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WE GET EXCITED WHEN our investments go up in price and disappointed when they fall. This is the logical “holder’s view” of a change in our immediate wealth. Some may feel the urge to buy more of the winners and sell any losers.
But there’s also an alternative way to view changing market prices: the “investor’s view.”
Consider that an investment’s price rise often indicates you’re taking a pay cut. Yes, you now have more money invested in that position, but you’ll likely get paid less per dollar of that new value. The reason: What we get paid in stock earnings or bond interest is unlikely to rise in sync with an investment’s price.
That’s undeniable with bonds: Interest and principal payments are fixed, so the math is clear. What about stocks? Earnings tend to be less volatile than stock prices, so it’s risky to assume earnings in the short term will grow commensurate with share prices.
If a holder’s view dominates your thinking, rising prices might tempt you to buy based on price momentum or FOMO—fear of missing out—with the hope of later selling at an even higher price to a “greater fool.” What about the investor’s view? The higher priced position may now be less attractive compared to alternative investments that haven’t gone up in price.
The situation reverses when prices fall. With a holder’s view, you might sell to avoid further loss. But taking the investor’s view, you see a pay raise, prompting you to buy.
The investor’s view can also help with portfolio allocation decisions. Consider two major investment risks: credit risk and interest rate risk. Credit risk is not getting paid what you expected to receive, while interest rate risk can devalue whatever you do get paid.
When balancing a diversified portfolio of stocks, with their credit risk, and investment-grade bonds, with their interest rate risk, it’s helpful to estimate the after-tax yield you expect from each at current prices. For bonds and bond funds, it’s easy to find the yield to maturity or SEC yield.
What about stocks? That’s not so easy, with stock market earnings subject to endless “expert” predictions. Yet, somehow, you should estimate the stock earnings yield you might receive in return for taking credit risk, so you can compare it to the yield available by taking on bond interest rate risk. To calculate the stock market’s earnings yield, you reverse the usual price-earnings ratio calculation—dividing share prices by earnings—and instead divide the earnings by the price.
There are many ways to estimate the S&P 500’s near-term earnings. You might look at trailing 12-month reported earnings, forward 12-month predictions, historical earnings adjusted for inflation or average historical earnings return on book value. You could pick one or a combination of these to calculate the current earnings yield.
Today’s stock and bond yields should then be adjusted for your expected marginal income tax rate for each type of investment. Now, you can assess the relative after-tax benefit of allocating your portfolio between the stock market’s credit risk and the bond market’s interest rate risk.
This is the investor’s view of portfolio allocation—one driven by relative yield—versus the holder’s view driven by price momentum. Which should you favor? I’d argue it’s best to consider both when investing. Why? You may want to split your bets. Add some money to a few positions you think might continue to go up, while placing most new money in positions with rising relative yields and a good chance to benefit from price reversals.
Thank you for the article. You’ve provided some guidance but I feel like I’ll mess up the calculation if I attempt it myself. I’d be interested in a current calculation of the “after tax yield” of the S&P 500, using the following methods you mention (trailing, forward, historical, avg historical, etc.) so I can compare against the current yield of common bond funds or individual bonds.
This is far too complicated for me. I take the benign neglect view. Set your asset allocation, and dollar cost average accordingly, rebalancing maybe once a year. Ignore the noise.