It is a common fear. Nobody wants to be the one who invested money in March of 2000 or October of 2007. Investing at the top of a market rally can leave a sting not only to your investment account, but also to your pride. In fact, behavioral finance experiments have proven that people are twice as likely to fear this mistake than they are to be excited about jumping in at a market bottom. Humans are genetically designed to fear risk.
Unfortunately, market tops only make themselves evident in hindsight. It seems obviously now that March of 2000 should have been an easily predictable top in the midst of the tech bubble of the ‘90s; however, it clearly wasn’t to almost all investors. Throughout the ‘90s, the market closed at a new all-time high on 46% of the trading days. In addition, the NASDAQ market index grew more than 100% in 1999, the last year of the bubble. In fact, despite a NASDAQ correction of 80% during the three-year tech bust, the NASDAQ only retraced its gains from February 1998. What this means is that if you would have invested in July 1997, several years into the tech bull market of the ‘90s when the market was making all-time highs, you would have still been holding a profit in 2003 at the bottom of the bust.
Markets are supposed to grow. Economies and populations expand, thus, expanding global markets. Certainly, stock prices don’t increase in a straight line and short-term corrections and busts are the price we must pay for outsized market returns; however, markets grow over long periods of time. Selling investments simply because markets are at all-time highs is a recipe for long-term underperformance. You may occasionally make a good timing call and get out before a major correction, but I guarantee that correction will be short-lived and any savings will be more than offset by the dozens of times you sold in the midst of a long-term rally, missing significant potential growth in your portfolio. The key to successful investing is to stay in, continue to put new money to work through good times and bad (especially during the bad). This is the only sure-fire strategy that will pay off in the end.
However, just because you should not change your investment strategy during all-time market highs doesn’t mean there isn’t anything you can do. Here are a few things to consider when markets are booming:
- Deleverage – During a good economy or market environment, the instinct may be to leverage up. Buy property, open credit cards, borrow to invest in a winning market. Although the lure may seem compelling, the opposite is almost always a better decision. Deleverage your financial life during a booming economy to prepare for the next bust. Pay off all consumer debt, pay down a mortgage, pay off your cars, etc. All of these will help position you in a strong place when there is an inevitable correction or bust to either survive or even thrive, picking up discounts when those less prepared need to sell their assets wholesale.
- Rebalance your portfolio – If a market correction is a serious fear, perhaps a portfolio rebalance towards a slightly more conservative allocation is in order. This does not mean getting out of stocks entirely or ceasing monthly contributions to retirement accounts; rather simply moving away 10-15% from stocks toward more conservative investments. Leaning this portion toward investments such as treasury bonds or even gold will help protect the portfolio if there is a market correction while still letting the bulk of the portfolio grow to outpace inflation.
- Increase emergency reserve – Everyone should have 3-6 months of cash sitting in an FDIC insured account in the case of an unforeseen emergency. Now maybe the time to increase this cash balance. During a market boom, redirecting a portion of contributions that are normally going towards aggressive investments into your emergency reserve to increase the balance to 9-months of living expenses will furnish a greater cushion if your prediction of a market and economic crash is correct.
Booms and busts are inevitable. Predicting them is impossible. 93% of automobile drivers think their driving skills are above average. I imagine that the percentage of average investors who think their skills are above average is higher than that. There are experts with years of education and experience in this field making millions of dollars a year who are terrible at predicting future market moves. Don’t make the mistake of thinking you can. Shore up your balance sheet using the three strategies above and keep investing. You will be much better off in the future!