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Value Indexing foundations: where do returns come from?

November 13, 2010 Leave a comment Go to comments

To introduce this blog I’ll be going through my overall approach to the investment process. A good place to start is with the fundamental ideas that drive my decisions. It all begins with an understanding of how the capital markets work. The most important part for me is what I get paid for when I invest, and how it affects each investment.

The investment returns of any asset come from only 3 sources:

  1. Current yield, in dividends or interest – the cash you actually receive this year for owning the asset.
  2. Changes in yield over the years – we hope that companies will increase their profits over time.
  3. Changes in valuation over the years – this largely happens due to the popularity of various areas of the market. This is usually expressed as the multiple between the current yield and the price.

The current yield is what separates any particular investment from putting your money in a high-interest account in the short-term, and while it can change without warning it’s the most stable of the three. Many stock investors don’t think about dividend yield but it does form an important part of the total returns you get so it plays a part in determining the performance.

The changes in yield over time will affect the future yield and value, and in some situations you can get an idea of what they’ll be even if we don’t know exactly how much (for example corporate earnings should grow at more than 0.1% most of the time), so in the long-term you can look at the effect they will have on your portfolio. If you remove the effects of inflation an increase in yield from stocks has to come from improvements within the businesses and growth in the economy. With bonds, the yield is more likely to go back and forth over a range since bond yields (after inflation and tax) can’t just increase forever. This is true of corporate profits too in the end; the increase always has to come from somewhere and sometimes they decrease when they’ve gone too far.

The last factor – popularity – is more of a counter-sign. I can’t even begin to try timing market opinion to speculate on prices. However I can make my own judgement of whether people are overpaying or selling out too cheaply. If done well this won’t be the same as perfect timing but should have a positive influence from buying assets that later increase in price with popularity, and reducing holdings before they decline. I want to be buying from people who have given up and selling to people who have lost sight of fundamentals. In fact this is the reverse of what most people think of as market timing – they try to buy as the price rises and sell as the price falls, while I would start to sell and the price is going up and start to buy when it’s going down.

This leads to one of the central points where Value Indexing is different. The main idea that lead up to this approach was that I don’t just buy at any price. I want to analyze an investment (in this case a market index) to see if the numbers are reasonable. If a broad enough bond index is yielding a real return of 10% I’m happy to take that any day, but if stocks have an earnings yield of 2% and don’t have the long-term growth prospects to justify it I won’t invest much in them.

Historically it has been a safe bet that the popularity of a market will swing between both extremes over time rather than just staying put in the middle. Sometimes this shift can take 10 or 20 years, while at other times it can happen in 5 years. This means that the decisions resulting from this approach could look very different from one decade to the next. US stocks over the last 40 years are a great example as they were declared dead in the 70s, while everyone was buying in by the end of the century. This change in popularity led to a higher return for anyone who held an investment over the whole period.

These are the main sources of returns (and often losses) that I’m concerned with on the level of individual investment options. By understanding these well and keeping track of how each asset class changes over time, I can decide on the asset allocation that seems reasonable to me and put my capital in the right places. As long as I’m always invested in assets that have a reasonable current yield and a minimal chance of losing most of their popularity I’ll be happy. At best, by paying attention to the price I expect that there may be some additional return – profiting from the long-term volatility in emotions.

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