There’s a Big Difference Between Saying That Valuations Matter And Exploring HOW They Matter

Valuations matter.

It’s not a controversial statement. I think it should be. If the market were efficient (which it would need to be for Buy-and-Hold to be a good strategy), valuations would not matter at all. There was a fellow who posted by the name of “SalaryGuru” at a number of discussion boards at which I participated, who often made the case that valuations do not matter at all. I respected him for that. I didn’t agree with him; I believe that valuations matter a great deal. But I admired him for his intellectual integrity. Buy-and-Holders should not be paying any attention to valuations whatsoever. SalaryGuru was a true believer and had the courage to publicly make the case for his beliefs when they were challenged.

Valuations Matter
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SalaryGuru was the exception, however. Most Buy-and-Holders acknowledge that valuations matter. The most commonly expressed view about valuations that I hear from Buy-and-Holders is that investors should expect lower returns on a going-forward basis at times when valuations are high. Few Buy-and-Holders will say that investors should lower their stock allocations at such times. But most will say that it makes sense to anticipate somewhat lower returns at such times.

Q2 hedge fund letters, conference, scoops etc

This is why I am not a Buy-and-Holder. My thought is that each asset class available to an investor should be considered in relation to all the other options. All else being equal, stocks are less appealing at times when the expected return provided is smaller. So an investor who determined that his stock allocation should be 80 percent at a time when he expected stocks to offer a long-term average return of 6.5 percent real should be going with a stock allocation of something less than that at a time when valuations have risen enough to cause him to expect a long-term average return of a good bit less than that. The lowering of the return changes the risk/reward trade-off. The investor seeking to keep his risk profile roughly stable over time MUST lower his stock allocation at times of sky-high valuations to have any hope whatsoever of achieving that goal.

The safe withdrawal rate is a number that drops to as low as 1.6 percent in some circumstances and rises to as high as 9.0 percent in other circumstances.

That’s an extremely controversial statement. If you don’t believe me, remind me some time and I’ll show you the scars. People who are happy to acknowledge that valuations matter are not at all willing even to acknowledge the possibility that the safe withdrawal rate is not always the same number (Buy-and-Holders believe that it is always 4 percent). Why?

Isn’t it a different way of saying the same thing? To say “valuations matter” is to make a theoretical statement. To say “high valuations can push the safe withdrawal rate down to 1.6 percent and low valuations can push the safe withdrawal rate up to 9 percent” is to give that theoretical statement practical application. Why would anyone who shares a belief in the theory object to exploring its practical implications?

It’s because exploring the practical implications of the belief that “valuations matter” gives that belief life. Buy-and-Holders don’t really believe that valuations matter. They really believe that valuations make no difference at all, or that, if they do sometimes matter a small bit, they matter so little that there is no need to calculate their impact so as to take that impact into consideration when making investment decisions. The reason why most Buy-and-Holders acknowledge that valuations matter is that they don’t want to paint themselves into the corner into which my friend SalaryGuru painted himself. It is an historical fact that Robert Shiller showed with peer-reviewed research that valuations matter and was awarded a Nobel prize for doing so. The investor who denies this reality makes himself appear silly by doing so. Most Buy-and-Holders acknowledge that valuations matter so that they can avoid a head-on collision with the 37 years of peer-reviewed research showing that they do.

They don’t take the obvious next step, however. The next step is to explore the many far-reaching and exciting implications of Shiller’s powerful research findings. If valuations affect long-term returns, the safe withdrawal rate is a number that changes in response to changes in valuations. If valuations affect long-term returns, long-term stock returns are to a large extent predictable and the risks of stock investing are thus to a large extent avoidable. If valuations affect long-term returns, investors can obtain higher lifetime returns without taking on added risk by going with the same overall stock allocations but by adjusting their allocations upward at times of low valuations and downward at times of high valuations.

Buy-and-Holders believe in Buy-and-Hold. They like their Buy-and-Hold strategies and do not want to make the shift to valuation-informed strategies. They want to maintain confidence that the numbers on their portfolio statements are numbers that reflect hard economic realities, not numbers that need to be adjusted for the effect of valuations to become useful for financial planning purposes.

Buy-and-Holders say that they believe that valuations matter. But they don’t believe that on a deep level. If they did, the belief would influence their investment choices. And then they would be Valuation-Informed Indexers, not Buy-and-Holders.

Rob’s bio is here.

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