“Objects in mirror are closer than they appear.” That’s a standard warning on cars’ side-view mirrors. While the mirrors’ shape provides drivers with a wide field of view, the cost is that it can make objects look smaller—and hence, farther away—than they really are. In a way, this is an apt analogy for how some investors may be looking at the market. The recent market gains have been so quick with the S&P 500 Index up 9% (total return) in the first half of the year, and the MSCI Emerging Markets Index up 18.43% in the same period, that some investors may be wondering whether the end of the run is closer than it appears.

Should investors worry about high valuations?

By most conventional metrics, equity valuations are high. Credit spreads are narrow. Where do you go when you’re afraid things will fall apart the moment you step in?

Let’s start with fear over high valuations. Some investors might be worried that investing more in equities when valuations are high is just asking for trouble. If valuations are high, that must mean they will go lower, right? I looked at the data and it suggests that high valuations can persist. As shown in the following chart, historically, when valuations were in the top quartile (the highest 25% of the time), they stayed in the top quartile 65% of the time over the next year. My take on the data: While valuations may fall, it may take a while to happen. For investors, it may be too early to get too defensive.

How about concerns over narrow credit spreads?

When it comes to narrow spreads, some investors might fear a scenario in which suddenly credit spreads blow out. But as shown in the following chart, historically, that scenario hasn’t tended to happen. Narrow spreads, just like high valuations for equities, have tended to persist.

While valuations may be high and credit spreads are indeed narrow, these things could persist for a while. In fact, valuations could potentially go higher and credit spreads narrower. If they do go higher and narrower (respectively), this may help investors understand why prudent investing typically requires diversifying and patience. High valuations often imply lower long-term returns, not necessarily negative returns. It just may require a bit more patience and a focus on total return, which includes interest and dividend income.

Not all price increases necessarily represent the start of a bubble

William Goetzmann of the Yale School of Management points out that market bubbles are actually quite rare; it’s just that the small number of bubbles we’ve had throughout history have tended to mislead people, by restricting attention to the crashes that followed large market increases.

If market bubbles are rare, then so is the bursting of market bubbles. In fact, bursts have been rarer than bubbles, as some bubbles were actually booms that occurred without a subsequent bust. Booms could happen when markets emerge from a bear market, a long period of low returns, or when most investors are expecting big economic changes.  Equity prices can run ahead of company fundamentals, like earnings, but these things may resolve with fundamentals catching up to prices, which is often what happens when markets move in anticipation of policy changes and those policy changes actually end up becoming realities.

Some gaps between prices and fundamentals may look so wide to investors, that it seems implausible that the gap could close. However, sometimes prices can take a long pause rather than quickly retreat. This is consistent with the viewpoint that sharp price increases do not, on average, predict low returns going forward. Sharp price increases may increase the likelihood of low returns, but it is equally likely that you could see higher returns leaving the average unchanged.

What are investors truly concerned about?

Most individuals tend to prefer avoiding large losses, even if there is the prospect of an equivalently large gain. This is called loss aversion, a scientifically studied cognitive bias. Overall, these investors focus more on how to avoid losing money, rather than how to achieve solid returns. With loss aversion, people would prefer to avoid losing 10% even if it meant giving up the chance of making 10%. That’s why it’s probably little comfort to these investors, when they hear market strategists say things like, “If we’re in a bubble, we’re probably in the early stages of a bubble.” Right thinking doesn’t always produce right action, especially in investing, where logic and emotion duke it out over who’ll govern investors’ decision-making.

Five ideas for investors worried about a bubble burst

  1. From a portfolio positioning perspective, it might just make sense for many investors to sell winners and reinvest in higher conviction value opportunities. This can involve simply rebalancing a portfolio more frequently towards one’s strategic allocations. Often, it pays to “let your winners run,” but that’s not always the case.
  2. Another approach is to not simply invest in broad sectors, but specific stocks that you like within a sector. The reason most investors shouldn’t always simply invest in a whole sector or broad swath of the market is because some stocks are more attractive than others.
  3. Rebalancing more frequently towards target allocations and focusing on stocks more than sectors could help favorably shift the potential upside-to-downside ratio while staying fully invested.
  4. Outsourcing investment decisions can be one way to help take the emotion out of investment decision making. That’s why using a financial advisor could be an effective way to wait out any bubble that may be brewing. Not only are they trained and licensed to help, they also aren’t encumbered by personal connections to the assets an investor may be concerned about, amidst talk of market bubbles.
  5. Investors may also want to look into options like target date funds or other asset allocation models. These vehicles take a disciplined approach to investing across a broad array of assets giving the benefit of diversification. Those options may also help investors stave off emotional decision-making, as they wait out potential bubbles.

The market bubble burst might be farther away than it looks to investors. In fact, the bubble investors think they see coming might even be a mirage.

Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

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