Whispers and warnings about an overvalued stock market have been circulating since last year. All the while, stock prices have kept on rising, with only minor, short-lived pullbacks. Right up until September, anyway.
In September, the S&P 500 and the Dow Jones Industrial Average both dipped more than 4%. You can see the dip in the table below.
For both indexes, the September downturn was the largest monthly drop since March, 2020. October then wiped out those losses -- but is there more rockiness to come? And if so, is it safer to pull your money out of the stock market now, while you're ahead?
More volatility is certain
Image source: Getty Images.
I can confirm that more stock market volatility is on the horizon -- though I can't say if it will happen next week or next year. Given that uncertainty, it's tough to know whether you should pull your money out now. What you can do is walk through the potential outcomes to understand how selling now could affect your wealth.
To do that, let's assume you liquidate your portfolio today for $100,000. Going forward, stock prices will either drop, rise, or stay the same. Here's a look at where you might end up in each scenario.
If stock prices drop
If the market drops 10% or 20%, you'll still have $100,000 in cash. That would be a positive.
You don't want to keep that wealth in cash indefinitely because inflation will sap your purchasing power over time. So you'll have to decide when to reinvest. Ideally, you'd rebuild your portfolio with that $100,000 just as the market starts to heat up again.
Getting that timing right will be a challenge. Even the experts often don't know in the moment if the market is heading up or down. It usually takes hindsight to identify how the market is trending, so there's a high probability you'll reinvest too early or too late:
- Reinvest too early and your portfolio will lose value after you reinvest -- the same situation you were trying to avoid initially.
- Reinvest too late and share prices will be higher than when you sold. You'll pay more than $100,000 to rebuild the same portfolio.
If stock prices rise
Say the market rises 3% or 4% through the end of the year. On December 31, you'll have about $100,080 in cash, assuming you earned 0.5% in a cash savings account. If you feel confident enough to reinvest, it might cost you $103,000 or $104,000 to rebuild your portfolio.
If stock prices stay about the same
You'll still have your $100,000 in cash, plus interest. The stock market slugs along, up one day and down the next. Probably, you'll be in a holding pattern -- waiting for a definitive sign that you should stay out or reinvest:
- If the definitive sign is a market correction, you have your cash, but no idea when to reinvest.
- If the definitive sign is a rising market while you were on the sidelines, you will have missed out on growth.
Selling has risk
As you think through these scenarios, you'll make your own conclusions on the safest course of action.
When I review these potential outcomes, I always end up at the same place: I see more risk in selling than in doing nothing. Even in the best scenario, where I sell and avoid a crash, I can still lose by mistiming my reinvestment.
An argument for doing nothing
Doing nothing has risk, too. I can stay invested, for example, and feel the full force of a stock market crash. I'd watch my portfolio balance drop and then wait, nervously, for share prices to recover. That wait could be months or years. In the meantime, I have an emergency fund that should keep me from liquidating when share prices are down.
Participating in a crash is stressful, for sure. But staying invested has one advantage that outweighs everything else: It's the only strategy that guarantees my portfolio will benefit from a future recovery.
I like that guarantee because stock market recovery gains can be steep and unexpected. The March 2020 crash demonstrates this well. As you can see in the table below, the market bottomed on March 23, 2020. Three days later, the major indexes were up more than 17%. If you had blinked, you might have missed it.
OK, back to the question at hand. Is it safer to pull your money out of the stock market now? I say no -- because I'm prepared to wait for a down cycle to end. To the extent you might need cash from your portfolio soon, your answer might be different.
