“A Portfolio with Higher Prices, by Definition, Is More Risky than the Same Portfolio with Lower Prices”

Set forth below are some words put forward by Joe Pitzi, a financial planner, to the comments section for a post at the Nerd’s Eye View blog (run by Michael Kitces, also a financial planner) titled What Is the Difference Between “Being Tactical” and “Market Timing:”

I find it amusing that some planners consider anything other than passive investing to be market timing. What you are describing here as “tactical” is essentially what you find in the teachings of Benjamin Graham. In his book, The Intelligent Investor, he outlines that investors ought to stay between 25% and 75% stocks at all times, and that valuations ought to be the driving force behind that decision. That provides a whopping 50% swing in your allocation to stocks when markets are extremely overvalued versus extremely undervalued. I would hardly call Graham a market timer…which leads me to ask, isn’t this simply value investing?

I submit that this concept is precisely what “value investors” like Grantham, Eveillard, Klarman, de Lardelmelle, Romick, Hussman and Leuthold preach year in and year out.

To your point Steven, there is no reason you cannot integrate a “value investing” strategy using index funds, ETFs, Vanguard or DFA. It doesn’t require “active fund management” to integrate a tactical approach. Furthermore, I completely disagree about your risk comment. You will never convince me that a 60/40 portfolio had the same risk in 2009 as it did in 2007. If you define risk as volatility (as the academic world tends to do), then the portfolio in 2009 actually had more risk. For a long-term investor, I submit that this definition of risk does not make sense. If you define risk as permanent impairment of capital (as value investors do), the opposite is true. A portfolio with higher prices, by definition, must have more risk than the exact same portfolio with lower prices.


  1. Arty says

    Much of the analysis that looked at PE 10 approaches and conventional buy and hold strategies has to do as to what approach will *outperform* using a PE/10-based strategy (if you can agree on an implementation) or buy-and-hold (again, depending on allocation/assets held).

    Perhaps outperformance, per se, is not the best way to look at this. Maybe the kind of emotional experience a strategy provides—that is, how it handles market swings, especially the drawdowns—is a better way to view “success”. I mean, why should I care if the far more volatile approach gives me only a bit more, while the rough ride this must entail threatens my ability to stay in the market, emotionally?

    Perhaps a conservative approach, based on your simple suggestion some time ago, is good for the PE/10 version and my the smooth ride need:

    “If you force me to give one rule on how to implement VII, I would say consider going with a 30 percent stock allocation when the P/E10 value is above 19, a 60 percent allocation down to a P/E10 of 12, and a 90 percent allocation for P/E10 values below 12.”

    For example, the Permanent Portfolio of Browne doesn’t necessarily “outperform” stocks, or some other buy and hold approach that contained a lot of stocks. It did better than most but about as well as many over a long period. But it did supply *smoother rides*, especially in every bear market since 1972.

    The smoother ride approaches may not outperform but permit one to keep more of what they have, and that enables them to stay in the market (for emotional reasons), which in turn is necessary to getting any reasonable returns at all. The same can be said (over the last 40 years) of buy-and-hold “conservative” portfolios that contained less than 40% stocks and the rest in high quality bonds—a smoother ride.

    One question on your example, above what are you suggesting for PE/15, say? Something between 60% (at 12) and 30? Or did you mean to stay at 30% until PE/12 where it goes to 60%. (Funny, but being conservative, I have been at 30% equities for years! )

  2. Rob says

    I agree with you 100 percent re the emotions/smooth ride point, Arty. It is the most important point of all. It gets missed because so much focus is placed on the “What outperforms?” question. But none of the “What outperforms?” analyses are worth a hill of beans to those who have not mastered the emotions/smooth ride question. That one is so important that it trumps everything else.

    In the words you quoted, I was saying 60 percent stocks from a P/E10 of 19 down to a P/E10 of 12.


