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Is it better to jump in all at once, to average-in over time, or to wait for a market correction?
Determine your desired long-term allocation
You first need to figure out how much to allocate to equities, which will depend on your view of the expected return and risk of equities and your clients’ degree of risk aversion. Over a long horizon, equity returns are driven by earnings and dividends, which are easier to predict than sentiment-driven short-term changes in valuation. Many analysts claim that the world equity market not just the US) has a long-term expected compound return above inflation of around 4% to 5%, based on today’s earnings yield of about 5% and dividend yield of around 2.5%.
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You’ll need to combine your expected return estimate with your view of the risk of owning equities and your clients’ risk aversion profiles to arrive at a target that feels right to you. All else equal, it will be higher or lower depending on your forecast of the return of equities, and only if your expected return is zero (or negative) would you want to have no equities at all.
How much to worry about the short term?
If your short-term forecast is different than your long-term one, it is the short-term one that should primarily drive your decision. Unfortunately, there’s a lot of evidence warning us that it’s very difficult to forecast short-term equity returns, as conveyed by the axiom, “time in the market is more valuable than timing the market.”
When equities are cheap, measured by any of the common valuation multiples, future returns have been higher than when they are expensive. Although this is already accounted for in long-term forecasts, some investors worry that short-term performance is more dependent on valuation reverting to fair value than is actually the case.
While we don’t have enough historical data to draw precise conclusions, what we do have suggests that the commonly used valuation multiples don’t give us much help in predicting short-term performance. For example, if we look back over the past 130 years of U.S. equity market experience when P/Es were in the highest decile, subsequent one-year real returns were lower than average, but still had a mean positive annual return of 3.4%. This is not to say that you can’t have an expectation that equities are going to go down 10% next year, in which case you really shouldn’t own any equities at all. It’s just that if you think equities are going down next year, based primarily on equities being over-valued, know that history is not on your side.
The benefits (and cost) of wading in gently
Once you determine the right allocation, should you immediately make the adjustment and move our allocation to the optimal point? An incremental adjustment over time (“averaging-in”) is not financially optimal. However, averaging-in provides a psychic benefit; if the markets go up over the period that we’re averaging-in, then we’ll be pleased we got some of our savings invested at the beginning, and if the markets go down we can be happy we didn’t move all the way right at the beginning.
By Victor Haghani, read the full article here.