By Jack Forehand, CFA, CFP® (@practicalquant) —
A member of my family called me the other day with a question I hear often from both people I know and from people we manage money for.
The question was a simple one:
With the market at all-time highs, valuations at very expensive levels, and the future of the economy very uncertain, should I reduce risk in my portfolio?
Although the question is a fairly simple one, the answer is far from it. So I thought it would be interesting to write about the thought process I would go through in addressing a question like that.
The best way to do that is probably to address each of the three parts of the question individually.
Investing at All-Time Highs
The first idea in the question is the concept that investing in a market that is at all time highs is riskier and that the risk of future declines is higher.
But is that actually true?
The answer is that the data does not support that conclusion.
Meb Faber looked at this idea in a post a while back where he tested two strategies. The first just followed a buy and hold approach. The second switched between bonds and stocks. It only invested in stocks if they had finished the previous month at all time highs. Otherwise, it invested in bonds.
If investing at all time highs is a bad idea, the switching strategy should have significantly underperformed buy and hold. But not only did it not do that, it actually outperformed.
As Meb noted in the article, that isn’t an endorsement for following that type of strategy, but what it does mean is that all-time highs are not a reason to reduce risk.
Investing in Expensive Markets
If investing when the market is at all time highs isn’t a bad idea, then at the very least investing in expensive markets must be, right?
Well, not exactly.
Market valuation can provide us with some insights into the returns that we can expect over the next decade. When valuations are high, expected returns are lower, and vice versa.
But valuations tell us next to nothing about what might happen in the next year, or the next three.
This chart from Vanguard does an excellent job making this point
Source: Vanguard, “Forecasting stock returns: What signals matter, and what do they say now?”
Look at the percentage of the variance of one year stock returns that is explained by valuation ratios (the first two columns). It is very close to zero.
And even though long-term expected returns can be interesting to think about and can help with things like retirement planning, investors live short-term returns and the path to lower long-term returns could come in many different ways. Some of those ways could include very strong returns in the next few years followed by lower returns in the future. And even though valuation does help us predict future lower long-term returns, that process is far from an exact one. It is possible that predictions of lower future returns won’t materialize as expected.
As was the case with all-time highs, high valuations are not a reliable way to time the market.
Investing Amid Economic Uncertainty
The last point is probably the easiest one to address. There is always economic uncertainty. There is always a wall of worry for the market to climb. But it usually does climb that wall.
We just went through one of the best examples of this we will likely ever see in our lifetimes. Think back to April 2020. What did you think about the economy then? What did you think that meant for the future prospects for the market? If you thought that massive government stimulus would lead to a strong economy and one of the best market runs in history, you are much smarter than me and you should probably stop reading this article.
But if most of us couldn’t have predicted that, what are the odds that we can predict the eventual outcome of whatever uncertainty we face at any other given time? The answer is that they are very low.
If you want to see the same point made empirically, look at the Vanguard chart again. There are a variety of economic metrics in the chart and all of them have one thing in common: they essentially tell us nothing about future stock returns.
So economic uncertainty also isn’t a great reason to reduce risk.
The Essential Role of Behavior
After I just spent most of this article addressing why the major reasons that many investors are thinking about reducing risk right now don’t really hold up to scrutiny, you would probably assume that my advice to my family member was that they should not adjust their risk exposure.
And you would be wrong.
How could that be? Either I am losing my mind or there is another major factor at play here. Although I am probably not the right person to evaluate whether I am losing my mind, I think the answer is the latter and not the former.
That major factor is investor behavior. My family member had built up their account during this market to levels that were close to where they need to be to meet their long-term goals. And they were much more likely to regret losing money from here than they were to regret missing out on a portion of future gains.
And the most important thing is that they were only making a minor adjustment. They were not going completely to cash or making the binary type of choices that typically lead to the biggest mistakes.
It is easy for those of us who write about investing theory to think about everything through that lens, but we also have to keep In mind that the theory we write about is put into practice by human beings who are impacted by the biases and emotions that affect all of us. Even if making a small change to a portfolio doesn’t make sense in our ivory tower of theory, it sometimes can in the real world. In my mind, this was one of those cases.
Living in the Gray
In the end, investing in rarely black and white. One of the biggest lessons of my career has been that the best outcomes are often achieved in the gray area in between. It might seem obvious to a practitioner like me that reducing risk in response to factors like those I discussed in this article doesn’t make sense. It might also make sense to the investor on the other end that going to cash to preserve gains makes the most sense. But when theory and behavior are balanced, the answer usually lies in the middle.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.