Is the Stock Market Overvalued?
Investing in the stock market has historically provided an excellent way to grow your savings over time. The compound growth available through investing allows you to reach your goals faster or to build a larger nest egg. The first step to investing is to decide whether it’s right for your current situation. Then, if you choose to move ahead, it’s a matter of learning more about your options and picking the best fit for your needs.
As you learn more about investing, one barrier that prevents some people from moving forward is the belief that the stock market is overvalued. The idea of paying more for something than it’s worth doesn’t sit well with people. On top of that, they fear the stock market may fall, bringing it back to the ‘fair’ value that they’re willing to pay.
There are two problems with letting this belief stop you from investing:
It’s difficult to determine if the stock market is overvalued.
If the stock market is overvalued, it doesn’t mean it will drop in price.
The fair value for the stock market
The first challenge is determining whether the stock market is offering a fair price. People will often reference historical trends and ratios to decide whether an investment is worth the price or not. However, because the world is continuously changing, it’s tough to say whether previous ratios and prices are the right comparisons. If the world fundamentally changes through new inventions (e.g., electricity, internet), then the way we think about the stock market needs to change as well. As a result, it’s challenging to know when an investment is overvalued.
There doesn’t need to be a drop in price
The main reason people avoid an overvalued investment is that they expect it to fall in price. The following graph demonstrates what most people expect to happen to an overvalued stock market.
The drop in value from the stock market’s price in year 3 to its ‘fair’ value in year 4 is what most people fear. As a result, some investors will hold off on their investment, hoping to buy in at a lower price in the future. This presents a risk because even if the stock market is overvalued, which we mentioned before is difficult to know, that doesn’t guarantee a drop in value.
An alternative graph shows that the stock market can return to its ‘fair’ value gradually over time.
If you don’t invest because you feel the stock market is overvalued, you could be right and still miss out on years of growth. This is important to remember. An overvalued investment doesn’t have to drop in value for it to eventually find its fair value.
Another potential scenario is that the market remains overvalued for an extended period. The following graph shows a market continuing to grow while remaining overvalued.
It’s difficult enough to determine whether the stock market is overvalued. On top of that, you may be right but never have the chance to buy at what you believe is a fair value. As a result, I prefer a different way of thinking about investing and deciding whether to move ahead or not.
Future returns and your alternatives
When I mention investing in markets that are considered overvalued, I’m not suggesting you invest blindly. Instead of looking at historical ratios and trends, consider your future returns and your alternative options. A stock market that is expected to grow at 5% a year over the next ten years would be considered overvalued by traditional standards. This is because stock markets have historically grown between 7% to 9% a year over long periods.
If you avoid investing in the stock market because you consider it to be overvalued, you could miss out on the 5% annual growth. If 5% is better than any other investment opportunity you can find, then you can still feel good about investing in the stock market.
If you can find a different investment (e.g., starting a business, purchasing a property) that is expected to give a better return with a similar risk level, then you could choose not to invest in the stock market.
Closing remarks
Trying to time the market is challenging. If you wait to invest, you could miss out on years of growth. As we’ve seen, an overvalued stock market doesn’t necessarily need to drop in price. The best thing you can do is to invest when it makes sense for your situation, and then ignore the market until you need the money. As we’ve mentioned before, purchasing riskier investments like stocks requires a long period to minimize the chance you’ll lose money. The strategy we outlined above doesn’t work if you’re only investing for a year or two since stock markets can change drastically over short periods. If you’re saving for a longer-term goal, the stock market is a fantastic tool to help you grow your savings, often even when it’s considered overvalued.