You would have to reside on Pluto not to notice the buckets of ink spent on warning investors that Armageddon looms as the stock market edges higher. It may well be that the market will correct—markets generally do at some point—but that doesn’t preclude profiting in the long run by adhering to solid investment principles.
What’s driving the stock market’s momentum? No matter which side of the political aisle an investor is on, few can dispute that the business climate has improved dramatically. Cutting the stranglehold of regulation has helped. In the aftermath of the Great Recession, legislators eager to ensure another one didn’t happen soon rushed to correct a financial services operating landscape that was fraught with abuse. Although their intentions were laudable, the execution, in terms of hoops companies where forced to jump through to comply with the rules, were time consuming and expensive. For example, employees who had no access to sensitive customer data often were forced to sit through training programs, periodic reviews, and be tested on protecting that data. A couple of hours out of a day, compounded by several training sessions a year, starts to adds up in lost productivity. More examples abound, all of which incur extra costs in hiring compliance personnel to enforce them. As some of the regulation was rolled back, savings have accrued to companies’ bottom line.
Prospects for passage of a tax bill have also helped buoy investors’ expectations for a stronger business environment. We the people pay for high corporate taxes, in terms of lower wages for workers, higher prices on the goods we purchase, and lower after-tax returns for investors, as a recent article in the Wall Street Journal points out. Although some may argue that the proposed tax bill benefits the wealthy to the detriment of the middle class, few can rebut the argument that higher wages that corporations can pay as a result of lower taxes will harm anyone.
Finally, inflation remains low, barely touching the Federal Reserve’s stated target of 2%. That means interest rate increases (barring an unforeseen geopolitical or domestic situation that could make them spike) will be modest and gradual for the near term. And because rates are low, investors have few options for investing, other than the stock market.
So, even though the stock market is high, it may have good reason, and at the top of the list are investors’ expectations that a better business outlook may make it continue. But that doesn’t mean there isn’t risk. Investing always carries risk, and the savvy investor knows how to mitigate it. So let’s review some solid investing principles that can help protect a portfolio and assuage concern about potential loss.
Crafting a portfolio with non-correlated asset classes is a key to long-term investment success. Various investment styles perform differently. Examples: small cap stocks often benefit when the economy is coming out of recession; dividend-paying stocks are an alternative to bonds that pay low interest rates. So a mix of assets, each performing differently depending on economic conditions, is a good strategy over time. Yes, there have been times when all asset classes fell (i.e., during the Great Recession), but investors who stayed the course not only recouped their losses but went on to participate in the market’s surge.
Don’t try to time the market
It’s tough to do it, and it can be a fool’s game. That’s because the investor has to make two decisions: when to get out and when to get back in. The annals of investing are replete with examples of investors who thought the market topped, sold out, only to watch it hit a new high, meaning buying back in cost them more. Although taking profits is never a bad thing, it gets expensive to buy back in when the market is moving up. Selling high and buying high is not a good formula.
Remember that stocks outperform over time
But the operative word is time. Investment returns seldom go in a straight line, and there will be periods when equities lose money, such as when a ‘flight to quality’ draws investors to the certainty of the fixed income market during periods of market duress. But those periods tend to be short, which is why it’s vital to rebalance a portfolio on an annual basis.
Have patience: What goes up goes down, and then back up (usually)
Investors who withstood October 19, 1987 saw their portfolios plush again a few months later. After the Great Recession in 2008-2009, it took a little longer, but the reward was higher. When the stock market begins to drop, many run for the exit, thus locking in losses that a bit of patience could have turned to profits. When panic sets in, its human nature to follow the herd, but that’s precisely when investors should exercise restraint. A portfolio comprising good companies with solid earnings will right itself in time.
A good rule of thumb is to contemplate a market drop of 20%. An investor who can weather that kind of loss for however it takes for the market to right itself is vastly different from one who shudders when the market brooks a triple-digit loss (even though that loss equates to just 1%). When a sell-off occurs, no one knows how deep it will become or how long it will last. It takes fortitude to stay invested. Those who aren’t comfortable in a volatile environment may be better off having a larger fixed income allocation, even though interest rates are low. At least their money will be there, and that can be a big source of comfort.
Keep some powder dry
Investors with cash at the ready can buy good companies on sale during a market correction. So although it’s a good idea to stay invested, a 5% – 10% allocation to cash means having some buying power. If the market were to drop by 15% – 20%, that’s an automatic 15% – 20% profit for investors who have the wherewithal to act, assuming the market turns around and reaches its previous high. Most times it does, and moves up even further.
In summary, the stock market is at a record high. In times past, “irrational exuberance”—to coin Alan Greenspan’s prophetic phrase—has been a precursor to a correction. And 2008’s market freefall began the worst recession most investors can recall. But investing is a function of understanding where opportunities lie and selecting among the choices available. The safety of fixed income may be where some investors feel most comfortable, and so long as they can live with low returns, that may be the answer for them, based on their circumstances and goals. For others who can accept the risk that investing in stocks entails, a strategy of diversification, exercising patience, and keeping some cash on hand to take advantage of a correction may be their answer.
*This article is meant as entertainment and is not to be considered investment advice. Consult your accountant or investment advisor before making any investment decisions.