Investor Exuberance - Rational or Irrational?
Led by emerging markets stocks, valuations of all asset classes continued to rise through the fourth quarter. Price volatility remained very low, despite significant geopolitical risk and a flattening yield curve. The cyclically adjusted price to earnings ratio for the S&P 500 stands at 33, the second-highest point in history. Is this irrational exuberance or can the stock market, fueled by recent tax cuts, continue it’s inexorable march upward? Richard Thaler, Nobel Prize winner, University of Chicago economist and expert in behavioral finance states “We seem to be living in the riskiest moment of our lives and yet the stock market seems to be napping.”
What do we make of this, and how do we prepare for an inevitable reversal? It’s a lot easier to recognize an asset bubble than it is to predict when it will deflate. There are no examples of anyone being able to consistently predict market corrections over long time periods. For those with a long time horizon, this isn’t a huge worry. But, this can be a particular concern for older investors or others either approaching or in retirement. How, then, should we make rational decisions about managing risk?
First, have a plan – understand how much risk is required to produce the return needed to fund future goals. It is not unusual for it to be less than you think. Then, manage the level of risk in your portfolio through effective diversification. If everything in your portfolio has gone up significantly over the past few years, it’s probably time to review the design. If you’ve done all this, stick to the plan and make sure that your portfolio hasn’t strayed too far from the allocation that was chosen to keep risk in check. Continue reading to see a summary of the markets for Q4 2017.