Valuation-Informed Indexing is the approach to investing that I developed as a result of my mid-1990s research into what the historical stock-return data says about how to invest successfully for the long term. My bare-bones understanding of what the data says was greatly enhanced by the investing discussions held by the Financial Freedom Discussion-Board Community from May 13, 2002, forward, collectively referred to as The Great Safe Withdrawal Rate Debate.
Scores of community members contributed to the effort, as did a number of investing experts from outside our community whose views we either solicited or consulted at various stages of the debate. John Walter Russell (owner of the Early-Retirement-Planning-Insights.com site) offered such outstanding community service over so long a period of time that he should be viewed as co-developer of this exciting new investing approach. Please understand, however, that the words below are mine alone and that Russell, the other community members, and the experts who contributed to the development of the concept do not share all of my investing views.
Set forth below are brief descriptions of the twelve key tenets of the Valuation-Informed Indexing investing approach.
The first tenet of Valuation-Informed Indexing is that planning is key to effective money management.
I put my faith in the conventional investing wisdom prior to the mid-90s, when I was putting together my plan for making a transition from the world of corporate employment to the far-more financially uncertain path of a freelance writer of nonfiction books. Given my family responsibilities, it was not possible for me to make that transition without first putting into place reliable income streams that would cover the essential spending categories in my budget–categories like housing and groceries and health insurance. It was my need to plan for this form of early “retirement” (from only those aspects of the work experience that I did not enjoy) that caused me to examine the historical stock-return data on my own rather than taking what I picked up from listening to the conventional stock-market investing advice on faith.
Those seeking financial freedom early in life must plan. That is the most basic rule of all. Planning is what makes you an effective saver. Planning is what makes you an effective investor. The reason why so many middle-class workers fail to obtain full value from their earnings is that they are not motivated by the conventional money advice to plan. Planning is what makes those who congregate at this site and at our community boards different from those who do not.
Valuation-Informed Indexing is a planner’s approach to investing. The primary reason why so many other middle-class investors find the conventional investing strategies “good enough” is that they are not planning to win financial freedom early in life. It is the drive to enjoy the benefits of effective money management well before turning 65 that drives Passion Savers to come up with something better.
In the investing area, the Valuation-Informed Indexing strategy is the tasty fruit of that all-important drive that we feel so much more than most others to plan our financial futures. This means that, as we evaluate new ideas, our focus is often on how they will serve our common desire to plan effectively.
The second tenet of Valuation-Informed Indexing is that planning must be at least partly numbers-based.
There are many considerations that must be taken into account in writing an investment plan. You need to form an assessment of your risk tolerance. You need to take into account whether you can count on a pension or on Social Security to cover some of your living expenses. If you are married and can in a pinch take advantage of the earnings of a spouse, that makes a difference. If you have children and hope to be able to pay for their college educations, that makes a difference. And so on.
Ultimately, all of these considerations must be reduced to numbers to be reflected in your Passion Saving plan.
There’s no getting around it.
It’s hard to reduce all of the various considerations to numbers. You don’t really know how much college is going to cost and you don’t really know how much you will obtain from Social Security. But if you are completely unable to assign numbers to the factors affecting your plan, you cannot assemble a plan that will do the job that you need your investing plan to do. The numbers assigned to many of the elements of your plan will be nothing more than educated guesses. But there must be numbers assigned to them for them to be taken into consideration in the investing plan at all.
The third tenet of Valuation-Informed Indexing is that the historical stock-return data provides the best numbers-based guidance available on how stocks will perform in the future.
It was the need for numbers-based planning that caused me to turn to the historical stock-return data for help in putting together the investing side of my Passion Saving plan. The historical data provides guidance that permits you to translate your vague and uncertain investing theories into hard and objective numbers.
