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Topic: Wealth Management

Understanding Market Risk in a Bull Market: Go Beyond the Noise

Many investors look at various factors in the process of understanding market risk—and this includes plenty of information you don’t need to worry about

When they first set out to formulate an investment strategy, many investors decide to focus their stock market research and understanding of market risk on a handful of measures. For instance, they may want to see a stock market p/e ratio (the ratio of the price of the stocks in the market to their collective per-share earnings) below 15.0, say, along with an earnings growth rate of 20% or more a year, and perhaps a 2% dividend yield.

Just as often, though, they look to the financial media for clues to the market’s direction. Here are some of the things they hear—and often react to:

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Understanding market risk: Three key “risks” investors hear during a bull market

  • “Stocks are getting expensive.”

You could agree or disagree on this one, depending on what yardstick you use. Stock prices are above average right now, based on various historical measures. Most of these measures are little help in forecasting stock prices. However, stocks are still moderately priced in relation to interest rates. This is a measure that can at times provide worthwhile stock-market guidance.

  • “Interest rates are rising.”

That’s true. However, interest rates are just one piece of a very large puzzle. That said, interest rates are still unquestionably on the low side. In many cases, stock prices have gone up for lengthy periods when interest rates were higher than they are today, and/or rising.

  • “This is already the longest-lived stock-market rise in history.”

This is like the kind of news coverage of a heat wave that quotes the town’s oldest resident that, “This is the hottest day I remember.” Sure, but daily temperatures go back a lot longer than a single lifetime.

More important, the length of a bull market is different from, say, the best-before date on a carton of milk. A few simple facts determine how long milk takes to go sour. The length of a bull market depends on a vast array of facts. In any one bull market, commentators can only guess at how many facts are involved, and how they fit together.

No one can predict the market, in other words. Still, many successful investors find that intelligent guesswork is more helpful than ignoring the subject.

Understanding market risk and your portfolio better during a bull market

In any bull market, conservative investors often wind up selling their best stocks way too early. Often they do so because their stocks seem to have gone up “too far, too fast,” or because “I can buy it back on a dip,” or because “they’re no longer cheap.” These are all bad reasons to sell.

There’s a large random element in all stock-price changes. When it seems to you that stocks have gone up “too far, too fast,” it may mean you’re mistaken about how far or fast they should go up. You may be unaware of good things that are going on out of sight and raising their value. Perhaps these things have already happened, and the stock is going up as the news spreads.

In a bull market, “they’re no longer cheap” is a particularly insidious rationale for selling. As we’ve mentioned, most stocks are cheap at the start of a bull market. As time passes and the rise continues, investors get more confident. A virtuous circle develops. Investors are willing to pay ever higher prices for earnings, sales and improving prospects, and this leads to higher levels of earnings, sales and prospects, pushing investor confidence and stock prices higher still. Eventually the fun ends, of course, but conservative investors tend to underestimate how long it can last.

If you sell when stocks are simply “no longer cheap” (or are “fully priced,” as a broker might put it), you will miss out on a lot of profit.

Understanding market risk: Predictions never work out as well as hard facts

You see this again and again in investing. Stock market predictions are terrible at determining what effect changes will have on an industry. It’s even harder to predict how long those changes will take to appear. Of course, adverse changes are hardest on companies with bad financing, poor products, weak management or other drawbacks. Meanwhile, successful companies figure out ways to adapt and even profit from change.

Most successful investors agree that it’s a good idea to base investment decisions on facts rather than stock market predictions. You can make mistakes with facts, of course, but predictions have a much higher failure rate. However, one obstacle to investment success is that it’s easy to mix the two up.

KEY POINT: Understanding market risk by tuning out the market noise

Market noise is financial news, data or minor stock movements that can distract investors from underlying stock value or true market trends.

Market noise, which can also include economic noise and is sometimes simply referred to as “noise,” is often responsible for speculative trading.

For this reason, you’ll often hear successful investors explain that you need to “tune out the noise” to make profitable investment decisions.

What is your greatest fear during a bull market?

What is the biggest investing mistake you’ve made during a bull market?

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