Recently, someone asked me what investors should be doing with their investments now that US stocks are creeping back toward record levels. Later in this blog, you will see my response, but let me begin by setting the stage for my thoughts.
Take a moment to look back 10 years ago to August 2008. We were in the middle of the financial crisis, and world stock markets were experiencing price declines. For most of us, it was an uncomfortable time. The economy was in recession, unemployment was increasing, and long standing companies were declaring bankruptcy. We didn’t know when stock price declines were going to stop. We were uncertain about the future.
Now, fast forward to today. Economic growth is hitting record numbers, unemployment is the lowest it has been in a long time, corporate earnings are favorable, and US stock1 prices are up. In fact, US stock1 prices have increased significantly over the past 10 years. The S&P 500 has increased on average over 8%/year2 during the past 10 years. All from a starting point that occurred in the middle of the financial crisis.
At Second Half Strategies, we read economic and investment research from several sources. In recent research, we have noticed lower projected future rates of return for stocks3. Does this mean that it’s time to panic? No! Actually, these projections really make sense. Current valuations for stocks, particularly in the US are high relative to what they were several years ago. Typically, when we are in a period with high valuations, we can expect future returns to be lower. It's all about the math.
For example, if the long term average return for an asset class is 8%, and over the past few years, the average returns have been 12%, in order to move returns back toward the long term average of 8%, we could expect returns lower than 8%. This is called "Mean Reversion." The same principal can be applied to housing prices which have recently been increasing at a much higher annual rate than long term averages. We could be expecting lower or even negative rates of return in the housing market.
But, back to stocks.
Lower future returns may come as a shock to many investors because most investors suffer from what we call "Recency Bias," meaning they expect future returns to be similar to what they have been experiencing during recent time periods. But often, this does not happen. So, rather than fall into this trap, let’s just set the expectation that we could experience lower than average returns on a going forward basis – due to “Mean Reversion.”
First, don't panic and abandon your long term strategy. If your strategy calls for a certain mix of stocks and bonds, stay with it. The market is unpredictable in the short run but much more predictable in the long run...meaning that the longer we are in the market, the more opportunity we have to receive long term average market returns. Your investment strategy should be tied to your time horizon, need for income and risk tolerance.
Second, if an investor has a well-diversified portfolio, he or she can choose to actively rebalance when prices decline. In other words, sell some of the investments that have performed well and have higher valuations and purchase some investments that may not have performed as well and might have lower valuations. 4
Third, when adding money to investment accounts (e.g., 401k contributions), purchase investments that aren't as highly valued as others. When prices are down, keep contributing - you have a unique opportunity to buy investments when prices are lower.
Fourth, interest rates have been increasing. Look for opportunities to supplement your bond holdings with cash type investments. When compared with bonds, you may receive a higher rate of return in the short run with certificates of deposit or by owning individual bonds.5
Finally, you may not want to put money you need for short term goals at risk in the stock market, particularly with valuations so high. Remember, the goal for most short term investments is to preserve principal first and generate some income / growth second.
With regard to short term investments, consider moving money out of stocks if it is earmarked for something you plan to buy in the next 1-3 years. Consider using money market accounts for money you need in 6 months or less, certificates of deposit for money you need in in the next 6 months to 2 years, and bonds for money you need in the next 2-3 years.
As with all general advice, make sure you consider it in the context of your specific situation, and leverage the knowledge and experience of your wealth advisor who likely has worked with you to craft plans to help you achieve your goals. Make sure you let your advisor know when you expect to need funds from your investments. It’s one of the most important pieces of information that helps drive your Second Half investment strategy.
You do have Second Half Strategies, don’t you?
1 Based on the S&P 500 index
2 Average returns for the non-managed S&P 500 index for the trailing 10 years ending August 2, 2018. Historical average returns are not indicative of future results.
3 Research projections do not guarantee future results.
4 Though its important to note there is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
5 Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.