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Are some people choosing to get more aggressive in their allocation right now?

Not everyone is fighting the urge to run for the hills. Some investors are seeing an opportunity to get more aggressive in order to fully capture gains from an eventual rebound. Larry Swedroe weighs in on that strategy.

Transcript

Tim Maurer:
Tim Maurer back with another episode of ask Buckingham, a new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today our thought leader is Larry Swedroe, Buckingham’s chief research officer. Larry, would you believe it that there are some people who are thinking about getting more aggressive at a time like this? Would you recommend that this is a time someone changed their asset allocation to invest even more in stocks that we see falling on some days?

Larry Swedroe:
Yeah, I think there are two answers to that question. Number one is, should you do it? And the answer is probably not. You had a well thought out plan, sat down with your advisor through the discovery process and we helped you identify your ability, willingness and need to take risks. I’ll assume for the moment that that has not changed here and therefore, you shouldn’t get more aggressive because we don’t know if this is the bottom, if it’s turn.

Larry Swedroe:
With that said, it’s certainly true now that stocks are cheaper because of the sharp drop we’ve had and valuations are a lot lower, so price earnings ratios are a lot lower. Price earnings ratios are by far the best indicator we have of future returns. If you are a speculator or an aggressive investor, which we know we have some people who are like that. That one advisor I talked to had a bunch of his clients call and saying, “Let’s jump in.”

Larry Swedroe:
All of those were ex traders on the Chicago Board of Trade or at banks. Every one of them has been trained to watch for these excessive drops and then to put your toe in the water, get more aggressive because history tells us the odds are good. We will come out of them. In fact, we’ve come out of all of them, although they all know they cannot predict the bottom, but they follow Buffett’s dictum to buy when there’s blood on the street because markets almost always because people are psychological, investors overshoot. They overshoot on the downside and they overshoot on the upside because on the downside it’s your stomach screaming, “Get me out.” And it’s the upside. It’s the reverse. We call it FOMO or the fear of missing out and markets overshoot because of that.

Larry Swedroe:
Here’s what we can tell people, which I think is helpful for both groups of investors. Today, stock still look relatively expensive in a historical sense. The Shiller CAPE 10 or the cyclically adjusted PE ratio was over 30 as we entered the year. I looked just the other day, it was at 22. That’s still higher than the historical average of about 16 or 17, but it’s actually about the historical average of the last 25 years.

Larry Swedroe:
Now that if we invert that, so we take an earnings yield, like a bond deal that would translate I calculated roughly on that day to about a 4.7% real return. That’s the best estimate we have of stock returns over the long term. Now that’s well below the historical 7% real and we had 3% inflation. That’s how we got 10, so people might say, “Tim, that looks still too expensive. We could have a long way to go.” But that’s not the right way to look at it.

Larry Swedroe:
What you have to do is compare that expected return. So let’s take that 4.7 and add roughly a 2% expected inflation rate to that and that gives us a nominal expected return of about seven. Okay, now let’s compare it to the risk list rate, which historically was three. It’s now zero, so we have a 7% or six and three quarters or something like that, expected return to stocks and many people are going to be sitting there and looking at 2008 and having learned the lesson. This kind of crisis is such a shock to the system. The federal reserve is very likely to keep interest rates low for a very long time to make sure we get out of this in good shape.

Larry Swedroe:
That’s going to push people to take riskier assets and invest in them trying to capture what looks like a very good risk premium of about 7%. now that doesn’t mean stocks can’t get cheaper, right? That number could get a lot higher yet, but looking at history, 7% risk premium looks pretty good. I would add this, Tim, internationally, we would predict develop market stocks because of their much lower valuations. You would add another 2% to theirs. So Germany, Europe, Japan, something on the order of 9% nominal and emerging markets because there have been even cheaper because they too have underperformed over the last decade, we would be looking more like say 11%. Now that’s a massive risk premium. Doesn’t mean you’re going to get it, but that’s our best estimate of returns over the next 10 years. Hopefully that helps people who are just sticking with their plan, giving them the confidence that they are likely to do well if they just adhere to their plan.

Tim Maurer:
Larry, if you keep throwing out all these numbers and calculations, we’re going to have to roll a chalkboard into your kitchen there. You can draw some of these numbers for us so we can see it, but more seriously, do we not have a disciplined approach to buying low and selling high that we can put into motion and times of these, if we do feel that sense of need to get a little bit aggressive just simply through the art of rebalancing?

Larry Swedroe:
Yeah, that’s exactly right. That’s what we recommend people do. By human nature, we tend to want to sell when things are bad because we get nervous and our stomachs are roiling. We want to sell and we want to buy out of this fear of missing out and everything looks safe as the market heads up. You end up doing exactly the opposite of what everyone desires to do because you’re selling when prices are low, which means expected future returns are now higher. Selling low and then buying high when things are doing well, you’re selling, you’re buying when things are at high valuations and returns expected are now low.

Larry Swedroe:
That doesn’t make any logical sense, but as I told you, we are psychological in terms of investing. In a way to help avoid that mistake is to have that well thought out plan, which states here is my target, say 60% stocks. You get a 25% drop like this. That’s going to push you down to maybe 55% stocks. Now if you stick with your plan, you’re going to be “forced to buy.” You’re buying low. Doesn’t mean it can’t get go lower, so you have to be prepared for that, but it’s historically, that’s been a great strategy. You are buying low. You get the rally. It goes back up and now you’re at 65% so you’re going to be selling high. Again, much better strategy than listening to your stomach.

Tim Maurer:
Well, we look forward to that opportunity to sell high after this particular downturn. Thank you Larry, and thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com or by emailing your question to question@askbuckingham.com or just click in the upper corner of your screen and it’ll take you directly to the website.

Tim Maurer:
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