The Simple Investing Strategy That Makes Stocks Virtually Risk-Free

By Rob Bennett
November 21, 2012

We accept that we need to invest in stocks to finance a middle-class retirement. But we wish we didn't. Stocks are risky. The stock investor can wake up to find he has lost a good percentage of the money he has managed to save over the years. That's a sickening feeling. We would all like stocks a lot more if they weren't so risky.

I have good news for you.

There's reason to believe stocks are on the verge of becoming a virtually risk-free asset class. There's academic research that supports this extraordinary claim. Investing is going to be a lot less stressful for most middle-class investors in the not-too-distant future.

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There are two major risks that have haunted stock investors for many years. One is already gone. The other is well on its way to no longer being much of a factor. It was Vanguard founder John Bogle's introduction of the index fund in 1976 that got things moving in this very exciting direction.

Ask yourself -- WHY are stocks risky? Is risk inherent in the stock investing project? Or is it the way we have gone about investing in stocks that has made stocks risky?

In the old days, owning stocks meant owning shares of individual companies. It's not possible to know in advance which individual companies will generate nice profits and which ones will not. So those buying stocks had to form assessments of which companies would do well and take the chance that they would lose their money if they made bad choices. That's a risky business. There is no way of getting around it.

We don't have to take on that risk! Index funds are available to us today. When Bogle founded Vanguard, he changed the investing project in a fundamental way. He made it possible for investors to bypass the biggest risk of owning stocks.

Still, you will have a hard time getting most stock investors to agree that risk has been eliminated. How about the 2008 price crash? Indexers didn't see that one coming. They lost lots of money. They got scared. They saw up close and in a personal way what stock investing risk is all about.

I believe that second big risk of stock investing is about to fall as well.

Take a look at this study by Wade Pfau, associate professor of economics at the National Graduate Institute of Public Policy Studies in Tokyo. Pfau examined a new approach to indexing (valuation-informed indexing) that I have been advocating on my website for 10 years. valuation-informed indexing is different from the conventional approach to indexing (buy-and-hold indexing) in one important respect. valuation-informed indexers do not stay at the same stock allocation at all times. They CHANGE their stock allocations in response to big swings in valuations with the aim of keeping their risk profiles roughly constant.

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The buy-and-hold strategy was developed at a time when not all of the research was available in order to invest effectively for the long term. The research at that time showed short-term market timing (changing your stock allocation because of a guess as to how prices will change over the next year or so) never works. But it turns out that long-term market timing (changing your stock allocation in response to valuation shifts with the understanding that you may not see a benefit for doing so for as long as 10 years) ALWAYS works. In 140 years of stock market history, there has never been a single exception. 

Had the researchers of the time known this, they would have stressed the need to engage in long-term timing as strongly as they stressed the need to avoid short-term timing. The key to long-term success is never trying to guess how prices are going to change in the short term while also always keeping valuations in mind when setting your stock allocation.

On a table near the top of Page 8 of Pfau's study, he compares a portfolio of 100 percent stocks held by a buy-and-hold investor with a stock portfolio held by a valuation-informed indexer who goes with a 100 percent stock allocation at times when valuations are reasonable and with a zero percent stock allocation when valuations signal danger up ahead.

The portfolio held by the valuation-informed indexer earns roughly the same return as the portfolio held by the buy-and-holder over the 140 years for which we have records of stock returns. But look at the line on the table for "Maximum Drawdown." That line shows the greatest loss in portfolio value experienced over the 140 years. The buy-and-holder at one time experienced a portfolio value drop of 61 percent. That's risk!

In contrast, the valuation-informed indexer never experienced a drop in portfolio value of more than 21 percent. valuation-informed indexers take on little risk when investing in stocks. The value of certificates of deposit (CDs) can drop by more than 21 percent in times of high inflation and few think of CDs as a risky asset class.

The Investing Answer: Stocks are not risky anymore, not for indexers willing to take valuations into account when setting their stock allocations. Stock risk today is something we choose to take on by electing either to pick individual stocks or to invest in indexes pursuant to buy-and-hold strategies.

Rob Bennett created The Stock-Return Predictor, a calculator that performs a regression analysis of the historical stock-return data to reveal the most likely 10-year return for the purchase of a broad index fund made at any possible valuation level.