I’ve posted Entry #341 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Effect that Valuations Have on Long-Term Returns Is Consistent Across the Range of Valuation Levels.
Juicy Excerpt: Valuations affect every aspect of the stock investing experience. Too often discussions of valuations are rooted in a presumption that the purpose is to guess when valuations are going to turn and to profit from the guessing game. That the one thing that Shiiller’s research findings do not help the investor to do; short-term price changes are highly unpredictable. The power of Shiller’s finding that valuations affect long-term returns is that it illuminates every question faced by investors other than the silly guessing-game one that garners so much attention.
Say that you were thinking of buying a car. You obviously would ask the dealer for the price. You don’t do that for a single purpose. Knowing the price serves multiple purposes. It tells you whether you can afford the car or not. It also informs you how you may need to adjust your desires to identify the car that is right for you; by comparing the prices of two cars, you can see how much one feature you like adds to the overall cost and assess whether that feature is worth the cost associated with it. Knowing the price attached to a used car with a specified number of miles on it signals how new of a car you can afford. Knowing the price of a car advances your car purchase project in many ways and the same is true with knowing the valuation level for stocks — identifying the P/E10 level tells you all sorts of things that you need to know to make an intelligent investment decision.
Long Time Hoco Researcher says
Valuations affect ~40% of future returns. Obviously they don’t illuminate every question an investor might have. Unless of course that investor is delusional is is the narcissistic, passive-aggressive, mentally ill internet troll and Habitual Liar Rob Hocus No Step 2 Bennett.
Rob says
40 percent is HUGE, John.
And please remember that whether that 40 percent works for the investor or against him is entirely in the control of the investor. Investors who go pure Get Rich Quick always have that factor working against them. Investors who are open to taking a look at the last 36 years of peer-reviewed research always have that factor working for them. Having a 40 percent factor always working for you rather than always working against you adds up over the long-term.
There is no other change that an investor can make that makes as much difference to his long-term success as being willing to toss the smelly Buy-and-Hold garbage into the nearest trashcan and take the findings of the last 36 years of peer-reviewed research in this field into consideration. I think it would be fair to say that most Buy-and-Holders possess at least a sense of how big a deal this is. Otherwise, what would explain the behavior that we have seen over the first 15 years of The Great Debate?
I would never go back to Get Rich Quick having seen what a difference it makes to take the last 36 years of peer-reviewed research into consideration. Knowing that the entire historical record of stock performance in on his side gives an investor the confidence he needs to stick with his plan for the long-term.
If you ever come across any factor that is even one-tenth as important to long-term success as taking valuations into consideration, I would be grateful if you would tell us all what that factor might be, John. Please mark me down as highly skeptical that you will ever be able to do so.
My best wishes.
Rob
Laugh says
You could also say that the folks with the 40 percent working for them have 60 percent working against them.
Which side to be on? And btw, that 40 percent only applies to a fairly narrow time band. It gets worse the farther out you go or farther in.
Rob says
Those who take advantage of what we know about the 40 percent don’t thereby lose the benefits of what we know about the 60 percent. We get the best of both worlds. Knowing about the effect of valuations on long-term returns is a win/win/win/win/win.
As for the time-band, what you are saying is so for time-periods of less than 10 years. The peer-reviewed research shows that short-term timing never works. Those who truly follow the peer-reviewed research know that.
The correlation between valuations and long-term timing is strong at 10 years, at 15 years and at 20 years. That’s not a “narrow” time-period. It’s 10 years. It is very important to know how your stock investing is going to do 10 years out and 15 years out and 20 years out. Consider the safe withdrawal rate question. Retirements either succeed or fail based on how they do in the early years. Knowing how a retirement is going to do in 10 years is HUGE in trying to assess whether it will succeed or fail. It’s impossible to come up with SWR numbers that are even in the right ballpark without taking valuations into consideration.
And the gains that Valuation-Informed Indexers see at 10 years and 15 years and 20 years continue to affect their portfolio size for the rest of their lifetimes. An investor who sees 2 points of added return for 10 or 15 or 20 years is going to be able to retire so many years sooner than one on the short end of that stick that it isn’t funny. Buy-and-Holders who invested heavily in stocks in 2000 gave up 5 percentage points of return for 10 years running by doing so. Those added gains go into their portfolios and generate compounding returns for the remainder of their lifetimes. Compounding returns is the eighth wonder of the universe. It is not possible for a Buy-and-Holder ever to catch up after making a mistake like that.
The last 36 years of peer-reviewed research is telling us something important, Laugh. I am 100 percent sure.
Please take good care.
Rob