Over the past few weeks, the media has attributed November’s financial markets volatility to an “overvalued stock market”. In other words, the current price of company stocks exceeds their intrinsic value when measured using metrics such as Price-to-Earnings ratio and investor sentiment. Layered on top of this discussion is the forewarning of an “AI bubble” given that so much of the market cap-weighted S&P 500 is concentrated in seven companies.
There are some legitimate points being made - the valuation of S&P 500 companies, particularly in the technology sector, are higher than historical levels. The explosion of AI in 2023 that burgeoned the stock market in recent years has led some companies to be priced on potential, not near-term earnings estimates. I’m not saying that stocks aren’t overvalued or that an AI-bubble doesn’t exist - it just shouldn’t change how regular people invest their money.
When the media starts reporting that the stock market is overvalued, the natural conclusion that many come to is that it’s immediately time to batten down the hatches because a significant and painful drawdown is soon approaching. In fact, whether the market is trending lower or experiencing new highs, the sentiment seems to always come back to “sell now before it’s too late”. [Encore: Investing When the Stock Market Is At All-Time Highs]
Is there a better, less reactionary way to approach investing in the current market environment? In this article, you’ll learn:
Why making investment decisions solely on stock market valuation can do more harm than good
The most important drivers of long-term investing success
Why Valuation-Based Market Timing Can Backfire
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Occasionally, I’ll have this type of interaction with a friend:
Bob sees the news headlines about the stock market being overvalued and now wants to either reduce his exposure to equities or sell out of the stock market entirely. He plans to re-invest back into equities when things are better / have calmed down / during the next full moon… etc.
“The market can stay irrational longer than you can stay solvent” - John Maynard Keynes
In addition, the stock market may continue to go higher despite it being “overvalued”. It can stay priced at levels beyond its valuation for years. During the 11-year bull market post-Great Financial Crisis from 2009 to 2020, there were numerous instances of analysts calling for a massive pullback due to stock market overvaluation. There were also other events that threatened the direction of capital markets (Eurozone debt crisis, US credit rating downgrade, trade war with China). Despite the headwinds, stocks climbed the wall of worry: the worst annual performance for the S&P 500 in the 2010s decade was 2018 when the index fell 6%. Meanwhile, the index averaged an annualized return over 11%. Not being fully invested during that time meant missing out on those gains.
The bottom line: if you’ve decided to sell equities or hold cash waiting for valuations to return to normal, you’re potentially missing out on important portfolio growth.
The Most Important Drivers of Long-Term Investing Success
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Making buy/sell decisions based on stock market valuation is a form of market timing. What are the actual drivers of long-term investing success?
Instead of basing our investing philosophy on valuations, we prioritize good investor behavior. That means staying invested in line with long-term goals, diversifying your investments, and rebalancing.
Staying Invested in Line with Long-Term Goals
Jumping in and out of the stock market can derail you from reaching your long-term goals. Once you’ve set a time horizon for each of your goals and set up an appropriate asset allocation, staying invested through the ups and downs of the stock market gives you the best opportunity to realize long-term success.
Here’s a personal anecdote of how consistency beats perfection. Scott and I have been competing to see who can run more miles before the end of the year. The loser has to make a small donation to the winner’s alma mater in their name. (It’s a win-win because we’re “getting in shape”).
My running pattern goes in cycles. Some weeks life is busy and I don’t run at all except for one day when I try to run 6 miles at once. Other weeks I’m consistently doing 2 miles every day. Guess which one racks up more miles at the end of the week?
It’s the same with long-term investing. Staying in the competition and being consistent will get you better results than stop/go seeking perfection. I’ll update everyone at year-end on who won.
Diversification and Rebalancing
Once you’ve committed to staying invested for the long-term, you must construct and monitor your portfolio. During portfolio construction, diversify your exposure. Investing your portfolio in different areas lowers the risk of a drawdown in one thing (such as AI companies) significantly impacting your entire portfolio. We like to diversify by company, industry, sector, geographic region, and asset type.
Occasionally you’ll want to monitor how your portfolio is doing. 1-2 times per year, rebalance your holdings back to your original asset allocation. Naturally some investments will do better than others. Rebalancing brings your portfolio back to your intended level of exposure to each investment. But be forewarned - this feels counterintuitive. During rebalancing, you’re trimming gains from the investments that you’re happiest with and committing more dollars to the investments that have lagged behind. It’s OK - do it anyway. Maintaining your target allocation and supporting your risk tolerance are the rewards for following this portfolio maintenance technique.
In Summary
Stock market valuations will likely continue to dominate news headlines in the coming weeks and the volatility we’ve seen so far in November may continue. In my view, retirees should not view valuation headlines as any type of guide to action. There is uncertainty - as there always is - on which direction the market is headed in the short-term. On the other hand, we know with 100% certainty that not staying fully invested has historically resulted in a worse outcome for long-term investors. In these moments, I encourage investors to return to the primary drivers of long-term success:
Staying invested: This also means reviewing your current level of risk tolerance and ensuring it’s still appropriate given your situation and goals. For many it’s easier to stay invested once you’ve gone through the steps to ensure you’re taking an appropriate level of risk.
Diversification: With the tremendous performance of technology companies recently, it’s more important than ever to be diversified into other sectors.
Rebalancing: Trim gains from your winners and add to underperforming assets to reduce portfolio risk and keep your portfolio aligned with risk tolerance.
That’s all for now. Talk soon!
Travis
Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor. This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.
