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Among those saying the stock market is currently overvalued is no less than Robert Shiller, who won a Nobel Prize in economics in 2013 for his research on market valuations and who has been credited with predicting the collapse of both the dot-com and housing bubbles. So while we know that prices could go higher, now is the time to consider adjusting your risk appetite.
In just a few years, the U.S. stock market has rebounded dramatically from the lows of 2009. Many investors who were fearful when the recession hit now appear more willing to take on additional portfolio risk. That seems like a perfectly human response to rising prices. But human nature often leads us astray — and there are a few types of investors for whom the danger is especially acute.
The busy or easily distracted
When time is tight, it’s easy to lose sight of seemingly less important priorities, especially when things appear to be going well. This may be the case for investors with portfolios that haven’t been reviewed or adjusted recently.
Complacency is a poor investment management strategy. Goals and personal circumstances change, just as the markets do — sometimes suddenly. Seemingly in the blink of an eye, children move from elementary school to high school, or a midlife accumulator is on the brink of retirement. Just as important are changes in health, family (divorce, loss of a spouse, a new baby) and employment.
Big life changes require you to reconsider your risk appetite — but those same changes can be distractions that prevent you from doing just that. So, individuals who have been distracted over the past five years would be wise to consider a risk appetite adjustment — especially after the market has seen such a dramatic rise.
This group includes those with considerable income or a sizable nest egg. Maybe they have been saving consistently for quite some time and have benefited from the strong market performance, which has put them ahead of their investing goals. Limit pushers may therefore be in a position to take on additional risk — but they may also be overlooking the effect their limit-pushing has on those close to them. What they should be asking themselves is: “Why take more risk than necessary, especially when market values are at such lofty levels?”
Goal line reachers
These investors are like the football player who gets stopped a few yards short of the goal line and stretches his arm toward the end zone, hoping to get the ball in for a touchdown. Extending the ball out from his body increases the risk that it will be swatted away for a fumble and a turnover.
Rather than stretching and taking on the added risk now, the goal line reacher should consider waiting until the next down to run the ball in — a safer play. Investors are taking a gamble when they stretch their personal risk tolerance or capacity for risk. They may be lulled into the idea that things are safer than they were a few years ago. It would be wise for the goal line reacher to go back to the huddle, review all the options and reset for the next down with a smart play in place.
I see two main challenges to taking action to dial down portfolio risk appetite:
- The first is the regret that may be felt if prices continue to rise. Economist Eugene Fama, who also won a Nobel in economics in 2013, has demonstrated that prices cannot be predicted in the short-term. The 1990s showed how the market, even when overvalued, could continue rising for years on end.
- The other challenge is figuring out where to place your risk if you’re not going to put it in the stock market. Typically, bonds are considered less risky than stocks — but continuing low interest rates and the perception that rates will rise make a move into bonds now unpalatable and scary, too.
The bottom line is we don’t have to look too far back in history to know that prices can change swiftly and without warning. Rather than be reactive, why not be proactive and adjust risk appetites to match your current situation and the current market?
Image via iStock.