How to Invest when the Stock Market is Overvalued?

In recent years, the market has seen great growth. Some may ask themselves if it is gone too far. Has it gone too high? Is the next stock market crash coming? The stock market is overvalued with P/E ratios higher than average. Valuations seem to be in bubble territory… Or are they?

 

The P/E ratio is the Price of a stock versus its Earnings. What a company earns is compared to the current price of its stock, the lower the P/E, the cheaper the stock is.

 

As of posting, the price per earning of the S&P500 is standing at 20.57 compared to the mean of 15.57 as shown in the graph below.

 

Source: Multpl.com

 

However, can we really still use P/E to value the market? Many technological stocks are now irrelevant to this metric since they intentionally keep their earnings low (Amazon for example with P/E of 403). The market has greatly changed and evolved from what it was even 20 years ago.

Earning growth and dividends are the driving factor that impacts stockholders returns. However, no one can successfully time the market or guess the future of the market. Even investing at the highs of the market has generated considerable returns over the long run. The game has changed and history cannot be used to predict future returns.

 

The secret is diversification

So what if the stock market is overvalued? We have established that you cannot predict the market. You cannot time the market but how can you protect your hard earn cash from the crash? Diversification.

For this previous research, I used the S&P500 for simplicity but you should diversify even more than 500 companies. I suggest a Total Market fund (VTI) with some International fund and some Bond fund (BND) depending on your age.

With great companies going out of favor (Polaroid…) and huge behemoths getting gamble away by management (Nortel, Enron…), you cannot expect to pick the perfect stocks and hold them forever.

However, with index funds, you can easily buy and hold a Total Market ETF such as VTI and expect it to grow considerably over the long-term. Investing in over 3700 companies lowers volatility and your overall risk of the fund.

To further diversify, I loosely use a three-fund portfolio (US, International, and Bonds) that maximizes returns with lower risks with very little fees. You can see my exact holdings and the type of account I use in my Open Book series.

Of course, being diversified will not save you from a market crash. It is healthy for the market to correct itself. Ups and downs simply mean that the market is volatile but you can use this volatility to your advantage with dividend reinvestment and a strong investment plan.

 

You need to be patient

At least once in our lifetime, the market will crash and there is nothing you can do about it. The only thing you can do is to diversify to soften the ride. As long as you have a long-term horizon to enjoy the ride up.

 

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. – Warren Buffett (2008)

 

Short-term investing is a loser’s game and can be very stressful. By taking a long-term approach, you allow yourself the time to capture the market’s biggest up-trends and greatly increase your total returns.

There is a really interesting study that shows how only a few days in a year will contribute to the majority of annual gains in the market (chart below). You can only imagine that it is incredibly hard to identify these days and much easier to miss out on the gains. When including dividend reinvestment, time is certainly on your side and anyone in this mindset will outperform cash.

 

What is important is time in the markets

If you are young like me and planning to invest for the next decades ahead, you have a lot of time ahead. There is one important thing in investing; stay away from the temptation to try to time the markets. What is important is time in the markets.

You can trade, buy, sell, all you want. In the end, chances are that you would have been better off simply holding it. The markets have their ups and downs. It is statistically very hard to get it right trade after trade, year after year.

 

Warren [Buffett], it strikes me that if you did nothing else you never sell. That is, if you can grit your teeth through and just disregard short-term declines in the market or even long-term declines in the market, you will come out well. I mean you just stick all your money in stocks and go home and don’t look at your portfolio you’ll do far better than if you try to trade it.  – Alan Greenspan

 

You are never the only one to get it wrong

There is a classic example of Bob the world’s worst market timer where Bob invested at every high of the market, just before every major recession. Even investing only at the very highs of the market, Bob would still end up with major profits (around 10.1% annualized since 1970) if he simply sticks to index investing with dividend reinvestment.

Market timing is hard, if not impossible over a long period, and I do not suggest it. What I do suggest, however, is having a good, clear plan that will sustain market dips. Grow your wealth over the next decades. As the historical data shows below, the annualized returns of stock indices would be much higher with a buy and hold approach rather than trying to time the market.

Being out of the market on the 10, 20 or 30 best days has significantly reduced returns. You simply cannot guess those days every single time. Remaining invested and staying focused on the long-term is the best strategy for investing in volatile markets.

 

 

A Good plan includes

• Savings rate (whether a saving schedule or defined amount each year)
• Investment accounts used (always try to optimize your taxes)
• Investment allocation
• Rebalancing schedule

To start, your savings rate is the principal instrument to determine your accumulation of wealth as explain in my basics for financial independence. Whether you use dollar-cost averaging, lump sum investing or investing at every pay, you need to have a plan to save and invest. When writing out your plan, you need to keep in mind:

• It is OK to make mistakes, do not lose focus and stick to your plan.
• Losses will happen if you invest in stocks, there is no way around it. You need to be prepared for them and again, stick to your plan.
• Saving more, thinking long-term and allowing compound interest to work in your favor are your biggest accelerator for building wealth.
• Time is your biggest asset in your investment plan, use it. Here again, stick to your plan.

 

Always optimize

To continue, you should maximize your tax-advantaged accounts such as 401k (or RSP in Canada). Doing so will greatly help you grow your wealth given that all profits and dividends will not be taxed. In addition, this will decrease your taxable income and leave you with even more money to invest. The difference in returns turns out to be phenomenal even at the lowest tax rates.

You should also consider any program where your employer is giving an employee match, this is free money. I prefer maxing out my retirement account to get the tax break on today’s income since I know I will have a smaller income once I am retired and therefore, will pay fewer taxes in the end.

As I said, investing pre-tax monies gives you a huge advantage over the long-run. For example, if you have $1000 to invest today, it will grow much more than if you were to invest only $700 of after-tax monies (assuming 30% tax rate). That $1000 will grow over the years all tax-free when kept in your retirement account.

 

Indexing is the key

In terms of investments, I will go over this in multiple posts but I suggest index investing to offer proper diversification and optimal growth. This strategy requires next to no effort and can offer great long-term growth. To each its own, the buy and hold value investing strategy that Warren Buffett has used to build wealth has worked out great for him. However, indexing requires less research, knowledge, and capital to grow wealth.

Rebalancing will also help reduce your portfolio’s risk and keep your portfolio allocation in line. I personally rebalance my funds once a year to make sure my allocation stays in line. If a fund has grown by the end of the year, I will sell the profits. Then, buy more of the under-performers to come back to my set allocation.

 

If all of this sounds too complicated, we suggest Wealthsimple.

Start your automatic investment account today!

 

I still think that the best time to invest is today and you should not try to time the market. Even if the market did tank tomorrow, I know that I am investing for the long-run and time is on my side.

Live Happily, Xyz.

 

 

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