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Investing

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.

 

is the market overvalued nowSource: 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.

 

how to properly diversify your portfolioThe 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

stock market timing or investingIf 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.

 

should you try to time the market or not

 

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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Investing

Every Stock is Falling, What Should You Do?

As someone who invests more than half its income, I know how stressful it can be to invest in a falling market. It is hard to know how to invest in a bear market and keep your cool. When the markets are falling it is counter-intuitive but the best thing to do might just be to invest more and ride the fall.

We see it times after times when the markets tank. The media starts yelling on every rooftop: SELL sell sell! This is the classic buy high, sell low, method everyone is talking about right? In his 1997 letter to shareholders, Warren Buffett wrote:

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If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. […] This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices. – Warren Buffett

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Over and over again, the market had its ups and downs but high savers with long-term investment goals should be happy about those bargain prices. Staying on the sidelines will not make you rich. To benefits from the great wealth-producing powers of the market, you can invest in a low-cost, highly diversified, index funds and try to automate all your savings.

The now infamous 1982 Business Week cover:  “The Death of Equities”. As it turned out marked the beginning of the greatest bull market of all times just goes to show you how the media should not always be followed.

If you look at any bear market, even the Crash of 1987, biggest one-day drop in history (brokers were, literally, on the window ledges and more than a couple took the leap), the market always recovers.  

Always.

If someday it really does not, well, no investment will be safe and money will probably have no value anyway.

 

SP500 market chart history

 

All-in-all, you cannot time the market and even market valuations will misguide you. Some easy steps to wealth are to you automate your savings, cut your spending, invest, and forget about it. Time will show again and again that equities will be volatile (it might be scary at times). How on the longer term, equities will always trump over cash. Staying on the sidelines is never a long-term solution.

 

Start investing today

Today is a better day to invest than yesterday. The longer your time horizon, the better chances are of positive returns. For example, over any 1-year holding periods, the worst yearly average return was -37% and the best was +52.62%. However, this changes drastically over longer periods.

Over 15-year periods, the worst average return was of +4.31% and the best of +18.93% per year. Finally, over any 25-year periods, the worst average yearly return was of +7.94% and the best was +17.24%.

If you are a millennial like me and have a few decades to invest, we can assume the average of the last century to hold true and generate considerable wealth over our lifetime. The annualized stock market return for the overall period is about 11% or about 7% after the average inflation rate.

The best day to start investing is today.

Do not try to time the market and do not try to outsmart the market. My best advice for you is to invest in a simple, low-cost, index fund and hold it long term.

The thing is, if you wait for the perfect entry point, you might just miss a great run up and miss on huge profits. On the other hand, if you invest now, even if the market could crash tomorrow you would not even feel the crash over the long-run.

If you want more details you can read my post on why you should invest in index funds.

 

Time is on your side

As a millennial, I will be over 50 years in the markets over my lifetime. Even more, if I choose to pass it on to my estate. My biggest asset is Time! I have recently read a great book by Patrick O’Shaughnessy. He is a portfolio manager at O’Shaughnessy Asset Management, who wrote about how millennials can get over their fear and into the market. It is worth the read, you can get Millennial Money: How Young Investors Can Build a Fortune at your local library for free.

This book introduces a strategy that can help overcome our shortcomings as investors. It underlines the fact that we have time on our side. You simply cannot underestimate the power of compounding!

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Make it all automatic and check your accounts as infrequently as possible. – Patrick O’Shaughnessy

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With that much time ahead of you, savings become much more rewarding. For example, if you would invest only 2,300$ per year for 50 years, (I hope you are saving way more if you are reading this blog!) you would reach the 1,000,000$ with average returns after inflation of the S&P500.

 

compound interest investingSource: Moneychimp Calculator

 

Automate your savings

The fallacy in humans is that we tend to overreact and get emotional when investing. The majority of investors know the secret of making money: Buy low, Sell high. However, our instincts actually make us buy high and sell when the markets are low.

Just look at the financial headlines or popular financial shows like Mad Money with Jim Cramer. Every time a stock rise and rise he will say that it is a HOT pick and time to get in the action! When it slumps he starts shouting at you to sell.

The easiest way I found to ignore the noise and invest logically is to automate my savings.

  1. Check with your employer for a 401k match and start investing on every paycheck. (or RSP in Canada)
  2. Check for employee ownership plans, most of them will match and there again, make it automatic on every pay.
  3. Set up an automatic transfer from your bank account to your brokerage account, either every year, month, pay or week. Then, set that amount to be invested in your desired allocation automatically.

 

Want something completely automated? We suggest Wealthsimple.

Start your automatic investment account today!

 

If you are hesitating between investing every paycheck or just investing in a lump sum, you can read my thoughts on the best way to invest and lump sum investing. I personally invest every pay just for simplicity. I do not think about it and never need to look at it.

Many brokers such as Vanguard offer free ETF trades. You can also choose a low-cost index mutual funds if your broker does not offer free trades. In Canada, we have the TD e-series mutual funds that are really cheap or you can set up accounts with Questrade who offers free ETF purchases. If you are interested in exactly what I invest in, you can read my Open Book series to see my holdings.

You should also check out with your employer for a 401k match and employee ownership plans that might be offered to you. Not maxing out these accounts is like leaving free money on the table.

 

Cut your spending 

Cutting your spending is a double edge sword. It will not only slash your retirement nest requirement but also increase your savings rate. The size of your required retirement nest is a direct result of your spending. The more you get used to a certain level of spending, the more you will need before you can safely retire.

Using the general rule of thumb of 4% safe withdrawal rate from the Trinity Study, your nest requirement would be about 25 times your yearly spending.

If you are spending 40,000$ a year you will need 40,000 x 25 = 1,000,000$ in retirement nest. You will then be able to live off that amount. Withdrawing 40k plus inflation every single year would have a very high chance of success. Some prefer to be safer and use a 3% withdrawal rate, therefore, 33x your annual spending.

Cutting your spending will directly affect this total goal for financial freedom. Therefore, the number of years you will need to work. The more you can put aside in your accumulation phase, the sooner you will be able to retire. The basic principles behind early retirement are fairly simple; if you can save more than 65% of your income, you can attain financial independence in less than 10 years! You can play around with historical simulations on cFIREsim or use Personal Capital’s free Retirement tools and get to your own conclusions. 🙂

 

Forget about it

To conclude, the best advice I can give you is to forget about it. Once you automate your savings into a proper asset allocation for your situation, simply stick to your plan and do not sell before your goal is attained. People will tend to sell when the markets are low but you should actually be buying at those great valuations!

Short-term investing is a loser’s game. As young investors, we have time on our side to profit from compound interest and capture the most of the market’s uptrend. If you think that you would be too susceptible to news events or daily swings, I suggest you start investing automatically and forget about it.

The only thing you might want to do is to rebalance once in a while but again, not according to news events.

The following years will be fun, invest properly and be smart. Be happy, Xyz.

 

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