Pitfalls to Avoid in a Lofty Market

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Stocks have largely continued their upward march this year and are up about 20% year-to-date. Joining me to share some thoughts on pitfalls to avoid during a rising market is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.

Hi, Christine. Thanks for being here.

Christine Benz: Susan, it's great to see you.

Dziubinski: Now, we often talk about how investors can get hurt--they can hurt their results by getting out of stocks during weak markets and doing some sort of market-timing. But very good markets can also lead you to make mistakes. Let's talk about one of those mistakes that you often talk about, which is chasing performance. What should investors be doing instead of that?

Benz: Right. This is something that we have observed, I've observed, throughout my career is this tendency for investors to try to get into whatever investment has performed really well over the past couple of years. Oftentimes, we see investors gravitate to the investment types that have the flashiest return profiles. But we see that investors systematically undermine their own results with those poor timing decisions where they're chasing the hot performers. I think there's probably a particular temptation today, for example, to look back, look at the tremendous returns that we've seen from growth-oriented investments over the past several years, where they've absolutely killed value-oriented investments, even though value has made a little bit of a comeback recently. And so we see this again and again. We see this in narrowly focused investment types.

Our colleague Amy Arnott produced some great research just within the past couple of months where she looked at this investor timing gap. And she saw that sector funds, for example, have very weak investor returns. Investors tend to get there late and leave early. So don't let that be you. Don't chase what's been hot in the past. If you're adding to stocks at this juncture, look at your portfolio, take a look at what has performed well. Consider adding to parts of your equity portfolio that haven't performed as well. International stocks, for example, would be a logical place to look. They've really underperformed for investors. So, use rebalancing to guide you to slightly more contrarian positioning if you're adding to stocks at this juncture.

Dziubinski: Now, what about the opposite? What about investors who are pretty risk averse in general, and they're very valuation-conscious. What mistakes might they be making today in this type of market?

Benz: Right. I get why they're fearful because we do have not inexpensive valuations for the U.S. market. So I think that there might be a temptation, especially given that we're also seeing some signals that the economy, the economic growth that we've had, might be cooling a little bit. I think there might be a temptation to completely retreat from stocks. And I would be careful there. Avoid that either/or mindset. Because if you are retreating from stocks, if you're taking a significant part of your portfolio out of the equity market and moving it into cash or bonds, for example, just remember that the return potential from those asset classes is quite low, which is not to say you don't need anything in cash or bonds, but you really do want to be careful about what you hold there and don't hold more than you need. And then also remember, if your thought is to potentially get back into the equity market when valuations look better, or where you're less worried about the economy, that's another timing decision that you'll have to figure out, and it's really a tougher one than figuring out whether to get out of the market. So I would avoid that either/or mentality. Here again, I would use my portfolio's positioning to decide whether to make any changes. Compare it to my target asset allocation. If I do see that I'm equity-heavy relative to my targets, by all means strip back on that exposure. But don't do it reflexively. And don't do it completely because you will often struggle with a decision about when to get back into the equity market.

Dziubinski: Christine, what would you say to people who have a decent amount of money to invest right now? Maybe they've inherited some money or come into some other sort of windfall. What should they be thinking about?

Benz: It's an important question. Here, I think, time horizon is really important. So if you are a younger investor, you're putting the money to work in stocks. Know that stocks over long periods of time do tend to go up, and you'll probably make additional contributions to that account. The effects of putting the money to work at maybe an inopportune time right now will be softened by those other factors. On the other hand, if you're someone with a shorter time horizon until you'll need your money, I would say dollar-cost average in--use a series of contributions to get the money to work over the space of six months to a year. And you might also consider contributing to some sort of a balanced account type rather than moving a lot of money into stocks. Maybe use a target-date fund or a balanced fund that will give you exposure to the stock market, certainly, but will also give you exposure to safer assets as well.

Dziubinski: And then another set of mistakes you can make in a lofty market is not considering tax consequences of your actions. What are some of the mistakes to look out for there?

Benz: Right, this is a big consideration. Many investors probably should be doing some repositioning in their portfolios, given that we have seen stocks perform so well in the recent past. But I would say that you would want to bear in mind tax consequences. Focus that repositioning within your tax-sheltered accounts if you can. So, if you have IRAs, if you have 401(k) assets, see if you can't get back to where you need to be by making your changes within those accounts where you won't pay taxes to do that repositioning. On the other hand, if you are looking at your taxable accounts--so your nonretirement accounts--be more careful there. You may be able to identify some losing positions to help offset winning securities that you're selling to lighten up on stocks, but definitely be deliberate, definitely mind the tax consequences of any repositioning that you might do in your taxable accounts because you will definitely owe a tax bill if you sell a lot of winners and you don't have offsetting losers.

Dziubinski: And then lastly, Christine, what about the idea of converting traditional IRA assets to Roth IRAs in a rising market? Why is that problematic?

Benz: Well, it's definitely something to bear in mind if you had in mind doing some conversions from traditional IRA to Roth. And the reason is that any money that is part of that conversion that hasn't yet been taxed will be taxable. So for many investors who want to do conversions, a series of staged conversions can make sense rather than doing a very big conversion in a single year. I would say this is a great area to get some tax help on how to do those conversions and how to factor in how that conversion will affect your tax bill, not just this year, but in the years ahead. Work with a tax advisor to help you figure out whether perhaps a series of conversions might make more sense in your situation. The risk of doing a big conversion in a lofty market is that you are paying more taxes because part of the taxes owe to gains than you would otherwise pay if you perhaps waited to do those conversions.

Dziubinski: Well, Christine, thanks for your time today, giving us some strategies and things to think about in a lofty market. We appreciate your time.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.