Over the next few days, I’m trying to get to grips with the concept of risk, diversification and building a better portfolio which might withstand the inevitable outburst of market volatility in the next year or so. Yesterday I discussed the idea that equities are a good more volatile, historically, than we are led to believe. Today I want to establish an idea – that the price at which an investor buys a financial asset matters greatly. This doesn’t sound terribly like an uncomfortable on initial inspection but counter-intuitively most investors run a mile from cheap stocks. If I were to give you the choice of a sexy, expensive but hugely popular option (a fast car or a highly rated tech stock growing in leaps and bounds) and a cheap, slightly tawdry alternative that has seen better days and is probably a tad unloved, which would you choose? The work of a small army of behavioral economist has proved beyond doubt that many will choose the shiny, new, expensive option – and not the cheap, unloved one.  The sexiness helps but what is probably more powerful is the affirmation of others – as a crowd we feel safety in numbers, and if the crowd loves a hugely popular product, we feel ‘safe’ in going with the flow. Our worry is that the cheaper option might after all be cheaper because it is less reliable, or more likely to prove problematic? Shares and bonds though are not like every other consumer product. As we’ve already discovered in our discussion on smart beta, copious amounts of evidence backs up the idea that buying a share that is cheap – using valuation metrics – is actually the ‘smart’ thing to do over the long term.

In sum, the cheaper you buy any financial asset, the greater your probability of making a big return. American stockmarket historian and strategist Ed Easterling ( his research is available for free at http://www.crestmontresearch.com/) has mined huge amounts of historical equity market data to produce the next graphic. This chart shows a massive series of individual 20 year periods from 1919 through to 2011 and attempts to link equity returns to the change in the price earnings ratio of the benchmark S&P 500 index.

The PE ratio is a very widely understood tool and simply measures the relationship between the aggregate profits of all the companies in the benchmark index versus the cost of buying the aggregate index through something like an ETF. A PE ratio of 15 for the S&P 500 index implies that the combined companies in the index trade at an aggregate 15 times their total earnings or profits.

Easterling then makes one small change to this measure  – instead of looking at simple year based PE ratios, he averages out the PE ratio over the 10 years of a business cycle. The change in this cyclically adjusted  PE ratio for the S&P 500 is then measured – over some 20 year periods the PE ratio starts at a very low level, and then finishes at a very high measure after a bullish rally, whilst in other years the exact reverse happens (a bear market). As you can see there is a relatively straightforward relationship between 20 year returns and the waxing and waning of the PE ratio.

The next table puts some more flesh on the bones of this argument – it looks at all these 20 year periods and then breaks them down into decile groups through to 2011. Easterling then looks at the range of stockmarket returns and compares them to changes in the PE ratio. In simple terms the bottom decile of 20 year periods boasted a PE which started at 19, and ended up with a PE ratio at the end of the period of 9 – these 20 year periods produced net returns of between 1.2% to 4.5% per annum, on average.

If by contrast you’d have picked those 20 year periods where the PE started at say 10 or 12 (the top two deciles), and then sat tight as that PE ratio expanded to 29 or 22 times profits, you’d have made a huge annual average return. According to Easterling these 20 year periods produced net annual returns of anything between 12 and 15% per annum, on average over the full 20 years. This ‘value’ based idea of buying an asset (share, bond or even ETF) when its cheap, based on fundamental measures, is one of the strongest and most powerful principles of all investing, backed up by a multitude of academic and industry research. The only downside is that financial assets such as equities remain expensive  for many years – this means that their share price trades at a level which is above the ‘cheap’ price,  implying that investors either stay in cash or be willing to accept smaller returns.

20 year periods ending 1919 – 2011 (93 periods in all)

Note: PE ratio based upon average 10 year real EPS