The historical data does not provide perfect guidance. It would be good if we had a larger data set. It would be good if we knew for certain that stocks will perform in the future as they have in the past. It would be good if there were no anomalies in the data set. Still, we have no choice but to make use of the data set we have. There is no better source of guidance available for us to make use of in trying to form realistic expectations of what sorts of income streams our investments will generate for us.
Our data set is flawed. It is the best data set we have available to us. We must never lose sight of the flaws when stating our findings. We must never lose sight of the reality that the flawed data set available to us is the best source of guidance we possess all the same.
The fourth tenet of Valuation-Informed Indexing is that it is far too soon in our examinations of the historical data to be reaching dogmatic conclusions.
The Stocks-for-the-Long-Run Investing Paradigm is the dominant investing paradigm of our day. It is a paradigm that offers great insights. It is also an investing paradigm that is terribly flawed. The worst mistake that has been made by those who have advocated the Stocks-for-the-Long-Run Investing Paradigm has been their inclination to engage in excessive dogmatism. Those of us seeking to develop a new Data-Based Paradigm need to work hard to avoid that mistake.
Are stocks a wonderful investment class? The historical data indicates that stocks are indeed a wonderful investment class. Are stocks always the best place to put all of your money? The historical data indicates that stocks are not always the best place to put all of your money. Is short-term timing difficult to pull off profitably? The historical data indicates that short-term timing is indeed difficult to pull off profitably, but that long-term timing is not nearly so difficult to pull off profitably.
Over and over again we see the same pattern play out in pronouncements made by advocates of the Stocks-for-the-Long-Run Investing Paradigm. What often happens is that a valuable insight is developed and then exaggerated to a point where its value is put into question or to a point where the advice following from the insight is actually so misleading as to be dangerous to the investors making use of it. The now-dominant investing paradigm is a paradigm rooted in half-truths.
Valuation-Informed Indexing is a non-dogmatic investing approach. Those of us following this approach aim not to be so open-minded that our brains fall out. But we also aim for humility. One thing we know from the historical data is that too-readily-accepted investing wisdom is foiled again and again and again. We aim to put forward non-dogmatic descriptions of the insights we uncover and develop and sharpen together.
Should most investors lower their stock allocations at times of extremely high valuations? The historical data says “yes.” Should all investors sell all of their stocks each time valuations go a little above the moderate range? That’s far too dogmatic a statement for Valuation-Informed Indexers to endorse.
These are all sorts of questions that we are only beginning to research. We are very much in the early innings of this ballgame. We know what we know. But one of the things we know is that there is a lot that we do not yet know.
The fifth tenet of Valuation-Informed Indexing is that it is important to distinguish between the Accumulation Stage of our investing life-spans and the Distribution Stage of our investing life-spans.
The annualized long-term real return on stocks is a number a bit below 7 percent. Does it follow that it is safe to take a withdrawal rate of 7 percent in retirement? It does not. In retirement, you are in the Distribution Stage of your investing life plan, a stage in which you are taking from the portfolio rather than adding to it. During the Distribution Stage, sharp drops in stock prices do far more damage than they do during the Accumulation Stage.
The most important contribution of the conventional methodology safe withdrawal rate studies (The Trinity study and its progeny) is their data-based demonstration of the distinction between the Distribution Stage and the Accumulation Stage. William Bernstein, author of The Four Pillars of Investing, referred to the Trinity study as “breakthrough research” for the help it provided investors in making the critical importance of this distinction clear. He was right to do so.
One cannot say that because the safe withdrawal rate (a Distribution-Stage concept) at a given valuation level is 2 percent that the expected real return for those in the Accumulation Stage is 2 percent. One cannot say that because a realistic real-return expectation for those in the Accumulation Stage at a given valuation level (and for a specified time-period) is 9 percent that the safe withdrawal rate is 9 percent. The realities of the Accumulation Stage and of the Distribution Stage are not the same (there are some realities that the two stages have in common, of course).
The sixth tenet of Valuation-Informed Indexing is that in the real world (in contrast to the theoretical world studied by academics) the distinction between the Accumulation Stage and the Distribution Stage is not always entirely clear.
