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.
John says
Clearly it is important to calculate the index fund properly in order to achieve the desired return.
But the real issue is how do you determine if an index fund is over or under valued?
Rob says
Thanks for stopping by, John.
I believe that P/E10 (the price of the index over the past 10 years of earnings) is the best valuation metric.
But the important thing is that all investors be informed that they need to use SOME valuation metric. Buy-and-Holders are not adjusting their stock allocations in response to valuations AT ALL. This is why our economy is in the mess it is in today.
If we achieve a consensus that occasional allocation changes are required, then we will have lots of people doing the research needed to figure out what works best and our tools will get better and better over time. Today, progress is stalled while we wait for the Buy-and-Hold advocates to get up to speed on the ABCs.
Rob
Van Beek - Trend Investing says
A question: Suppose that the majority of all investors would start using VII, what would that mean for how the stock market behaves in terms of busts, booms and cycles? Less severe booms and busts I suppose since inflow and outflow of money from the market would smooth those patterns?
And what would be the impact on ETFs and Mutual Funds when many people apply VII?
Rob says
I think you have it exactly right, Van Beek — the more people who follow valuation-informed strategies, the less volatility we would see with prices. Stocks would go up roughly 6.5 percent real per year because that is the amount of gain justified by the added productivity that comes with an added year of work effort by all the people employed by all the various companies.
Stocks would pay the same high returns they have always paid. But this would become a virtually risk-free asset class. People often say that stocks are risky. But they fail to point out what causes the risk. The cause of the risk is investor emotion. If we help people understand what is going on with prices, the emotion goes away — people become capable of investing rationally. And we all benefit as a society when they do so. Stock risk is optional and it is by teaching people about the effect of valuations on long-term returns that we elect as a society not to experience it.
This would mean huge economic growth. It is the boom and bust cycle in the stock market that causes recessions and depressions. This can be verified by checking the historical record. If we permit honest posting on what the academic research of the past 30 years says, we will have a far more stable economy. That means lower unemployment. And less money being spent on government stimulus programs. And less friction between Democrats and Republicans and all this sort of thing. It’s a win/win/win/win. There are no losers.
This is why we have a First Amendment protecting our right to free speech. Our society is a dynamic one. That means that we achieve growth through new ideas. This new idea is being blocked by people who profited from promotion of the discredited old idea (Buy-and-Hold is rooted in a presumption that the market always sets prices properly but the research that some people believe shows this was discredited by subsequent research published from 1981 forward and ignored until now) who don’t want to give up the status they obtained pushing that idea. Our Constitution says that we must permit the new idea to compete with the old idea, and, if there are people who don’t want to see the old idea fail in the court of public opinion, that’s just too darn bad for them. I think that the people who wrote the Constitution were smart people. I think we have benefitted as a people from many great new ideas in the past and this is just one more particularly compelling evidencing of that same wonderful phenomenon.
Thanks much for stopping by and asking that very important question, Van Beek.
Rob