  3. Arty says

    Various points

    One other point we touched on has to do with what equities to hold while holding any at all. (Here talking about conventional, indexing, not the Harry Browne portfolio). I understand why you’d restrict use to the S&P 500. That is where the Shiller research has been; the S&P 500 alone could be a powerful enough driver of returns. And although a slice/dice of equities approach can outperform the S&P over full market cycles (like these last 10 years, where international plus small plus value has benefitted), I’m not sure I’d use it were I to implement a PE/10-based strategy. After all, many bear markets show ALL risky assets dropping in value—together.

    But In the case where I would recommend a conservative buy-and-hold, I would rather use a slice/dice approach for greater “smoothing” and likely greater *expected* returns long term.

    I’m also looking at periods where buying-in at fair market value PEs (say, around 15) still resulted in long periods (next 10 years) of low returns.

    Here is a chart that shows an updated PE/10. And we can look at times, say 1970, and see such moments.


    Most other times that the PE/10 has been where it is today (PE 23.5) it has not done well in the next 10 years.

    Again, just looking at equities. The last 40 years has featured a bond bull, so if an investor had a lot of high-quality fixed income, and not too many stocks, he did well. Or if he had the Harry Browne portfolio where he always did at least “OK” vs. inflation. You may have a few years where you underperform a broad market index portfolio, but you NEVER had severe losses. And over time, the returns are good as almost any, due to its peculiar correlations of its asset classes. And no timing fuss; just rebalance. Something worth thinking about regarding what we’ve discussed on emotions.

  4. Rob says

    I strongly agree that all investors should be exploring these issues in depth, Arty. I also think that we all need to be hearing a variety of perspectives. My views are not 100 percent in accord with yours. But I certainly don’t suffer under the illusion that there is any magic to my views. You help everyone here out when you share views that are not in accord with mine. I only wish that we had more people doing that.

    I don’t entirely share your take on the 1970 situation. But I think you bring up a fascinating test case of the VII concept. I am giving serious thought to writing one of my columns on that particular test case. There are a lot of interesting things that can be said about it.

    The P/E10 was 17 in 1970. That’s slightly above fair value but indicates a strong long-term value proposition for stocks on a going forward basis. We saw a big drop for the first five years. Then stability (which is good — returns are 6.5 percent real when there is stability) until about 1982. Then another significant drop. Then the best time to own stocks in the history of the United States, extending all the way until January 2000.

    You always need to keep in mind that a core principle of VII is that it is impossible to predict the short term effectively. So we cannot tell people to wait until the huge bull is beginning to get into stocks; we have no way of knowing when the huge bull is going to begin.

    Was 1970 a good time to get in? I think it can fairly be said that it was a not bad time to get in. You lost money for five years (there is a clear possibility that you can lose money buying at 17 — so this was no surprise). Then you did well for nearly seven years. That was enough time for your emotional wounds to heal. Then you took another hit, a short-term one. Then you entered paradise. I see that as a very good long-term outcome.

    Your emotional point is very important, however. NOT ALL INVESTORS COULD TAKE THE TWO HITS. If you cannot take the two hits, you would never have entered paradise. So your end result in real-world terms would have been poor.

    I think that all investing analysis should be centered on the question of what the probabilities are that various sorts of hits are coming and what sorts of tools can be supplied so that investors can determine whether investors in various particular circumstances can take on those hits or not. This is the future of investing analysis, in my assessment.

    IN A GENERAL SENSE, I think it is fair to say that stocks offered a strong long-term value proposition in 1970 and that that strong value proposition was indeed delivered. HOWEVER, I also agree with you 100 percent that not every investor could in practical terms obtain that value proposition for himself or herself and that ultimately it is only the practical that matters. So caveats are entirely appropriate when the P/E10 is 17 and we are in the process of recovering from an out-of-control bull market (as we were in 1970).

