April 12, 2021 – Featuring Kent Schmidgall, Wealth Advisor
Concerns about market downturns certainly come as no surprise. After all, steep corrections and crashes can be disconcerting for even the most steely and disciplined investors.
What has been surprising to me, however, is the number of inquiries I have received over the years raising concerns about the stock market being “too high” or “overvalued.” These concerns generally manifest themselves in some variation of questions like the following:
These are logical, appropriate and entirely rational questions, and only a flinty-eyed Vulcan would think otherwise. Well, I’m no Vulcan, so I’m going to share not only logical, but also psychological, insights into whether or not it may make sense to invest hard-earned dollars when the markets are high.
I distinctly recall implementing a new portfolio just after the market breached 18,000, a new high at that time. I recognized that the market was at an all-time high, yet in the absence of a clear crystal ball (something that no one possesses), proceeding with the well-thought-out plan remained the prudent option. I was confident in this course of action because less than a third of this new portfolio had exposure to the asset class that the financial media and general population refer to as “the market.”
Did you notice how casually I equated “the market” with the Dow Jones Industrial Average in the preceding paragraph? One of the critical keys to investing when “the market” is at an all-time high is to ensure that your portfolio is not concentrated only in asset classes represented by benchmarks popular in the news. When someone brings me a concern about “the market” being high, I must ask, “Which market are you referring to? Domestic stocks? International stocks? Bonds? Value stocks? Growth stocks? Large-cap stocks? Small-cap stocks? Real estate? Liquid alternatives?” I’m sure you see where this is going.
Diversifying among various sources of risk serves as a hedge against placing too much wealth in only one risk basket. Thus, while a conventional portfolio heavily concentrated in large-cap U.S. stocks may rightfully cause concern when popular benchmarks such as the Dow or the S&P 500 are at all-time highs, it doesn’t necessarily mean that other asset classes or sources of risk are as richly valued.
Taking the plunge
A common fear of investing cash when the stock market has reached a new high is the possibility of a market crash shortly after deploying the funds. Although this is a rational and understandable fear, the evidence demonstrates that investors are best served by ignoring recent market performance. The timing around when to invest in the stock market should instead be governed by a holistic plan anchored in your goals and that takes into account a wide range of potential market outcomes. At the beginning of each trading day, the expected return for stocks is positive, regardless of what happened the day before. Thus, it’s always a “good” time to invest for the long-term. And if today isn’t a good day to invest, when would you know the “right” day to invest has arrived?
According to data compiled by Dimensional, from 1926-2019, the average annualized compound returns for the one-, three- and five-year periods after new market highs (using the S&P 500 as the benchmark) were, respectively, 13.9%, 10.5% and 9.9%. What’s more, bucking conventional thought, the returns for those same time periods following market declines of at least 10% (at 11.3%, 10.2% and 9.6%) were lower than the returns after market highs. From this data we can conclude that trying to time an entry point for investing cash is futile.
Evidence shows that lump-sum investing is a superior approach to spacing out the investment over time, a timing strategy known as dollar-cost averaging. Here is one way to think about this concept: If you chose to invest a portion of your cash immediately, and then space out the remaining investments, there now exists inherent tension in answering the question, “Now that you have invested a portion of your portfolio, would you rather that the stock market go up or down?”
Of course, most people would prefer to see the stock market rise after making an initial investment, yet, logically speaking, if the market were to drop, then subsequent purchases could be made at lower prices. But we aren’t purely rational creatures. While the logical solution may be to invest cash all at once, the psychological solution for you may be to space out investments over time, if that is what will allow you to take action and move forward.
If you have a diversified, well-thought-out investment plan that appropriately factors in your willingness to take risk, your interests are best served by implementing the plan immediately without viewing past performance in the rearview mirror. If the thought of investing the entire lump sum at once ties your stomach into knots, then embrace the fact that you are not a Vulcan either and spread out the investment in a structured and disciplined manner.
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