How Do You Invest In An Overvalued Market?
Since 2009, we’ve seen a bull market, with stocks making a dramatic recovery in value back to where they were before the crash of 2007-8. It’s been a good time for investors.
Sadly, this can’t last forever. A growing number of commentators are suggesting that the market is now overvalued, bringing with it the risk of another crash.
So how do you invest in an overvalued market?
Identify Overvalued Investments
One of the priorities is identifying the most overvalued assets so that you’re not taking unnecessary risks.
The most common test for this is the price to earnings ratio (P/E).
This is the price of the asset divided by its earnings. It picks out investments for which you would have to pay an amount that’s disproportionate to their income value.
The higher the P/E, the more likely it is that a stock is overvalued.
Since 1985, the average P/E for the S&P 500 (http://www.multpl.com/shiller-pe/), a popular measure of the state of the market, has been just over 15.
It’s currently just under 30, one of several signs of an overvalued market.
When considering your investments, look at how their P/E compares with the historical state of the market, its current P/E, and each other.
Another sign of an overvalued investment is excessive price gain compared with the company’s fundamentals and with prices in the rest of the market.
Look at your investments in these terms and consider ditching the most overvalued now, while you can get a reasonable price for them.
Rebalance Your Portfolio
Such sales should be part of a broader strategy of rebalancing your portfolio.
Because stocks provide good returns, they’re always going to be an essential part of that portfolio, but the balance of risk and reward can be adjusted.
Reduce the proportion of your portfolio that’s invested in overvalued elements. If you want to give yourself greater stability and security, increase your exposure to fixed income investments.
Invest Internationally
A home country bias isn’t just an instinct for an investor; it’s an approach that has advantages in money handling and researching your investments.
But with western markets looking overvalued, there’s a lot to be said for investing internationally.
One step you could take in rebalancing your portfolio is to increase the proportion invested in international markets.
Countries such as China and India won’t go untouched if American and European markets slump, but they won’t be following the same pattern.
Many international investments can provide you with good returns and a way to reduce your exposure to a single overvalued market.
Spread Purchases
When you are making purchases, consider spreading them out throughout several months.
This way, you can average out the cost of the investments.
Yes, it means that you won’t be able to get them all at the lowest possible price, but it also removes the risk of buying everything at its highest price.
Take the Long-Term View
If you can afford to take a long-term view, then ignoring the overvalued markets may be the best solution.
Historical analysis of the markets shows that, for all the falls in the market, if you stay invested then you’ll profit in the long term.
Short-term decision making, like getting out during a crash, will make sense at the time, but so does riding out the storm.
Unless your strategy is reliant on short-term decisions – a risky and stressful way of investing – your best bet may be to just ignore overvaluations if you have the wealth to accept the lean years.
Be Ready for the Dip
Whether you’re sticking with the long view or not, you should prepare yourself for the drop.
If your income relies on your investments, then make sure that you’ve got funds available to see you through a year’s worth of expenses, along with a bit extra to cover emergencies or a major purchase.
This way, you won’t have to sell off stocks after their prices have fallen so that you can pay the bills.
And be ready to start buying again once the market hits bottom
That’s the best time to make new investments, when everything it undervalued and heading towards the rebound.
Don’t Panic
Above all, don’t panic.
Successful investment is almost as much about psychology as it is economics.
When alarming news stories appear, whether about overvaluations or a crash, and commentators come up with all sorts of wild strategies to survive it, ignore them.
Stick with the strategy you’ve developed. Follow through with your long-term plan. Remember, that long term is where profit lies.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
