I’m sure you’ve heard it before from your friendly investment advisor--dollar cost average (DCA) into mutual funds (buying more when the market is low, and buying less when the market is high); keep your money invested at all times in a strategic allocation between stocks and bonds (and other asset classes); and rebalance annually.
In the Intelligent Investor, Ben Graham defined investment and speculation as follows: "An investment operation is one which, upon thorough analysis, promises safety of principal and adequate return. Operations not meeting these requirements are speculative."
When it came to allocating holdings, he also advised using a tactical approach to the stock/bond mix ranging from 75% stocks/25% bonds to 25% stocks/75% bonds, as valuation conditions dictated. As the market gets expensive, lighten up on stocks and buy more bonds. As the market suffers a major decline, lighten up on bonds, and buy more stocks.
A DCA program on the surface sounds sensible and intelligent. But when you peel back the layers you soon realize there’s an element of speculation involved...which is continuing to buy when the market is expensive.
Why would an advisor recommend this? Valuations matter--the price you pay determines your returns. No company, and by extension no index, is a good investment at any price. Doing so will give you very disappointing results indeed—just ask Coke (KO) investors in the late 1990s who are just now breaking even. Yet your advisor would ask you to continue to invest at elevated levels. Wow, and to think people pay for that advice from “professionals.” I’m sure the answer why has more to do with their pocketbook and fees from Assets Under Management than your pocketbook and financial independence.
So how does a person intelligently invest in his work-place offered 401K, so as not to speculate and suffer dismal returns, when all that’s offered are index funds? How can you “DCA with a brain?” The answer: judge the valuation of a US Stock Market index, by using the Total Market Capitalization to Gross National Product (TMC/GNP) ratio and buy the market when it’s cheap, sell when it’s not. (Note: TMC/GNP is Warren Buffett’s favorite market valuation metric and is outlined here: http://www.gurufocus.com/stock-market-valuations.php )
A ratio of 0.75-0.9 is considered fairly valued with a growth curve of about 6% ann. Anything over 0.9 is overvalued, and anything under 0.75 is undervalued. At all times, you can determine the likely returns over a given time period, typically 8-10 years. As of this writing, the current expected return from the market over the next 8 years, at the current price level, is 3.9%.
Since asset classes compete for investment dollars, compare the market’s expected return (3.9%) to your alternative investment of comparable duration for preservation of capital—the 10 year T-bill, currently yielding 3.6%. For perspective, next compare it to the corporate bond index, currently yielding 5.8% and available here: http://www.bloomberg.com/markets/rates-bonds/corporate-bonds/
Now ask yourself, is there a sufficient margin of safety, and is this a sufficient return over the T-bill or bonds? If you answer yes, then buy the index. If you answer no, put your funds in short-term bonds/cash until such time as you get the required margin of safety and sufficient return. Do this periodically as new funds are added to your account. Please note, like value investing, this approach may involve some patience as markets can stay irrational for long periods.
Since I eat my own cooking, I apply these principals to my personal 401K using the table below, modified from Graham’s approach listed earlier:
0.90 – 1.15
0.75 – 0.90
0.50 – 0.75
Over time, this approach will force purchasing stocks when conditions warrant, and avoiding them when they’re expensive. It also has the advantage of preservation of capital by putting you into the bunker of bonds or cash when markets are overvalued.
When Mr. Market has his next manic-depressive mood swing, you’ll be ready and able to take advantage of the dirt cheap prices he offers with your slug of cash.
Happy index investing!
PS: I find it to be a telling matter of over-valuation when the expected return from the market is 33% less than corporate bonds, and just about on par with a T-bill.
Disclosure: my personal 401K is currently allocated as follows:
- Extended Market Index (21%)
- Aggregate Bond Index (49%)
- Short-Term Gov’t Securities (30%)