Another criticism is that it is a long term indicator and does not provide enough buy and sell “signals”. This is more evidence that too many investors are focused on short term results and too impatient to think long term.
In addition I believe these critics take PE 10 too seriously. There are no set rules for buying or selling. There are no “magic formulas” that give exact answers. However the general valuation of the market, as presented by PE 10, gives the analyst a frame of reference to judge the balance between risk and reward.
Implementing PE 10 In Your Portfolio Asset Allocation
I don’t use any iron clad rules. This isn’t a scientific formula that makes your research and homework go away. This is how I implement PE 10 into my portfolio asset allocation:
When PE 10 is Low:
When PE 10 is low I know the odds of higher than average long term returns are in my favor. So I increase my asset allocation to equities.
I also know the odds are better for the entire market when PE 10 is low. Therefore I might be apt to broadly diversify my portfolio by having a higher percentage of assets in ETFs or low cost index funds.
Summary: The lower the PE 10 the higher percentage I allocate to equities. Broad diversification through market index funds and ETFs is acceptable.
When PE 10 is High:
When PE 10 is high I know the odds of lower than average long term returns are what to expect. So I decrease my asset allocation to equities.
I also know, because of higher risk, I need a higher margin of safety in the investments I choose. This means I will place a higher percentage (maybe even 100%) of my equity allocation in individual stocks, instead of index funds or ETFs. This allows me to tightly control my risk and only invest in individual companies that meet my margin of safety requirements.
Summary: The higher the PE 10 the lower percentage I allocate to equities. Broad diversification is less desirable and concentrating on individual stocks that offer a high margin of safety is preferred.
Stock Market Valuation and PE 10
The Shiller PE 10 is not a magic formula to make your asset allocation decisions for you. It is a valuable stock market valuation tool for risk/reward management. PE 10 will help guide you to asset allocation decisions that improve long term returns and lower your risk of large portfolio drawdowns.