Your Personal Financial Planning CAPE Ratio

I was thinking some more about this piece I wrote about moving averages and how we get too much data, and then found myself thinking about how CAPE obsessed many investors have become.

For the uninitiated, CAPE aka Cyclically-Adjusted Price/Earnings Ratio aka CAPE10 aka PE10 aka Shiller’s CAPE is a valuation measurement designed to smooth out the variability in corporate earnings for a more normalized view at how cheap or expensive stocks might be to those earnings. CAPE has been the subject of much debate and if you really, really want to get into it you can’t do much better than the pseudonymous Jesse Livermore’s take on Fixing the Shiller CAPE.

If CAPE is such a great tool to look at stocks, perhaps we should borrow from the concept when we talk about financial planning and being individual investors. What if, instead of bashing our heads against the wall with the day-to-day noise of market fluctuations, you could insulate yourself from this. What if, instead of worrying when the market was down 1%, you had no idea?

Here’s my proposal. Someone out there writes a few lines of code to give you a cash-flow-adjusted 5-year moving average of your portfolio value. First, you strip out all of the contributions you’ve made and withdrawals you’ve taken from the portfolio. Then you get an average value over the last five years, then you add those contributions or withdrawals back in. Presto, CAPE for financial planning.  CAFP? This number would be useful in a number of ways, including:

  1. Basis for retirement planning. Should you run a retirement projection when the markets are up or down? Who cares! Use your CAFP. You’ve removed (or at least minimized) the impact of big market swings in your financial plan – isn’t that what you are after anyhow?
  2. Something to look at other than what the market is doing right now, or did last year. I’ve written before that investors should really only care about what they can control. If you’re working and saving, the only thing that really matters is how much you were able to put away (assuming you’re watching taxes and fees of course). It’s disheartening to put away a big chunk of savings and have the market make it disappear in a matter of months.
  3. Another chance to reign in your bad behavior. If you can’t “see” what the portfolio is doing day to day, you don’t have to lose any sleep over it. Of course you still will be aware of the news, but a little self-insulation can go a long way. A smoothed figure would also keep you from obsessing over what the portfolio “used to be worth.” Anchoring to high-water marks is a both human thing to do and useless.

Maybe what I’m proposing is a fancy version of sticking your head in the sand, but if it looks stupid and it works, it ain’t stupid.

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