I count on the earnings from my investments to cover some of my costs of living in years in which my writing income is not sufficient by itself to do so. The income I bring in from my writing work will likely be enough in some years for me to add to my portfolio rather than to need to subtract from it. Am I in the Accumulation Stage or in the Distribution Stage?
I have one foot in both stages. That’s true for a lot of folks, although generally to a lesser extent than it is for me. The line between the Distribution Stage and the Accumulation Stage is often not a thick bold line.
If you retire at age 60 and expect to begin receiving a pension at age 65, you are not entirely in the Distribution Stage in regards to the portfolio amount you had in your possession on the day you retired. In five years, a new income stream will come into effect to help you cover your living costs. You need to make adjustments to safe withdrawal rate analyses for them to be meaningfully applicable to your particular circumstances.
If you are age 40 and seeking to retire at age 50, you do not hold the attitudes toward potential investing outcomes that the conventional safe withdrawal rate studies presume are held by investors in the Accumulation Stage. The presumption is that the investor feels no concern about short-term drops in the value of his portfolio, that even a halving of his portfolio will not prompt him to sell any shares. Someone with a desire to within 10 years put the income streams generated by his portfolio to use covering his costs of living is probably not emotionally prepared to endure a 50 percent drop in his portfolio value without flinching. He needs to modify the lessons of the historical data to make them applicable to his particular circumstances.
The seventh tenet of Valuation-Informed Indexing is that the conventional safe withdrawal rate methodology is analytically invalid for purposes of determining safe withdrawal rates.
The conventional safe withdrawal rate methodology studies constituted breakthrough research. That said, they did not constitute accurate research. All conventional studies get the safe withdrawal rate number wrong.
The error was not intentional. But it was serious. For retirements beginning in January 2000, the conventional studies show a safe withdrawal rate of 4 percent for a portfolio comprised of 80 percent S&P stocks and 20 percent short-term Treasuries. The number you get from an analytically valid study of the historical data is 1.6 percent. That’s a difference between a retiree handing in his resignation with $1.5 million saved living the last 30 years of his life on $60,000 per year and living the last 30 years of his life on $24,000 per year. That’s no rounding error.
The conventional safe withdrawal rate methodology is analytically invalid for purposes of determining safe withdrawal rates because it fails to take into account the critical factor of changes in valuation. The historical data shows that valuation changes are the most important factor that goes into determining safe withdrawal rates. It is not possible to calculate the number accurately at times of low or high valuation without taking the valuation factor into account.
The Valuation-Informed Indexing approach is a non-dogmatic approach. It is too early in the game to say which of the various analytically valid approaches that we have examined so far will prove to be the best. It is not too early, however, to declare that valuation has an effect and thus must be taken into account in some way. Bernstein says that valuations affect long-term returns as a matter of “mathematical certainty.” That’s as strong a phrase as could possibly be used, and all of the research that has been put forward during the first 41 months of the Great Safe Withdrawal Rate Debate backs up Bernstein on that point.
The conventional safe withdrawal rate studies calculate the Historical Surviving Withdrawal Rate (HSWR), not the Safe Withdrawal Rate (SWR). The HSWR can be used as a not-too-bad approximation of the safe withdrawal rate at times of moderate valuation. At times of low or high valuations, use of an analytically valid safe withdrawal rate analysis is required for Passion Savers seeking to put together an investing plan helping them to achieve financial freedom early in life.
The eighth tenet of Valuation-Informed Indexing is that valuations matter.
The point of Valuation-Informed Indexing is, just as the name suggests, to take valuations into account when developing investing strategies. Stocks provide a far better long-term value proposition when purchased at times of low or moderate valuations than they do when purchased at times of high valuations.
Valuation-Informed Indexing not only permits you to avoid the full hit experienced by other investors when stock prices take a big drop. Valuation-Informed Indexing also permits you to buy more stocks when their prices are appealing. Valuation-Informed Indexing is a win-win investing approach, presuming that stocks perform in the future much as they always have in the past.
