Is the Stock Market Too High to Invest?

May 23, 2013

Usually when I talk about investment mistakes, I refer to what is known as the “greed, hope, and fear” cycle. This is the well-known tendency of investors to invest more aggressively when the stock market is doing well, hope it will come back when the market begins its inevitable downturn, and then eventually sell near the bottom out of sell fear. Investors are then typically reluctant to get back in until things “settle down,” which means when the market has gone up for an extended period of time and is possibly nearing another high point. This causes investors to buy high and sell low, the opposite of what you want to do.  

As you can imagine, this can really eat into your returns. For example, a Fidelity study of 401(k) participants showed that those who fled stocks during the financial crisis in 2008 and stayed out of the market until mid-2011 grew their account balance by only 2%. Those who bailed out of stocks and later got back in at some point during that time period, averaged about a 25% growth. But those who stayed in the entire time, earned over 50%. Perhaps this is part of why Morningstar’s research has consistently shown investors under-performing the funds they invest in.

I’ve been hearing something else though lately. Since the market has been doing well recently and is reaching new highs, many people are worried that we’re reaching a new top and that it’s now time to cash out their winnings or at least stop putting more money in. They cite concerns about the economy, especially what will happen when the Fed eventually slows down its printing press. Is this justified?

Well, a market high isn’t a good reason to sell on its own. Take a look at any long term stock market chart and you’ll quickly notice that getting out at any new market high would cause you to miss all the highs above it and hence most of the returns. What’s the point of investing if you don’t let your investments grow the way they’re supposed to?

But what about the Federal Reserve? One reason the Fed might raise rates is a growing economy, which is typically good for stocks. In other words, stopping the medicine doesn’t necessarily mean you’ll fall back into sickness.

Of course, the Fed could raise rates prematurely or for other reasons like inflationary pressures. That’s why we diversify with cash for the former and real assets for the latter situation. Otherwise, good luck trying to read Ben Bernanke’s mind.

The reality is that lots of time and money has been spent by some of the top investment minds trying to figure out how to time the market like this and none of them have been consistently successful. Do you really think you’ll do any better? (If so, you really should contemplate a new career since this unique skill of yours is sure to be more lucrative than whatever you’re doing now.

So what’s the answer? Make sure you’re properly diversified (not too much in any single security or sector) according to your risk tolerance, re-balance your portfolio at least once a year to stay properly diversified, and look for ways to minimize costs like fees and taxes. Boring? Maybe but your portfolio shouldn’t be the source of excitement in your life. So go ahead, relax, and enjoy your summer instead.