The answer to this dumb question is simple. Just. Don’t. Invest.
Because if you know that a market or a particular stock is overpriced, why would you invest in it?
See, this second question was rhetorical. And so, you get my point.
A more intelligent question might be: how do we know if a market is overpriced? The short answer is: we can never know with 100% certainty. At least not until we have the benefit of hindsight. And by that point it’s too late to avoid a crash.
An even more intelligent question might be: well, if we can’t predict a crash or ever truly know if a market is overpriced, how can I invest so that I’m not impacted by a crash? The answer to this question requires understanding the following 3 concepts (yes, only three!), and stitching them together into a coherent narrative:
- Investment Timeframe
- Diversified Portfolio
- 1 Year Cash Buffer
Have a go at creating your own, personal narrative around these three concepts. I’ll discuss them at length in another post.
So, back to the first question: “How can we tell if a market is overpriced, and for that matter, under-priced?” Well, we’ve already heard the depressing short answer. Now for the long, over-simplified answer… are you ready? Here it is: there are market metrics we can track and interpret their meaning in the overall local & global context. Sound too vague to you? Yes! That’s because while a metric by itself may point to overpricing or under-pricing, which is objective and factual, when you consider that same metric in the context of the status-quo, a different, subjective interpretation will arise.
For instance, the Shiller PE ratio is the most often-mentioned market metric used to determine where the market is at. Currently it is pointing to overpricing. The following website will explain it far better than I can here so go and check it out. https://www.multpl.com/shiller-pe
The story goes, because the average Shiller PE ratio is 16.64 and today’s ratio is above 30, the market must be overpriced. According to concept of “regression to the mean”, at certain times the market price will overshoot and undershoot the average, but it will always return or regress to the average in the long run. This is an inevitability. Or so they say.
I think this is a very dangerous concept to subscribe to. Here are my 3 reasons why I believe this.
- Opportunity Cost of Not Investing
- New Price Data Changes the Historical Mean
- Market Timing is an Unhealthy Habit
Again, I want you to read between the lines and try to piece together your own understanding of these three points. Each one of the above points really needs to be expounded on at length and I will do so in a later post. The bottom line for me is: Keep Calm and Keep Investing. Don’t try to outsmart, time, or wait for the market. Be a part of it and in the long run you will do just fine.