A few weeks ago I published a guest post by Rob of A Rich Life. In doing so, it appears that I inadvertently stumbled into the middle of a religious war. Schroeder, a critic of Rob's has asked me to post the critique which follows, and having read it, I thought I would share it with my readers and let you all make up your own opinions. This critique is broader than a direct response to the guest post on Money and Such. With this, I think that I will gracefully bow out of what appears to be a larger dispute between these two thoughtful writers. I am sure that Rob will respond in detail in the comments below. The guest post.
This is a critique of Rob Bennett's "Valuation Informed Indexing" or VII for short. Here is Rob's claim:
"Valuation-Informed Indexing always provides better risk-adjusted long-term returns than Passive Indexing. If you take the same portfolio as the Coffeehouse Portfolio or the Wellington Fund and instead of following a rebalancing strategy you adjust your stock allocation in response to big price changes, you will achieve higher risk-adjusted returns. I am not able to imagine how there could be any exception to this general rule." [Shadox - this quote is taken from Rob's comment (#24) to this post on Get Rich Slowly]
Adjusting your stock allocation in response to big price changes" is the key phrase and defines Rob's VII. And the claim is that if you adjust your stock allocation in response to big price changes, you will achieve higher returns than sticking with a static, never-changing stock allocation.
In order to compare VII versus a static, never-changing stock allocation, we need decision rules that tell us how to implement VII. Rob provides us VII decision rules here:
"A Valuation-Informed Indexer might go with a stock allocation of 50 percent at times of moderate prices (a P/E10 level from 12 to 20), a stock allocation of 75 percent at times of low prices (a P/E10 level below 12) and a stock allocation of 25 percent at times of high prices (a P/E10 level above 20)."
How do we determine P/E10 levels? P/E10 data is contained in an Excel spreadsheet on Robert Shiller's website. Here is the link.
So if you were a VII investor and followed Rob's guidelines, you would have maintained a normal stock allocation of 50% when the P/E10 level ranged between 12 and 20. This was the case up to 1992. However, you would have switched to 25% stocks in 1993 when P/E10 first went above 20. P/E10 stayed above 20 for the next 16 years before dropping below 20 in October 2008.
Now that we have defined Rob's VII, we can take the next step and test Rob's claim. Repeating what Rob wrote above:
"If you take the same portfolio as the Coffeehouse Portfolio or the Wellington Fund and instead of following a rebalancing strategy you adjust your stock allocation in response to big price changes, you will achieve higher risk-adjusted returns."
I will choose the Coffeehouse Portfolio because the returns are tracked on Bill Schultheis' website:
Annualized 17 Year Return 8.61%
Rob says that a VII investor would have reduced their stocks to 25% when P/E10 went above 20. This occurred in 1993. And since the Coffeehouse Portfolio is 60% stocks, we need to add a bond fund to make the valuation-adjusted stock allocation equal 25%.
To achieve a 25% stock allocation with the Coffeehouse Portfolio, we would need to add a bond fund such as the Total Bond Market (TBM). By my calculations, you would place 58% of your money in TBM and 42% in the Coffeehouse Portfolio.
So for example, if you had $10,000 and only want $2500 in stocks (25%), you would put $5800 in TBM and $4200 in the Coffeehouse Portfolio (CH). How much do you now have in stocks?
$4200 * 60% = $2520
Which is close enough to $2500.
We now have almost all the information to test Rob's claim that when you take the Coffeehouse Portfolio and instead of following a rebalancing strategy, you adjust your stock allocation in response to big price changes and thus, you will achieve higher returns. The only piece missing is the returns for the Total Bond Market. That data can be found at this website:
So with a little spreadsheet work, we can apply Rob's VII guidelines and produce valuation-adjusted returns for the Coffeehouse Portfolio. The left column represents the unmodified Coffeehouse (CH) and the right column represents the Coffeehouse modified using Rob's VII guidelines:
Year CH VII
1991 23.55% 23.55%
1992 9.57% 9.57%
1993 15.64% 12.18%
1994 -0.58% -1.79%
1995 22.89% 20.16%
1996 14.53% 8.18%
1997 17.95% 13.01%
1998 6.88% 7.87%
1999 8.30% 3.05%
2000 7.25% 9.65%
2001 1.88% 5.68%
2002 -5.55% 2.46%
2003 23.56% 12.20%
2004 14.18% 8.41%
2005 5.97% 3.90%
2006 15.00% 8.78%
2007 2.91% 5.24%
2008 -20.25% -5.58%
Coffeehouse (CH) 18-year annualized return = 8.52%
VII 18-year annualized return = 7.93%
So it appears that adjusting the stock allocation for the Coffeehouse Portfolio in response to big price changes did not produce higher returns. The valuation-adjusted returns were 7.93% annualized over the 18 year period from 1991 through 2008. This is lower than the unmodified Coffeehouse annualized returns of 8.52% over the same period.
To repeat, the Coffeehouse Portfolio maintained a static, never-changing stock allocation of 60% over the full period. By contrast, the valuation-adjusted Coffeehouse added TBM in response to big price changes as occurred in 1993 and thus reduced its stock allocation to 25% and maintained that lowered stock allocation from 1993 through 2008.
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