The world is oversupplied with oil, U.S. interest rates are rising and international prospects look dim, with slowing growth in China and persistent troubles in Europe and Japan. How should investors react?
When asset prices decline, people naturally want to take action to alleviate the pain. Yet sometimes no action is the best reaction. Trying to avoid the next market meltdown or identify the next hot market is a siren song for all investors, but even professional investors are collectively unsuccessful when they try to time buying into or selling out of particular investments. For the 15 years ending December 31, 2014, only 19 percent of stock mutual funds and 8 percent of bond mutual funds survived and outperformed their indexes, according to data from Dimensional Fund Advisors and the Center for Research in Security Prices at the University of Chicago.
Understanding Valuation Principles
The basic theory behind investing is easy to understand: Buy low; sell high. However, determining what an investment is worth, and thus which investments are underpriced and which are overpriced, is not as easy as it seems.
U.S. Treasury Regulations define “fair market value” for federal tax purposes as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Essentially, this describes what happens in the stock market every day. Two independent parties reach a mutually agreed-upon price at which to trade an investment.
Each investor makes certain assumptions about the future and has reasons to buy or sell an investment. Every time a trade occurs, it is another affirmation that two parties agreed on an appropriate fair market value for the investment at that time. In this way, the market incorporates the collective wisdom of all investors’ different predictions of the future.
The degree to which a market’s prices are accurate and its mispricings are unpredictable is known as a market’s efficiency. Efficiency varies by markets. Markets with more participants, a freer flow of information, better-informed participants and more trading tend to be more efficient than markets that lack these features.
Avoiding The Temptation To Time The Market
Many of us think we are smarter than the average investor, so we should be able to outperform the market. We read headlines about the hedge fund manager or other star investor who profited handsomely by accurately predicting the last unexpected event. The next time you hear about these predictions, remember this quotation from Malcolm Gladwell: “If you make a great number of predictions, the ones that were wrong will soon be forgotten, and the ones that turn out to be true will make you famous.”
One investor may get several predictions wrong before getting one right and may be too early with his or her prediction. In hindsight, we will recognize such clairvoyance, but before the unexpected occurs, multiple experts would likely predict wholly different scenarios. The majority of professional investors underperform the market, and those who consistently outperform may do so by chance.
Investors can get a little more information about how expensive a company or market is by looking beyond recent stock market movements. Just because markets have declined does not mean their value cannot fall further. Nothing in the laws of math or the markets prevents an investment that has fallen 50 percent from declining another 90 percent. For this reason, you should not concentrate your portfolio in an area that has had recent trouble with the hope of it bouncing back.
Experienced investors often look at certain valuation metrics to give them an idea of how expensive an investment is. The most widely known of these measures is a stock’s price-to-earnings ratio, but there are several others, including its price-to-book value, price to cash flow and dividend yield. These measures provide more information than just looking at a market’s recent moves, and they can be compared across time and across markets to determine a market’s relative valuation. However, again investors as a whole might be correct to seemingly over- or underprice a market, and it is hard to know when the market is wrong.
You can find substantial support to prove that almost any valuation is right, and probably just as much to prove that it is wrong. Cheap markets can get cheaper, and frothy markets can get more expensive.
Those who invest in the market do so with the aim of maximizing their profits. Unless you think you know something of which others in the market are unaware, think twice before changing your portfolio. Markets quickly incorporate new information into prices, and you are unlikely to be trading ahead of the crowd.