    We need to tell both messages. Both are real. There is no one good answer to the question “What stock allocation is best at such-and-such a P/E10 level?” I wish people would stop asking that question. I think that the question itself is an unfortunate by-product of Buy-and-Hold thinking. Once we move away from the Buy-and-Hold silliness, all sorts of possibilities open up to us. One exciting possibility that opens up is the possibility of giving useful, practical, helpful guidance in response to the question “What stock allocation is best at a P/E10 level of 17?”

    Helpful guidance points out that there is more than one returns sequence possible at ALL valuation levels and that the successful long-term investor needs to be well-positioned for any possible returns sequence that might happen to pop up starting from the valuation level that applies on the day he makes his stock purchase.


  5. Arty says

    I thought the PE was a bit lower in 1970 (like 15). No matter. I hear your points here. For me, were I to use the tool, I’d likely use it at the extremes (12 and lower; 25 and higher) and maintain a conservative equity allocation all other times. And, I think that is likely the best use of the tool—extremes—especially when regarding the upper end of valuations, where the potential for big losses lives. (For me, losing big is a crime far worse than not gaining big.)

    And even at fair value, one must be emotionally willing to take some “hits,” as you say. That is why equities always entail risk—unexpected events can happen even at good valuations. It is worth respecting this.

    I understand why you get asked about the stock allocation percentage. It does flow naturally from the proposition about valuations, especially when you voice that proposition strongly, and mean reversion indicates thus. Though, of course, it is not up to you to establish the global answer, for reasons that each individual has circumstances that shape their allocation. You, for example, have no equities. Shiller was waiting for PE 10 in 2009, even at the March lows. So no formulaic answers. Others in different circumstances will also have personal modifications. However, you have, over time and in various posts, given responses that list specific numbers and examples, albeit hypothetical as they must be.

    A different problem today is that the alternatives for fixed income are not as attractive as they have long since been—nowhere. Now, that, of course, is not a reason to go into equities, as many talking heads on CNBC say. Just that this is a time where returns of any sort seem muted until valuations get cleared.

    Finally, have you looked back at the Permanent Portfolio concept? I see they have a large site dedicated exclusively to it. It is firmly buy-and-hold, but of a completely different sort than the conventional, and has for 40 years enjoyed the advantage of not requiring a timing mechanism of any sort (other than rebalancing). I don’t see any conventional flaws in it, though it is “different”. Interesting site name too. Curious to hear you updated views.


  6. Rob says

    It makes perfect sense to use P/E10 only at the extremes, Arty. That’s not the only reasonable way to go. But there’s no question but that the guidance provided is most valuable at the extremes. Things get less compelling as you move away from the extremes. So one way to go is to use P/E10 in circumstances where you can hardly go wrong and let the rest be.

    We disagree a little when you say that equities always involve risk. It is certainly true that you can see price drops of 50 percent starting from fair value. That is a form of risk. But if you study the data enough to understand that that is just part of the game, much of that risk goes away.

    A 50 percent drop starting from high prices is permanent — you will never see that money again. But a 50 percent drop starting from fair value is a temporary thing and nothing for the long-term investor to worry much about. I see much less real risk in the latter scenario. But what I am saying is so only for investors who understand all this. If you don’t understand how it all works, the risk is very real in practical terms (because it affects your decisions).

    I understand why I get asked to give specific numbers too. As a general rule it makes all the sense in the world to ask someone putting forward a new idea to get specific about how it works. The trouble is that Buy-and-Hold is a purely numbers-based model and so people want to see this all reduced to numbers.

    Investing is PARTLY numbers and partly emotions, so it is not reasonable to expect a solely numbers-based analysis to bear good fruit. But people do not know this! Many still believe that Buy-and-Hold is reasonable. So people formulate their questions based on that belief and the expectations behind the questions lead things in an unfortunate direction.

    I haven’t done any further thinking on the Permanent Portfolio concept, Arty. I have a lot of my plate saving our economy from going over a cliff! But I have long found much theoretical appeal in the concept, as you know from our earlier discussions.


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