Perhaps you’ve noticed the repeating headline this year that the S&P 500 Index of U.S. stocks has reached an all-time high. Through the end of October this index has reached a high 33 times this year, the most highs in a year since the 1999 technology boom.
Investment decisions during periods of big gains (and big losses) are a critical determinant of your overall success as an investor. Decisions at these points are challenging because they are influenced by the biggest factors in money management — fear and greed. They may seem like inflammatory terms, but no one is immune to their influences.
With a bull market now reaching 56 months, here are insights that may be helpful in making decisions amid market highs.
First, notice I did not write market tops. Only one new market high price (identified only in hindsight) will be synonymous with a market peak. Markets occasionally run well past their previous highs. Even if company profit growth slows down — providing less real justification for growing prices — momentum-oriented investors could keep driving stock prices higher.
It is usually not a worthwhile exercise to try to figure out where any investment will go over the short-term, but there are principles of wise investing that you can apply effectively, especially when rising markets tempt you to act in one direction or another.
PUT YOUR STRATEGY IN WRITING
Whether you are accumulating assets or spending down your savings, your investment approach should be defined by a written investment policy statement. This is a common practice of large investors who are serious about keeping their money aligned with their goals or liabilities. An investment policy at the very least should:
• Clearly state the objective of the accounts
• Identify target weights for stocks vs. bonds, U.S. vs. international, etc.
• Define how performance will be measured compared with a relevant benchmark
When evaluating investment progress with this framework in mind, you’ll have clear indicators of when your holdings should be rebalanced back to the previous levels you were comfortable with given their balance of risk and return prospects. This will help you counter the biases and emotional aspects of gains and losses, evolving beyond a buy-and-hope investment strategy.
Applying an investment policy will force you to overcome human nature, especially at market extremes. The process of rebalancing will guide you to sell some of what has done well, growing to a higher percentage of your overall portfolio than originally intended in your policy statement. Sure, it can be tempting to let winners keep running. You wouldn’t be alone in worrying about cutting off a rally short of its peak. But rebalancing doesn’t call for wholly moving out of investments, it’s about reducing what has become expensive (capturing profits) and investing in what is less expensive (likely out of favor with the market in some way).
Particularly, look for individual holdings that may be outperforming the market as a whole. While they may be well managed and continue to post very solid performance, they won’t outperform persistently. Take the position size back to what it was at the beginning of the year. If it was a comfortable position then, it should still be appropriate. This way, you remain invested in the position in case it continues to perform well, but you’ve locked in some profits as well.
Selling might create capital gains taxes if held outside of a retirement account, but don’t let the tax tail wag the investment dog. Tax efficiency matters but realizing your gains matters more. You’ll be a happier investor when you ultimately get to use those gains toward your goals and life experiences.
WHAT TO DO WITH PROFITS
Selling what has done well can be particularly difficult if there don’t appear to be any more relatively attractive options.
If you need to replenish cash reserves to support spending over the next several months or to pay down debt, that’s a naturally good use of realizing gains. But if you’re simply rebalancing, keeping the same amount of money invested, the big challenge now is that other options are not screaming buys. U.S. stocks don’t appear to be on sale. International stocks may be trading at more attractive values and most people are underweight this asset class. But if your rebalance suggests that you need to take from stocks and add to bonds, it may be best to diversify beyond typical bond holdings. Adding floating rate bonds, convertible bonds, or selective foreign bonds may be more useful than buying U.S. government bonds.
Having a written investment approach and disciplined process to follow it, doesn’t have to be overly complicated. Follow the Leonardo da Vinci model — “Simplicity is the ultimate sophistication.”
If it seems too complex for your time or interest, hire a good adviser to help you simplify and apply strategies driven by discipline and defined goals — not fear and greed.Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Reach him at firstname.lastname@example.org.