Executive Summary
Although financial planners often rely on long-term averages when making capital market assumptions - whether to design a portfolio or create a retirement plan - there is a growing body of research that makes it clear: not all starting points are the same. Even over time horizons as long as 20-30 years or more, investing in high valuation environments tends to lead to below-average returns (and a notable dearth of results significantly above average), and the reverse is true if valuation is low when the investor begins. While many have written about the investment implications of market valuation, my interest is broader - how would it change our financial planning recommendations, beyond just the portfolio composition?
The concept of secular bull and bear market cycles are relatively straightforward - high valuation levels tend to lead to extended periods of sub-standard performance, and the reverse is true when initial valuations are low. This has been supported in research ranging from Robert Shiller's Irrational Exuberance and his P/E10 ratios to Ed Easterling of Crestmont Research (and his great book, Unexpected Returns: Understanding Secular Stock Market Cycles), and more. The implication - don't take so much risk in high valuation environments, and load it up when valuations are low (favorable).
Yet the implications of market valuation extend beyond just the portfolio. As I have written in The Kitces Report, they also have a significant impact on determining a safe withdrawal rate when someone retires. Those who retire in favorable valuation environments have safe sustainable spending levels that start 20% higher than those who retire when stocks are overvalued.
And I believe the ramifications extend even further. Overvalued markets - with a high risk for market declines - also increase the risk of a significant market decline. And even if the decline is temporary, the impact on an individual's saving behaviors can be long-lasting. The point being - even young investors with incredibly long time horizons must be cognizant of market valuation, or they risk damaging their long-term financial success, even if the long-term return eventually averages out to what was anticipated!
Market valuation can also be relevant for tax decisions. Investors often trying to hold onto investments for the long-term for tax reasons - whether it is to hold an appreciation position long enough for it to qualify for preferential long-term capital gains rates, or simply an unwillingness to sell a position and take a gain (and some risk) off the table because of the tax impact that will occur. Yet the reality is that it takes a remarkably small decline in an investment to completely wipe out the benefit of years of tax-deferral. The end result - perhaps we should be far more aggressive about taking our gains (and cutting our losses) in high valuation environments, and be more open to letting our winners run and our losers try to recover when favorable valuations support it. Similarly, an acknowledgement of valuation could shift an individual's decisions about when to sell a business, or exercise stock options.
The impact of valuation on long-term market returns is also relevant for most forms of financial planning projections we analyze. Return assumptions for a retirement plan might be adjusted upwards or downwards to account for current valuation levels. Monte Carlo projections may acknowledge a dispersion of potential returns, but the probabilities could be adjusted further to account for a valuation environment that still further underweights or overweights the risk of a bad return sequence or the possibility of a good one.
The bottom line is that a long-term average is a useful piece of information, but it just doesn't tell the whole story. And once you begin to account for how markets are valued, the implications quickly spread beyond just a pure discussion of portfolio composition.
So what do you think? Is market valuation a relevant factor in your financial planning discussions? Should it be?
I’m surprised this extremely important article on valuation, returns and goal satisfaction drew no comments. I say “hurray to all” the points made. We argue long and loudly to clients that entry into positions is a hugely critical factor in both investment success and goal satisfaction. What would we do if someone gave us money to invest today? In fact, we did recently receive a client’s inheritance. We’ve invested 80% over the last two month so that it would generate income, but we are acutely aware that we are not at March 2009’s valuations – far from them. On a Schiller valuation basis, we’re overvalued by a long shot compared to historical norms. But valuation is a mug’s game to resolve in the present – it’s only resolved in the future. We are remaining mostly invested, but we are looking carefully at capital preservation in the event of a significant collapse – either in fundamentals or in price. We have more than one risk management tool, fortunately, including rebalancing, hedging and raising cash. But we are acutely aware that we are probably on borrowed time.