The following is a guest post from Rob Bennett, who writes for A Rich Life. He aims to put the “personal” back into “personal finance” by focusing on the role played by emotion in saving and investing decisions.
Everybody loves the high returns obtained by investing in stocks. Nobody likes taking on the risk that comes with doing so.
The happy reality that few know about is that risk is today almost entirely an optional element of the stock investing story.
Current General Belief
Our belief that stocks are a risky investing choice goes back to the days when investing in stocks meant picking individual companies that would perform well in days to come. That is a difficult business. To pick individual stocks successfully you need to do enough research to figure out which companies have good managers and which companies have a strong product pipeline and which companies produce products and services coming into fashion and on and on. Few of us possess either the ability or time to pull it off.
Everything changed when John Bogle founded the Vanguard Group of funds in the mid-1970s and made index funds available to the average investor. Index funds do well when the U.S. economy does well. Which is pretty much always. The U.S. economy has been generating enough growth to support an average index-fund return of 6.5 percent real for 140 years now.
So the first thing you need to do to eliminate stock investing risk is to invest solely in index funds. You won’t earn as high a return investing in index funds as you would picking the best stocks. But you will never make bad picks. Going with index funds insures that you will always obtain a “good enough” return.
And that’s what most of us are looking for.
Here’s one more step you need to know about.
If stocks were always priced at fair-value levels, indexers would see that 6.5 percent real return every year.
That would be investor heaven. We are not there quite yet.
Stock valuations often go crazy. And the price you pay for stocks makes a huge difference in the long-term return you obtain from buying them. The most likely annualized 10-year return on an index fund purchased in 1981, when valuations were low, was 15 percent real. The most likely annualized 10-year return on an index fund purchased in 2000, when valuations were sky high, was a negative 1 percent real. Even index funds become risky if you fail to take valuations into consideration when setting your stock allocation.
So take valuations into consideration!
My Stance and Shiller
I am the co-author of peer-reviewed research showing that investors who buy only index funds and who take valuations into consideration when setting their stock allocations thereby reduce stock investing risk by nearly 70 percent. That really is investor heaven!
You can never eliminate risk entirely because short-term returns are not at all predictable. But there is now 33 years of peer-reviewed research showing that long-term returns are highly predictable for those who consider valuations. Risk is optional! Go with a high stock allocation when prices are low, a moderate stock allocation when prices are at fair-value levels, and a low stock allocation when prices are high and you cannot lose. That’s not just my opinion. That’s what the entire 140 years of U.S. stock market history available to us today tells us.
This new approach is called “Valuation-Informed Indexing.” It is rooted in the research of Yale Economics Professor Robert Shiller, who won a Nobel Prize last year for his work in this area. It is solid stuff. And it is a very simple strategy to implement. You need to check valuations once per year. And you need to change your stock allocation because of a big swing in valuations perhaps once every ten years. That’s it.
Making that one change in the conventional advice to stick with the same allocation at all times reduces risk by nearly 70 percent. That’s exciting. I think this is the future of stock investing.