Valuations Are 80% Of The Stock Investing Story
By Rob Bennett I often make the claim that it is a terrible mistake for buy-and-holders not to take valuations into consideration when setting their stock allocations, because the peer-reviewed research in this field shows that valuations are the most important factor bearing on whether an investor achieves long-term investing success. I say that if you get valuations right, you are almost certain to do well in the long run even if your understanding of all other issues is poor, and that if you get them wrong, you are almost certain to do poorly in the long run even if your understanding of all other issues is strong. I sum up the point by stating that the valuations issue comprises roughly 80 percent of the stock investing story. It’s an informed estimate. I don’t believe that there is any way to say precisely how big an impact understanding valuations will have on an investor’s long-term success. But the evidence that I have seen has persuaded me that the valuations factor is of far more importance than most people realize, that it may well be 80 percent of the stock investing story or perhaps even a bit more than that. How much would you say that price matters when buying a car? It’s certainly not the only factor. You need to be sure that a car is well made. A poorly designed car is not a good deal even at a low price. And you need to be sure that the car you buy is one well suited to your needs. Someone who desires a sports car will not be happy with even a well-designed family van. And there are lots of personal considerations that need to be taken into account. Some people like red cars. Some people like black cars. Getting the color right can add a good bit to your enjoyment of the car you buy. Still, I think it can be said that researching prices and negotiating a good deal on price is 80 percent of what makes one a successful car buyer. Getting the color right is easy – you just need to be willing to drive to a second dealer if the first one you visit does not have the right color in stock. And it doesn’t take too much effort to identify the best style of car to satisfy your particular needs. We all know what is out there. You might need to check out a few vehicles to decide which particular sports car or which particular family van is right for you. But it is not difficult to get that aspect of the car buying experience settled in your favor. Nor does it take much research to learn which cars have a reputation for being built well. Getting the price right is harder. If you accept the dealer’s price, you are almost certainly going to overpay by hundreds of dollars, and quite possibly by several thousand dollars. If you do enough research to enter the dealer’s lot with confidence that you know the fair market value of the vehicle that you intend to purchase, and are willing to invest the time and energy needed to negotiate a good deal, you are going to enjoy a huge dollar return for the hours invested. You can improve your car deal by thousands of dollars by working the price aspect of the matter, potentially turning a very bad deal into a very good deal by focusing on this all-important issue. There is now 34 years of peer-reviewed research telling us that it works precisely the same way when buying stocks rather than cars. The safe withdrawal rate in 2000 was 1.6 percent real. The safe withdrawal rate in 1982 was 9 percent real. This means that a retiree with a $1 million portfolio who began her retirement in 1982 could live the life available on a $90,000 budget for her remaining years, while a retiree with a $1 million portfolio who began her retirement in 2000 could only live the life available on a $16,000 budget for her remaining years. That’s a big difference! It is critical to take valuations into consideration when planning a retirement. I think it would be fair to say the numbers show that valuations are roughly 80 percent of the retirement planning story. The story is the same for investors who are in the stage of life where they are accumulating assets, rather than living off the earnings from them. A regression analysis of the 145 years of historical data available to us shows that the most likely 10-year annualized return for stocks purchased in 1982 was 15 percent real. The most likely 10-year annualized return for stocks purchased in 2000 was a negative 1 percent real. That’s a difference of 16 percentage points of return! For 10 years running! Knowing about that difference and taking advantage of the knowledge by going with a higher stock allocation when going-forward returns are likely to be good than you go with when going-forward returns are likely to be poor turns the magic of compounding returns very much in your favor. I think it would be fair to say the numbers show that valuations are roughly 80 percent of the asset allocation story too. Lots of non-valuation factors matter. Interest rates matter. Unemployment rates matter. Consumer confidence levels matter. Inflation rates matter. And on and on. But those factors are all factored into the price that is available to the individual investor considering a stock purchase. So, while these other factors play a role in the investing game, we as individual investors need not pay attention to them. There is only one decision in our control – what percentage of our portfolio will be comprised of stocks. If we buy at good prices, we always do well in the long term. There has never once in the history of the market been an exception to this rule. And if we buy at bad prices, we always do poorly in the long run. Again, there has never been an exception. Most investors accept that valuations matter. But few realize how big a factor the valuations factor is (I can’t help but wonder if the reason might be that there is so much money to be made on the selling side by persuading investors that valuations are not a big deal). The reality is that the stock market is like every other market known to humankind – price is by far the dominant factor in the determination of whether market participants are able to achieve a good deal or not. Disclosure: None.