It Can Take 20 Years For Sound Long-Term Investing Strategies To Pay Off

| June 30, 2016

Tip to trade penny stocksJust about everyone agrees that it’s smart for stock investors to take a long-term focus. What most do not yet realize is how much Shiller’s “revolutionary” (his word) finding that valuations affect long-term returns changes our understanding of what constitutes “long term.”

Many investors have a hard time not being influenced by the day-to-day news. Buy-and-Holders properly dismiss weekly, monthly and even yearly developments as so much “noise.” But Shiller’s research shows that even looking two or three or five years out is not enough. Stock risk diminishes dramatically when returns become highly predictable and that doesn’t happen until the investor looks 10 years out. So at the minimum the effective investor needs to be thinking about how his investment will perform in 10 years. Even better is to focus on what is likely to happen 20 years out or 30 years out.

The Investor’s Scenario Surfer helps you do this. The investor identifies the conditions that he wants to examine (such as the valuation level that applies) and the calculator reveals one year of returns at a time (permitting the investor to change his stock allocation at the end of each year.) Returns are of course to a large degree random. So numerous return sequences are possible. But Shiller showed that in the long term returns are far from entirely random. So while the calculator will generate different return scenarios on different tests applied to the same conditions, the mix of scenarios generated changes depending on the starting-point valuation level selected. Long-term returns are of course in a general sense better for purchases made at low or normal valuation levels than for purchases made at times of high valuations.

The calculator is not of much value for those who make use of it only a single time. There is a good chance that a single use is going to generate an outlier scenario, one likely not to apply for a real-life stock purchase made at the same valuation level. However, the investor returning to the calculator multiple times is rewarded with powerful insights. I have performed many hundreds of runs on the Surfer. I have developed over time a confidence about what to expect in real-life return scenarios that I do not believe I could have achieved by reading many accounts of how the market has performed through history. There is something about seeing a 30-year returns sequence play out year by year that helps one develop a sense of how the market always come to reward investors who exercise price discipline.

I can identify several important lessons that I have learned from my many runs of the Scenario Surfer.

High stock allocations almost without exception beat both low stock allocations and moderate stock allocations. The calculator compares results for a fixed stock allocation of 80 percent, for a fixed stock allocation of 50 percent, for a fixed stock of 20 percent and for the changing allocation chosen by the person using the calculator on a year-by-year basis. It is rare for the 80-percent fixed allocation not to beat the 50-percent fixed allocation and it is rare for the fixed 50-percent fixed allocation not to beat the 20-percent fixed allocation. I of course knew before creating the calculator that returns on stocks generally beat those offered by other asset classes. So these results should not have been surprising. Still, the point gets brought home in a compelling manner when you see a return sequence play out before your eyes in which for ten years or more the 20-percent fixed allocation goes a good bit ahead (this of course does happen from time to time in real life) but ultimately is beaten soundly because the odds of a non-stock portfolio prevailing over 30 years are just so small.

The one big exception to this general rule is that the Valuation-Informed Indexing portfolio nearly always beats the 80-percent fixed allocation (as well as the fixed 50-percent portfolio and the fixed 20-percent portfolio). Again, this probably should not have surprised me as much as it did when I first started using the calculator. Shiller showed that valuations matter and referred to this as a “revolutionary” finding. If fixed-allocation portfolios did not generally fall behind portfolios in which the investor adjusts her stock allocation in response to valuation shifts, Shiller’s discovery would be of no practical value and could hardly be termed “revolutionary.” The calculator (which is driven by the historical return data going back to 1870) shows that valuations matter a great deal indeed.

Valuations matter enough that the variable-allocation portfolio has beaten the three fixed-allocation portfolios in roughly 90 percent of the runs that I have performed over the years. My view is that even that claim understates the case. In the few cases in which the 80-percent fixed portfolio wins, the difference between the ending-point portfolio values is usually small. In the many cases in which the Valuation-Informed Indexing portfolio wins, the difference between the ending-point portfolio values is often quite large.

In short, the Buy-and-Hold investor has a small chance of being ahead by a small amount at the end of 30 years while also having a large chance of being behind by a large amount at the end of 30 years. I think it is fair to say that on a risk-adjusted basis, practicing price discipline when buying stocks is always the superior choice.

The Scenerio Surfer teaches patience. It is important that investors following a Valuation-Informed Indexing strategy possess a firm understanding that the strategy can leave them behind for a long stretch of time. Stock prices do not fall in the pattern of a random walk. Momentum plays a big role. But it’s tricky. When prices get very high or very low, the odds of a reversal in the momentum grows large. So outlier prices increase the odds for both large price increases AND for big price drops. The investor using the calculator can see this phenomenon play out to cause his strategic choices fail to pay off for many years and then race ahead by the end of the 30-year time-period being examined.

 

Note:  The author of this article is Rob Bennett.

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The author of this article is a contributor to ValueWalk.com. ValueWalk is your everyday source of breaking and evergreen news on everything hedge funds and value investing.