Is the Market Too Risky for You? Four Factors to Help You Decide
Maybe you got a $1,000 bonus from work or a windfall from a recently departed relative. Can you make more of it in the stock market?
It looks doable and exciting if you’ve been watching the stock market hit record high after record high in the last year. But is it too late? Should you be worried about the money you’ve already invested?
Markets occasionally get overheated or panicky. That’s not a bad thing. It’s what makes it possible to earn many happy returns. Ideally, you want to invest when everyone is abandoning great investments for cheap and sell them once they are priced higher than they deserve. Unfortunately, it’s hard to time the market.
Most of the time, you’re better off committing to systematic investing, often referred to as dollar cost averaging. But it’s always fun to try. If you prefer a more hands-on style of investing and want to try to “beat” the market, here are four factors that might help you decide whether to put money in stocks now.
Is Now a Good Time to Invest?
This article addresses when to invest. If you know you want to invest, but aren’t sure how to do it or where to do it, check out How to Invest for Beginners: The Ultimate Penny Hoarder Guide. For now though, here are four factors to consider if you are trying to answer the question: Is now a good time to invest?
1. Let’s Talk About You
If you invest sensibly and stay patient, stocks are some of the best vehicles to help you become wealthier. First, though, you should make sure your money wouldn’t be even better served somewhere else. Stocks returns aren’t as certain as debt payments coming due, nor do they provide the comfort of cold, hard cash if something unexpected comes up.
The higher the interest rates are on credit cards or loans, the more sense it makes to pay them off before putting any money into the markets. When you pay off a credit card with a 19.99% rate, that’s a sure fire way to improve your finances. Over the long haul (periods of 20 years or so), stocks tend to return between nine to 10 percent before taxes.
Some financial advisers recommend you have a rainy day fund as high as a year’s worth of expenses set aside in cash before you start investing in riskier investments. Aside from helping you maintain a stable lifestyle, you’ll worry less about your investments fluctuating when the market goes nutty. Whether you put aside a year’s expenses or not is up to you, but it isn’t prudent to put money you may need immediately into stocks.
2. Let History Guide You
Past performance of the markets doesn’t guarantee anything, but it does help with perspective. Look at a long term chart for the market.
For stocks, many experienced investors prefer the S&P 500 index instead of the Dow Jones Industrial Average, because the S&P index looks at 500 stocks while the Dow only uses 30. Start with the longest time period you can on the chart settings. That might be over 50 years. Then start to look at progressively shorter periods until you feel you understand what’s typical market movement and what isn’t.
Now look at how the market performed during specific market events, such as when the pandemic started to ramp up in 2020 or maybe during the Great Recession in 2007 to 2009, along with the booms that followed. Eventually you’ll have some perspective on how the market has performed. You can do this with individual stocks or any investment that publishes regular quotes and has a long enough history.
If the market is exceptionally high or low compared to its history, you’ll want to not only understand why, but also think about whether it’s higher or lower than justified. One example is how the market plunged during the pandemic. Some stocks went down by more than two thirds. Though many industries were stressed and a few companies would fail, many came roaring back.
3. Don’t Pay Too Much for Profits
Wall Street calls profits “earnings.” Professionals regularly compare investment prices to profitability. Let’s say a share costs $10 and over the last year, the company made a dollar in profits. Then the price to earnings would be 10, since the share price is 10 times the profits made.
Investors see that as a P/E ratio. The higher the P/E ratio, the more investors are willing to pay for each dollar of profit, usually because they expect that profit to keep growing.
You can Google charts for the market’s P/E ratio. In May 2021, the P/E ratio for the S&P 500 was above 40. That’s the highest it’s ever been for over a century, if we exclude the Great Recession, when profits plunged more dramatically than stocks. But at present, if profits for the S&P stay the same, it would take over 40 years for companies’ profits to make up for the market’s current price. Yikes.
4. A Little Common Sense Goes a Long Way
Do you remember in 2006 when people were flipping houses in hours or buying way too much real estate than what they could afford? That was a sign of a classic investment bubble.
Sometimes, your friends and neighbors’ comments will signal whether the market is overdone or a screaming bargain. Are they giddy about their profits? Do they act as if a rally will continue forever? Is everyone around you sharing stock tips?
That’s become increasingly common in the wild market we’ve enjoyed for the past several years, and it’s a classic signal stock prices may be due for a correction or that they will plateau.
When everyone (including the financial media) is afraid to predict that the market might go down, then there isn’t much new money left to drive stock prices higher. Basically, everyone is fully invested, or at least close to it. That suggests the next piece of bad news might cause everyone to take profits at once.
Don’t get caught in a bubble when it pops. With enough experience and observation, you can almost feel when a market is becoming irrational.
If you’re an otherwise average investor, simply reducing the impacts from a few excess markets will do wonders for your long term results. It doesn’t hurt to think like a millionaire either. You can do even better if you can spot when the market has thrown the baby out with the bathwater, too and buy at those rock bottom prices alluded to earlier.
That’s tougher than selling a profitable investment, because studies show we’re more afraid of losing money we already have than we are about missing out on profit (even though effectively they’re the same things).
And in the End
Predicting the market’s direction is and always will be a challenge. You may be right on direction, but off on timing or by how much of a move the market will make.
The most you should hope for is to be more right than wrong. Even that will take experience and insight. But you can stick to a regular plan while always having an opinion. That keeps investing fun while you continue to build wealth.
Contributor Sam Levine holds Chartered Financial Analyst® and Chartered Market Technician® designations and has written on finance topics since 2003. He is an adjunct professor of finance at Wayne State University in Michigan.