Safeguarding Investments From Asset Bubble

The best advice for investing is “never time the market”. Which means no matter you feel the market is pricy or not, keep investing. But it doesn’t mean you should keep buying assets at ridiculous prices. Instead, we should diversify into different asset classes.

Think about the Japanese asset price bubble in 1989. When the bubble busted, the stock market lost half of its value for the following decade. Another good example is the dot-com bubble.

So the question is how do we know if the stock market is too expensive? It’s very hard to tell. Stocks tend to be always pricy because investors price them for future earnings or earnings growth. Stocks only become cheaper when the market is crashed and investors are panicked. We cannot tell how expensive by just looking at the prices.

A good option is using the equity risk premium (ERP, %).

ERP is the expected return on stocks (S&P 500) over the expected yield of risk-free asset (e.g. 10-year treasury bond) that investors expect to receive. It is a quantitive method to tell how stocks are priced for earnings.

I will adjust my asset allocation according to the ERP.

For example,

• If ERP goes below 4%, rebalance to stocks:bonds=80/20
• If ERP goes below 3%, 70/30.

This doesn’t mean < 4% is bubble, but mean 4% is low return for risky assets and should consider putting more money into bonds or other cheaper asset.

To get ERP, I am using Aswath Damodaran’s web site.

Originally posted on January 4, 2021