Stock markets around the world are trading at or near record highs. What, if anything, should investors be looking to do? The American journalist, author and financial educator JONATHAN CLEMENTS offers this perspective.
Stocks have been edging ever higher, and portfolios getting ever fatter, and yet the conundrum facing investors remains the same. We have no idea what will happen next to share prices — and no reliable way of figuring it out.
Consider:
Valuations are rich, but they have been for much of the past three decades. Indeed, if above-average valuations were your signal to sell, you likely would have dumped stocks long ago and missed out on substantial gains. The reality: Valuations don’t predict short-term returns, though they have some bearing on 10-year results.
Just because a market has gone up doesn’t mean it won’t keep going up. Yes, it feels like we’ve had a nonstop 10-year bull market. But there’s been a slew of intervening dips — including a 19.4% drop in 2011 and a 19.8% plunge last fall — so maybe we shouldn’t be especially bothered by the current bull market’s length.
Bonds and cash investments offer skimpy yields, so arguably stocks remain the most attractive asset class, despite their rich valuations. Moreover, while US stocks look overpriced, foreign shares seem far more reasonably priced.
That said, it feels like there’s a limit to how much better the news can get. The 10-year Treasury note is barely above 2%. How much further can yields fall—and hence how much more of a lift can they give to share prices? The corporate tax rate was just cut, giving a onetime boost to company profits. It’s unlikely we’ll get another big corporate tax cut any time soon. Meanwhile, corporate profits are at 9.2% of GDP, versus a 50-year average of 7%. Can we really expect profit margins to widen further?
Where does all this leave us? If you’re under age 45, I’d just keep shovelling money into the stock market, both here and abroad. Even if you have a substantial sum in stocks, you’ll likely save as much — if not more — over the next 20 years. Any decline in share prices could ultimately rebound to your benefit, as you buy at lower prices.
“Goal rebalancing”
But if you’re older, let me put in a plug for an idea that might be dubbed “over rebalancing” or “goal rebalancing”. This harks back to an idea I’ve discussed before — and which I purloined from friend and fellow author Bill Bernstein. As Bill says, “When you’ve won the game, stop playing with money you really need.”
The notion: If you’re comfortably on track to meet your retirement goal, maybe you should dial back the amount of risk you’re taking, so there’s less chance your financial future will unravel because of horrible markets.
Reach for the calculator
To get a handle on the topic, all you need is a relatively simple financial calculator. Suppose you’re age 50, you have $375,000 socked away for retirement and you plan to save $15,000 a year over the next 15 years. Your goal is to retire at age 65 with a $750,000 nest egg, which should be enough to generate $30,000 in annual retirement income, assuming a 4% withdrawal rate. This would be on top of Social Security and any pension income. To calculate your target nest egg, simply multiply your desired annual retirement portfolio income by 25.
We’ll ignore inflation and do the calculation in today’s dollars. There will, of course, be inflation in the years ahead — and, to compensate, you’ll need to step up the sum you save each year with inflation. Let’s also assume you have 75% in stocks and 25% in bonds, which you figure will give you a blended real rate of return averaging 3.25% a year — with the stocks clocking a 4% real annual return and bonds notching 1%. Remember, these are after-inflation rates of return: If we get 2% annual inflation in the years ahead, you’ll need a nominal return above 5% to make the numbers work.
Result? At age 65, assuming that 3.25% real return, you’d have $890,000 in today’s dollars, comfortably above the $750,000 you were hoping for. What if you dropped your target real rate of return to 2.5%, which is what you might earn if you had your portfolio 50% in stocks earning 4% and 50% in bonds earning 1%? You’d still reach age 65 with $812,000, more than your $750,000 target.
A matter of temperament
So should you over-rebalance? I think it’s a matter, in part, of individual temperament. Do you want to lock in your financial future — or continue taking risk in the hope of an even more comfortable retirement?
I also think you need to consider your personal margin for error. What do I mean by that? If a big market drop would put your retirement at risk — and you fear you couldn’t compensate by working longer, saving more or spending less in retirement — I’d be more inclined to declare the game won and opt for a less risky portfolio.
This article was originally published on Jonathan Clements’ blog, HumbleDollar. You can follow Jonathan on Twitter @ClementsMoney.
Jonathan is a regular contributor to TEBI. Here are two of his recent articles you may have missed:
What I learned from five crashes
Picture: Ilnur Kalimullin via Unsplash
