It’s Not Overvaluation That Matters So Much, It’s the Emotions That Cause Overvaluation

I’ve been writing for 10 years about the importance of considering valuation levels when setting your stock allocation. I get a mixed reaction. Just about everyone agrees that valuations matter. But most investors think I am wrong to advise investors to change their stock allocations in response to changes in valuations. They argue that timing doesn’t work and that changing allocation levels could be dangerous.

I think about this and think about this and think about this, trying to understand the source of the disconnect. I of course get it that making an inappropriate allocation change could hurt you. That’s obviously so. What people miss from my perspective is that you also can hurt yourself by failing to make a needed allocation change. There is no neutral territory. If an allocation change is needed to keep your risk profile constant, the danger is in failing to make the change.

I have come to believe that most investors do not fully grasp the significance of a finding that stocks are overvalued. The implications are far-reaching. High valuations signify a dysfunctional market. When prices are high, you cannot trust anything that anyone says on any subject relating to stock investing. To say that stocks are high priced is to say that the entire system by which investors go about the business of financing their retirements has broken down.

When investors are behaving rationally, they set the stock price at fair value. If one investor makes a mistake and offers to overpay for a stock, the prices for all shares go up and investors who were on the edge of believing their allocations were proper seek to sell their stocks because they understand that the value proposition is not as strong at the higher price. It is through this process that a functioning market establishes proper prices. When prices remain high indefinitely, the market is telling us that investors have become so emotional that it can no longer do its job.

People often point out to me that stocks have been selling at insanely high prices since 1996. “Should I have stuck with a low stock allocation for that entire time?” they ask in a tone suggesting that the question is obviously a crazy one.

I don’t think the question is crazy at all. I have been going with a zero stock allocation since the Summer of 1996. When stocks are again selling at reasonable prices, I will be heavily invested in stocks. The fact that stock prices have remained at insanely high levels for so long doesn’t make a case for ignoring valuations. It makes a case for paying attention to valuations. We should all be ashamed that we have not been doing our part to get stock prices back to reasonable levels.

Say that you had a friend who was 100 pounds overweight and continued to live a more or less normal life for 16 years despite that reality. Then one day he up and died at age 50. Would you say he was smart to ignore the warning signs? Would you say that the fact that he didn’t die during his first 16 years of being 100 pounds overweight signified that being 100 pounds overweight is not a problem?

Overvaluation is not something that hurts us in a day or a week or a month. It always hurts is in the end, however.

To understand why that is so, you need to understand what overvaluation is. Overvaluation is the product of investor emotion. That’s by definition. So long as investors are rational, there never can be overvaluation. When you see large amounts of overvaluation, you are seeing large amounts of investor irrationality. That should scare you to death if you have large amounts of money invested in stocks.

The trouble with discussions about overvaluation is that people on the two sides of the debate are speaking different languages. Those who believe that overvaluation is a bad thing become increasingly alarmed as prices move higher and higher. Those who believe that overvaluation is no big deal become increasingly convinced that this is so as prices go higher and higher. These people view rising prices as a good thing. So even higher rising prices are viewed an even better thing. And even higher, higher, higher prices are viewed as an even better, better, better thing.

If you don’t see overvaluation as a big deal, there is no price level that could ever concern you. The attitude of those who believe that overvaluation is not a big deal is that any price set by the market must be more or less right, more or less okay. Those of us who worry about valuations focus on the fact that it is we investors who comprise the market and that, once we stop caring about valuations, we lose the ability to handle the important responsibility handed to us.

Many investors take comfort in the fact that stock prices have shot upward since the 2008 crash. I see it just the other way. I had hoped that we were all going to come to our senses after seeing the damage done in the crash and be doubly sure from that point forward not to permit high prices ever to reassert themselves. Those hopes were obviously in vain. We are now back close to where we were prior to the crash and thus have paved the way for a second crash, one with more devastating impact given that it will come at a time when millions of consumer/investors are more concerned about their financial futures than they were prior to the first crash.

The road leading from investor irrationality back to investor rationality is a difficult one. I have come to believe that the key to having functioning markets is putting in place guardrails that prevent the majority of investors from ever coming to approach the investing project in irrational ways in the first place.

Want More FREE Finance Tips?
Like what you just read and want to get more great content from Financial Highway? Just enter your email address below and you'll automatically get Financial Highway posts sent straight to your inbox.
We hate spam just as much as you

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>