With stocks setting new records almost every day, and with valuations appearing stretched by historical standards, investors may be wondering if it is time to get out of the stock market. Surely we can’t go much higher, many must be thinking. Why not sell, go to cash and wait until the inevitable market collapse, then buy in cheap?
Be Wary of Media Fear-Mongering
The media is constantly fueling our fears. We read the market news, hear experts warning us that the market is overvalued and the end must be near. We naturally want to do something to protect our hard earned money. But can we trust the advice the media experts are feeding us? (For more, see: Are Equity Markets Overvalued?)
The great thing about the internet is that it is easy to go back and see just what kind of “advice” the experts were giving in years past and what would have happened if I had followed their most dire warnings. Here are some headlines I read in the Motley Fool in 2013: “The Stock Market is Overvalued,” “Low to Negative Returns are Ahead” and “Save the Women and Children!!”
The Motley Fool does appear like a fool in this case. From the time the article was written until today, the S&P 500 is up 59%. If you had sold on this advice and gone to cash, you would have missed the better part of one of the best stock markets of recent history and still be waiting for that elusive correction.
Here is a headline from MarketWatch in 2014: “Stocks are Dangerously Overvalued." Suppose you had agreed with this article and decided the market was too dangerous in June of 2014 and pulled $100,000 out of the market. You would have failed to see that nest egg grow to $143,000 by November of 2017. Were stocks really overvalued? Not if you knew that unemployment would drop to a 20 year low within three short years and corporate profits were about to skyrocket. Wouldn’t you love to have a crystal ball.
Here is a headline from CNBC in April 2015: “Stocks are Way Overvalued.” If you believed this expert’s very compelling case for stocks being overvalued, you would have certainly wanted to get out of the stock market and stuff all your Benjamins in the mattress. And you would have missed out on a 31.5% gain over the following 30 months.
A 50% Chance of Being Right
I can choose any year and find well educated and experienced experts who are convinced the market will go down. And an equal number who think it is bound to go up. Pick which side you like – you have a 50% chance of being right. (Actually, since stocks go up in seven or eight years out of 10, your odds are increased just by betting on higher stock prices, but you get the idea). To effectively time the market though, you need to guess right twice. You need to time you exit correctly (which we have already demonstrated isn’t easy), but you will also have to choose when you will put your money back in. (For related reading, see: Understanding Cycles - The Key To Market Timing.)
Imagine that in 2013 you heeded the Fool's advice and went to cash, but the market continued higher. Eventually you come to realize that it will take a monumental collapse to ever get back into the market at the same price as you pulled out. But if you decide to jump back in, you may find that long awaited crash finally does happen. You were now wrong twice. This magnified your loss, since you did not have the benefit of three years of gains that the more patient investors enjoyed.
Or lets say in an alternate reality the market did indeed fall, as you predicted. Hope you didn’t start bragging about your investment prowess too soon, because you now need to figure out when to get back in. Falling markets are scary. Markets fall when there is a lot of fear surrounding the economy. Few investors will have the nerve to get back in until things look better. But markets tend to bounce out of their doldrums rapidly, while the doomsayers and doubters still rule the airways. Trying to catch the bottom of the market is even harder than trying to catch the top.
Build a Portfolio With Losses You Can Stomach in a Downturn
We know that over time, stocks provide higher returns than most other investments. But we also know the stock market can be risky. If predicting and avoiding the next bear market isn’t the solution, then what’s an investor to do?
The answer is to build a portfolio that is not likely to lose more money than you can stomach in a downturn. Then leave it alone. Include stocks for growth and dividends, but use non stock investments such as fixed-income or real estate, which may not fall when stocks do. The more fixed income you include in a portfolio, the less you are likely lose when the stock market falls, but the less you are likely to earn over time as well. The more stocks in your portfolio the higher your expected return, but at the cost of bigger swings in value. Avoid the temptation to up the risk level when times are good and markets are booming. You want an allocation that you will be able to stick with through the bad times as well.
Building a diversified portfolio is far less sexy than trying to outguess and outmaneuver the stock market. After all, no one brags to his or her neighbors at the annual block party about their amazing diversification strategy. But over the long run, a well-diversified portfolio left alone to do its thing will almost certainly outperform your overconfident market timing co-worker. Just don’t expect him to admit defeat. (For related reading, see: Diversification: Protecting Portfolios from Mass Destruction.)