Those investing in index funds must consider valuations when setting their stock allocations. This article explains why.
Strategic Consideration #1 for Those Investing in Index Funds: The Availability of Indexes Does Not Do Away With the Need to Think Strategically
The introduction of index funds in the mid-1970s changed the history of stock investing in a dramatic way. We are only now (this article was posted in June 2011) beginning to come to terms with the significance of this innovation.
Stock pickers succeed or fail based on whether they are able to successful identify successful companies or not. Indexers of course do not need to worry about this. So in the early days of indexing the conventional wisdom has been that there is not need for indexers to employ investing strategies. All they need to do is to buy the indexes and hold them and they are sure to make out well in the long run, according to this line of thinking.
No! It doesn’t work like that.
Indexers must be strategic in their purchases of index funds to hold any realistic hope of long-term success. It is true that the strategic considerations that apply for indexers are different from those that apply for stock pickers. But it is a terrible mistake to think that by virtue of buying index funds rather than picking stocks you have freed yourself from the need to adopt smart investing strategies.
Strategic Consideration #2 for Those Investing in Index Funds: All Factors Other Than the Price At Which the FInd Is Being Sold Are Immaterial
The strategic considerations that matter for indexers are certainly different than those that matter for stock pickers. Stock pickers need to consider whether the business they are buying has sound and ethical management, a good pipeline of new products, a moat that protects their profit-making potential from competitors and on and on. None of those considerations matter for those investing in index funds. Those investing in index funds will own some companies with good management and some companies with bad management, some companies with good product pipelines and some with poor product pipelines, some with effective moats and some lacking effective moats.
It is this difference that has led many to believe that indexers need not worry about strategy and may profitably follow a Buy-and-Hold strategy. What these people are overlooking is that there is one factor that remains of great strategic importance for indexers: the price at which they purchase the index fund.
Strategic Consideration #3 for Those Investing in Index Funds: Mispricing Can Never Be Priced In
The question of how strong management is, how good of a product pipeline is in place, how effective a moat exists — these are all “priced in” when you purchase an index fund. But there is one factor that can by definition never be priced in — Mispricing!
Think for a moment what it means to say that an index fund is overvalued or undervalued. It means that the index fund is mispriced. Mispricing can never be priced in. So those investing in index funds must take the extent of overvaluation into consideration when making an index fund purchase.
Strategic Consideration #4 for Those Investing in Index Funds: The Effect of Overvaluation or Undervaluation Is Huge
The overvaluation factor is no small factor.
Stocks were priced at one-half fair value in 1982. They were priced at three times fair value in 2000. That means that your investment dollar possessed six times the buying power when used to make index fund purchases in 1982 than it possessed when used to make index fund purchases in 2000. It is not possible to ignore that strategic consideration and invest effectively.
Index funds offered an amazing value proposition in 1982. A regression analysis of the historical stock-return data shows that the most likely annualized 10-year return for stocks purchased at the prices that applied in 1982 is 15 percent real. In contrast, the same number for stocks purchased at the prices that applied in 2000 is a negative 1 percent real. Those purchasing stocks in 2000 were essentially buying a different asset class from those who purchased stocks in 1982.
Strategic Consideration #5 for Those Investing in Index Funds: Valuations Matter More for Indexers Than They Do for Stock Pickers
There are always some stocks that offer a strong value proposition, even at times of insane overvaluation. Stock pickers would be smart to lower their stock allocations at times of overvaluation but it is not critical that they do so.
If stock pickers pick good stocks, they can avoid the worst risks that follow from investing in stocks at times of overvaluation. Indexers obtain the market return. There is no escape from the dangers of going with a heavy stock allocation at a time of overvaluation for those investing in index funds.
Strategic Consideration #6 for Those Investing in Index Funds: Indexers Must Employ Strategic Asset Allocation
Most indexers follow Buy-and-Hold strategies. That is, they stay at the same stock allocation at all valuation levels. Some employ what Tactical Asset Allocation. That is, they lower their stock allocations a small amount when they believe stocks will be performing poorly in coming months and they increase their stock allocations a small amount when they believe stocks will be performing well in coming months.
The need for an indexer to lower his stock allocation at times of high prices is not a tactical need. It is a strategic need. Vanguard Founder John Bogle says that the most important rule of indexing is that indexers should aim to “Stay the Course.” He’s right. But Bogle often fails to point out that investors seeking to Stay the Course in a meaningful sense must lower their stock allocations at times of insanely high prices (like those we have experienced during the time-period from 1996 forward).
Stock risk is not evenly distributed. The historical return data shows that stock risk is minimal at times of low prices and sky-high at times of high prices. Stocks have never provided a poor long-term returns starting from times of low or moderate prices. Stocks have never provided an appealing return starting from times of sky–high prices. Most stock risk is concentrated in those times when prices are out of control. The indexer who fails to lower his stock allocation at such times thereby permits his risk profile to go wildly out of whack He thereby fails to honor Bogle’s injunction to “Stay the Course!”
Keeping your risk profile roughly constant is a strategic consideration, not a tactical consideration. Indexers who fail to adjust their stock allocations in response to big price swings are permitting Get RIch Quick emotional impulses to overcome their ability to make rational asset allocation decisions.
Strategic Consideration #7 for Those Investing in Index Funds: Indexing Can Be a Virtually Risk-Free Way to Invest in Stocks
The risk of stock investing can never be eliminated for stock pickers. Even Warren Buffett makes mistakes. No matter how careful your research, it is never possible for a stock picker to invest in a virtually risk-free way.
This is not so for indexers. Since all risks except the risk of investing heavily in stocks at times of massive overvaluation are eliminated by investing in index funds, all that an indexer needs to do to overcome most investing risk is to abandon Buy-and-Hold strategies and instead follow valuation-informed investing strategies. That is, indexers must lower their stock allocations when valuations and risk are high and increase their stock allocations when valuations and risk are low.
A statistical analysis shows that the valuation level that applies on the day an index fund is purchased tells the investor 78 percent of what he needs to know to identify the price that will apply for that index 20 years down the road. Risk is uncertainty. Most uncertainty is eliminated for Valuation-Informed Indexers.
Indexing is the future of stock investing. It is likely to cause massive wipeouts for the many indexers who have followed Buy-and-Hold strategies. But once we all become better informed as to how to investing in index funds can be accomplished in a strategically intelligent manner, this new approach to investing will offer huge rewards for many millions of middle-class investors.
Indexing is the future of middle-class investing and Valuation-Informed Indexing is the future of indexing!