Equity Valuations Matter
What can we learn from the above data? First, starting valuations clearly matter—a lot. Higher starting values mean that future expected returns are lower, and vice versa. However, there continues to be a wide dispersion of potential outcomes for which an investor must prepare when developing an investment plan.
Here’s the bottom line: Periods of higher-than-expected returns lower the need to take risk for investors who have already accumulated substantial assets. Such investors should consider taking advantage of that situation to lower their equity allocation. Investors who did so following the bull markets of the late 1990s, and after the period from 2003 through 2007, were much better positioned for the bear markets that followed. They experienced smaller losses than they would have otherwise.
On the other hand, for investors in the early stages of their investment careers and far from achieving their goals, bull markets are bad news because they raise the need to take risk. They require such investors to increase their exposure to equity risks to make up for the now lower expected returns. Or, alternatively, they could lower their goals, save more or plan on working longer.
Of course, the reverse is true of bear markets. They may raise the need to take risk for those who had already accumulated substantial wealth, while lowering the need to take risk for those in the early stages of their investment careers, because expected returns are now higher.
These are simply facts. However, they don’t mean that when valuations are high, and your need to take risk has increased, that you should automatically go ahead and take more risk. In addition to considering your ability and willingness to take risk, it’s also important to keep in mind your marginal utility of wealth.
Ask yourself: Is the extra risk I have to take to achieve my goal worth the expected (but not guaranteed) extra wealth? Or should I lower my goals, or increase my current savings levels so I don’t need to take as much risk? Or, plan on working longer? Helping investors to understand the math, and helping them understand the consequences of their decisions, is how a good advisor adds value.
Bond Yields Matter Too
The same principles apply to the bond side of a portfolio. For example, if real interest yields are high, you have a lesser need to take equity risk, and vice versa. Thus, as real yields change, it may require that your investment plan adapt to the new environment.
For example, today we have very low real yields on TIPS, and also very low expected real yields on nominal bonds. That increases the need to take equity risks, term risk and/or credit risks. For the record, I would not recommend taking credit risk. If real rates rise, that will lower the need to take equity risk. Thus, a plan that’s developed today should adapt to future changes in assumptions.
A good way to address issues surrounding the need to take risk is to run a Monte Carlo simulation every few years, or whenever returns are much different (higher or lower) than your original plan anticipated. If the original assumptions (inputs) no longer apply, the plan should be reviewed.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.