It's been a bumpy ride in the stock market lately, and it has a lot of investors worried that their savings are about to take a beating. That's a scary thought, especially if we're talking about years of hard work that have gone into your retirement account. It would be silly to ignore some of the warning signs, but now's not the time to give up on the stock market. The evidence overwhelmingly suggests that a steady approach will result in the best long-term investment performance.
Fear is a bad reason to avoid the stock market
Withdrawing from the market right now would be a fear-driven act, and you should strive to remove emotion from your investment decisions. Fear and greed cloud your judgement. Instead, we can use actual data to make decisions.
It's completely sensible to have concerns about the market right now. Major indexes are just below all-time highs, and the strong returns over the past 18 months have made stocks expensive relative to earnings, cash flow, and dividends. Interest rates look set to rise within the next year, and we still haven't fully recovered from the economic impacts of COVID-19. There's a good argument that a correction is likely coming.
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Unfortunately, investors need to have a more sophisticated approach to risk management. Opportunity cost, for example, can be just as destructive as a market crash. What if the next crash is still 12 months away, and major indexes climb another 15% before the hammer falls? Even if your analysis correctly indicates there's more downside risk than upside potential at the current valuation levels, there's still a plausible scenario where staying invested pays off.
Every good investment strategy assumes that market cycles are inevitable and that stock portfolios are volatile. You shouldn't abandon your strategy just because the likelihood of volatility is higher than normal.
A crash probably won't justify selling out
Timing markets is insanely difficult. In fact, it's so challenging that the majority of asset managers fail to consistently outperform the market, even during volatile periods when they're supposed to shine. It's too simplistic to boil this down to active vs. passive investing, but it's important to establish the likelihood of bad outcomes for investors who are lured into short-term stock picking. There's simply too much that we don't know and cannot predict, and timing requires a level of precision that nobody's really been able to achieve. A small number of days provide a huge proportion of total growth. Missing them can completely derail your long-term performance.
Even if we are striding toward a crippling market crash, it's only going to be a temporary setback. Stock valuations ultimately reflect the cash profits that a business is capable of producing. That leaves a lot of room for interpretation and guesswork if we're talking about a high-growth company that could be either defunct or 100 times bigger 20 years from now. That uncertainty is inherent in investing.
However, the stock market as a whole is less uncertain. The market represents aggregate ownership of large corporate entities, which generally grow along with the global economy. Some companies and industries will lead or lag over time, but economies tend to grow. Make sure that your portfolio is set up to absorb an amount of volatility that's consistent with your risk tolerance, and let it rip. Don't be surprised by periodic turmoil.
Who actually shouldn't buy stocks right now?
Most people should be investing in the stock market right now, but there are exceptions. There are people out there who need to cover bases in their financial plans before sinking more cash into stocks. Even these cases are temporary -- it's just a matter of getting their ducks in a row.
The most prevalent group of people who shouldn't be investing in the stock market are those with high-interest debt. Credit card balances are the best example of this, with APRs generally ranging from 15% to 25%. It's highly unlikely that you'd be able to achieve a long-term investment rate of return that exceeds the interest rate on credit card debt. An investor could comfortably outpace the market every year, yet they'd still be better off if they focused on paying down any high-interest debt.
Investors with misallocated assets should also consider a temporary hiatus from buying stocks. If you don't have any cash set aside in an emergency fund, you might consider selling some stocks or building your short-term savings before making any investments. Many experts recommend having three to six months worth of expenses saved as cash. Stocks are liquid assets, but they're too volatile to function as a proper emergency fund, especially because bear markets tend to accompany periods of high unemployment.
Similarly, anyone who is overallocated to stocks should take this time to rotate toward lower volatility assets, such as bonds. Your investment time horizon and risk tolerance determine what percentage of your portfolio should be invested in stocks. If you're overweight equities relative to a model portfolio, then it's time to unwind some of those positions. Even in this case, though, you almost certainly should keep some fraction of your portfolio invested in the stock market.
If you don't fit into one of these categories, then you should stay invested in the stock market. It's fine to make some modest allocation adjustments to changing market and economic conditions, but it's highly unlikely to work out in your favor if you make drastic changes to your portfolio in an effort to time the market.
