tells us that the days of free money can never last. The market has its ways of pushing prices back to fair value. If it didn’t, it would have collapsed a long time ago.
So the same pattern has applied since the day the market opened for business: Over the course of 15 or 20 years investors push stock prices up to two or three times fair value and then over the course of 10 or 15 years they push them back down to one-half of fair value. We are today about halfway through the long-term downward path of this particular boom-bust cycle.
Valuation-Informed Indexers don’t worry about when the turns are going to take place. You don’t need to know that to benefit handsomely from the long-term trend. All you need to know when stock prices are high is that the long-term value proposition of stocks is poor and that when stock prices are low the long-term value proposition of stocks is fantastic.
If the idea holds any appeal to you, I invite you to look at recent academic research that shows that Valuation-Informed Indexing has outperformed Buy-and-Hold in 102 of the 110 30-year rolling time-periods in the historical record. That’s good enough for me!
Rob Bennett has created a stock cycles calculator called “The Returns-Sequence Reality Checker.” His bio is here.
Next & Previous Blog Post
- ‹ previous
- 79 of 174
- next ›
