I recently posted a Guest Blog Entry at the Balance Junkie blog titled How to Use Valuation-Informed Indexing — Part One.
Juicy Excerpt: There is one important factor that can never be priced in to your purchase of an index fund — overvaluation. To overvalue a fund is to misprice it. Mispricing by definition can never be factored into the price you pay and must be considered separately.
Say that you pay two times the fair price for an income stream of 6 percent real. You obviously are not going to obtain an income stream of 6 percent with that purchase. Your return will not be $6 for each $100 you spend but $6 for each $200 you spend. Your income stream will be 3 percent real.
If you pay three times fair value (stocks were priced at three times fair value in the United States in January 2000), your return will be $6 for each $300 you spend. That translates into an income stream of 2 percent real.
If you pay one-half fair value (U.S. stocks were priced at one-half fair value in January 1982), your return will be $6 for each $50 your spend. That translates into an income stream of 12 percent real.