Take valuations into account when setting your portfolio allocations, and you will likely attain financial freedom many years sooner than you would have had you failed to take valuations into account. That’s why the Valuation-Informed Indexing approach is the focus of most investing articles published at the PassionSaving.com site.
The ninth tenet of Valuation-Informed Indexing is that there is no one optimal stock allocation.
One of the ideas you sometimes see put forward by advocates of the Stocks-for-the-Long-Run Investing Paradigm is that it is possible through manipulations of numbers to determine the best stock allocation for all investors at all valuation levels. It’s not so, at least not according to the historical stock-return data.
Valuation-Informed Indexing is a customized investing approach. It is an approach for investors who understand that they will likely obtain more value for their investing dollar by crafting plans that make sense for their particular life circumstances rather than making use of prefab investing strategies purporting to be effective across-the-board.
The tenth tenet of Valuation-Informed Indexing is that a revolution is needed in our understanding of what sorts of investing strategies are most likely to lead to long-term investing success.
Please take a look at this article to read the argument for why Valuation-Informed Indexing is rooted in a rejection of the conventional stock market investing advice of today.
The eleventh tenet of Valuation-Informed Indexing is that buy-and-hold investing is a far more complicated and difficult (but effective!) strategy than it is often portrayed to be.
The article linked to above includes a discussion of why buy-and-hold investing is more difficult to pull off than many today realize, and why the Valuation-Informed Indexing approach places a focus on learning what it takes to engage in realistic buy-and-hold strategies.
The twelfth tenet of Valuation-Informed Indexing is that the primary driver of investing decisions is emotion, not reason.
Are investors all acting rationally to pursue their self-interest? Is the market efficient (as that term is commonly understood)? The answers are “no” and “no.”
Investors are rational in many ways, of course. And the market appears to be efficient in some important respects too. But valuations would not reach the extreme levels at which they are at today if the markets were entirely efficient. And investors would adjust their portfolio allocations when valuations went to such high levels if investing were an entirely rational process.
Emotions always come into play when you make investing decisions. We saw that clearly during The Great Safe Withdrawal Rate Debate when defenders of conventional safe withdrawal rate studies engaged in all sorts of highly emotional claims to frustrate our community’s desire for reasoned debate on what the historical data really says about how to invest successfully for the long term.
Our community is comprised of some of the greatest savers in the world. We have more to invest than most. So we have more at stake than most in the project of coming to an accurate understanding of what the historical data says. Yet many community members directed large amounts of their life energies into blocking the discussions rather than adding constructively to them.
Why?
A review of the Post Archives shows that it is an emotional desire not to acknowledge the errors of failed and failing investing strategies that was the driving force behind many defenses of the conventional methodology studies. The safe withdrawal rate is a data-based construct. If the data does not support the findings of a methodology, there is obviously a serious problem with that methodology. There are serious problems with the conventional methodology. But it is hard for a good number of investors who experienced success using the Stocks-for-the-Long-Run Investing Paradigm to acknowledge those problems.
Valuation-Informed Indexing is a numbers-based approach to investing. It is a reasoned approach to investing. But those of us making use of this approach do not pretend for 10 seconds that we are above the emotion-related influences that have so many times in the past crushed the investing dreams of middle-class workers. We use what we learn from our analyses of the historical data to rein in our emotions, to help us to invest at least a bit more rationally than we otherwise could.
We don’t always get it right. Advocates of Valuation-Informed investing need to be wary of being betrayed by our emotions, as have so many of the advocates of the Stocks-for-the-Long-Run paradigm. At least we are aware of the dangers and are putting a serious effort into the project of overcoming them. That is the defining characteristic of this exciting new approach to investing. We acknowledge the power of emotion in the investment decision-making process, and are doing what we can to come to terms with it and even to transform it into a positive.