This is an unusual time for the market. Our clients have been happy about how well their accounts have been growing, even in conservative portfolios. At the same time, many are unnerved about the daily chaos coming out of Washington, and worry about an impending crash if Trump should do something unexpected that would upset the U.S. market.
There is reason for concern. The U.S. market has been on a tear for the last 8 years, and we know that on the average, we have a market crash every 8 to 10 years.¹ A correction in the U.S. market would be a normal and healthy occurrence, and is overdue.
Moreover, U.S. companies are currently overvalued. The ratio of a company’s share price to its per-share earnings, known as the Price-Earnings or P/E Ratio, is an average 23.8 for U.S. companies. Since 1988, the average P/E ratio has been 18.8.¹
However these statistics don’t tell the whole story. When the media and pundits talk about the market, they tend to put the blinders on, and focus on the U.S. market alone. However, the U.S. market represents only 36% of the world’s total stock market capitalization.² An investment strategy that is based on broad, global diversification keeps this fact in mind. Under this approach, you are not invested just in the U.S. market, but in every market around the world — just the opposite of putting all your eggs in one basket.
We saw first hand in the Great Recession of 2007 how lack of diversification can be a disaster. The Standard and Poors 500 Index, representing the 500 largest companies in the U.S. based on capitalization, fell 60%. Many investors who had only the S&P 500 or similar investments in their portfolio panicked and sold everything at the bottom of the market. They not only locked in their losses, but failed to benefit from the strong rally from 2009 to the present.
Yes, the U.S. market is overvalued, but the media has been saying that every year for the last 10 years, and the market has continued to rise. If you have a diversified portfolio, you would also have international investments that have reasonable valuations (the P/E for German companies is 16)², and also in emerging market investments (countries like China and India) where the P/E is even lower. In fact, emerging market investments were among the best-performing asset classes in 2016.
We learned valuable lessons from the Great Recession that we would do well to remember at this time:
• Don’t try to time the market and pick stocks. They say “the Hall of Fame for market timers is an empty room”.
• Don’t try to skew your investments in anticipation of expected future events, no matter how plausible they sound — they might not happen for a very long time, if ever.
Warren Buffett stated it best when he said there are 3 certainties in life: death, taxes, and rising markets. The Great Recession was the worst crash we had seen since the Depression, but as long as you didn’t panic and sell everything, you would have broken even in 4 years, 5 months.³ That would be just a blip, compared to the 25 to 30 years we are likely to spend in retirement. For many people, a diversified investment portfolio makes it possible to maintain their lifestyles in retirement. By comparison, avoiding all risk by keeping all your money in the bank could make running out of money a guarantee.
Buffett looks forward to market downturns as a buying opportunity. Remember when Bank of America stock was $3 a share in 2008? When you employ automatic quarterly rebalancing, you can buy low automatically. Here’s how it works — when you have a globally-diversified investment, you have about 15 distinct asset classes in your portfolio. They don’t all go up and down at the same time — they take turns. If any asset class increases 4% or more in a 3-month period, you sell some it while it’s up high (like taking some of your winnings off the table in Vegas) and put the proceeds into another asset class that is a bargain at the time. Just doing quarterly rebalancing can make a dramatic difference in long-term performance.
In a volatile and uncertain market, diversification and rebalancing can be your best friends. Not only do they allow you to sleep better at night, but they will make it possible to stick to your plan, accomplish your long-term goals, have a comfortable retirement, and pass something on to your children and grandchildren.
¹ Investment News, 5/2017
² CNBC, 3/13/2017
³ Bloomberg, 6/2017
⁴ Business Insider, 11/6/2016