Buy and hold investing doesn’t have to be about tenaciously sticking with what you’ve picked no matter what happens. However, there’s an interesting twist on buy and hold investing called valuation informed indexing. While there is a bit of a battle going on between the advocates of buy and hold and those that favor valuation informed indexing, from an outsider standpoint, there are definite similarities between the two.If you are concerned that buy and hold doesn’t quite fit your investing style and needs, but are afraid to wade into the waters of market timing, valuation informed indexing might not be a bad way to go.
Rob Bennett has been advocating valuation informed indexing for years, and his insistence on it has even had him kicked off investing forums, including the Bogleheads forum.
“Buy and hold is intellectually dead,” he says. “It’s not practically dead, since plenty of investors still use the theory, but intellectually it’s been dead for more than 30 years.”
Long-Term Market Timing
Bennett points out that the biggest pitfall of buy and hold is it doesn’t allow for any market timing at all. “It’s true that short-term market timing doesn’t work,” he says.
“Eugene Fama deserves the Nobel Prize [in Economics] for his work. His discovery was short-term market timing doesn’t work. However, his paper was written up saying market timing doesn’t work. They didn’t even look at long-term timing.”
So, what is long-term market timing?
Bennett says it’s possible to time the market over the long-term by looking at periods of 10 years. This is the basis on which valuation informed indexing is founded. Rather than just looking at short-term valuations — what a stock or an index is valued at now — valuation informed indexing is based on PE 10.
The concept of looking at long-term valuations was introduced by Benjamin Graham and David Dodd in Security Analysis. They suggested that a multi-year average of earnings per share should be used when evaluating which assets should be considered “value” investments.
Robert Shiller, another Nobel winner, suggested the time period should be 10 years, and he popularized the idea of PE 10, which is the average value over a 10-year period. PE 10 can then be expressed as a number. Between 1881 and November 2013, the ratio expressed by PE 10 has varied from 4.78 (December 1920) to 44.20 (December 1999).
Valuation informed indexing is a way to take PE 10 and use it to engage in long-term market timing. “PE 10 shows that valuations matter,” says Bennett. “As it goes up, so does the risk.” He points out that PE 10 provides insights into what could be coming. “If you look at overvaluation just before the dot com crash, and reduce it to dollar terms using PE 10, you would see that the market was overvalued by about $10 trillion.”
Understanding how that works can allow you to shift your assets. Bennett favors using index funds, since it prevents the need for stock picking, and you are working with large swaths of the market. When it appears that the PE 10 ratio is getting rather high, it’s time to sell your stock index funds (while you can get a decent price) and move your money into an index fund that follows a different asset class.
“The only real change from buy and hold,” Bennett says, “is that it is about staying the course, while valuation informed indexing is about making changes to manage your risk profile. I say to keep your risk profile constant, while buy and hold is about keeping your asset allocation constant.”
How to Use PE 10 in Valuation Informed Indexing
If you are interested in valuation informed indexing, Bennett suggests the following plan:
- When the PE 10 value is below 18, a high stock allocation makes sense.
- When PE 10 is between 19 and 22, Bennett says it’s time to shift to perhaps a 50 percent stock allocation.
- And, when PE 10 gets above 22, he would drop to a 25 percent stock allocation.
As of this writing, the current PE 10 ratio (for the S&P 500) is 24.99. An economic crisis is considered imminent at a PE 10 ratio of 25.
Bennett says there are other rules of thumb you can use when guiding your investment policy using PE 10 and valuation informed indexing. “I worked with a professor who was at Princeton, Wade Pfau, and we found you can get better returns when you pay attention to valuation and invest accordingly,” Bennett says. “Try a 90 percent stock allocation when stocks are valued low, 60 percent when they are moderate, and 30 percent at high prices.”
These two different plans can be tweaked according to your own risk profile and needs, but the idea is essentially the same: Use index funds to put together an appropriately diverse portfolio, and then use PE 10 values to help you determine when it’s time to change your asset allocation.
“Buy and hold might say you keep it steady at 60 percent stocks, no matter what,” says Bennett. “But Pfau and I found that just by using valuations to adjust your allocation to keep your risk profile steady, we reduced risk by 70 percent and increased returns dramatically.”
So, What’s the Catch to Valuation Informed Indexing?
“You have to wait 10 years,” says Bennett. “It doesn’t happen in one year, or two years, or three years. It doesn’t work in the short-term. Think about Warren Buffett. He makes intelligent picks and they don’t always pay off immediately. This is the same idea. If you don’t have the patience to keep with it for 10 years, it’s not for you.”
Bennett is also quick to point out that your “10 years” starts from whenever you adjust your portfolio, since PE 10 looks at the average outcome for 10-year chunks of time. “When stocks are too overpriced and you put the money somewhere else, you have to wait 10 years for that decision to pay off,” he says.
That doesn’t mean that you doggedly stick to your decision for the next decade, though. Valuation informed indexing is about switching it up when it makes sense. “I suggest looking at PE 10 value every year,” Bennett says. “Make a change to your portfolio only if the PE 10 value changes dramatically. You don’t need to change it up for a difference of only one or two points.”
“Look at PE 10 today, and use it as a predictor,” he continues. “In most years, you won’t have to make any adjustment. However, since it’s an average, you might need to make a change two years in a row, or leave it for a long time. For example, from 1982 to 1996, you would never have needed to make a change.” Bennett has a number of tools on his web site, including a stock return predictor that uses PE 10, that can help you plan ahead.
“People plan their lives based on the amount in their portfolios today,” Bennett says. “When it falls, they get depressed.” Instead, he suggests investors take a longer term approach. Valuation informed indexing, based on PE 10, can help them do that.
What do you think of this strategy? Would you use it for your portfolio?