Earlier this month, the S&P 500 Index (SNPINDEX: ^ GSPC) has doubled its pandemic low of March 2020. While returns to investors over the past year and a half have been phenomenal, it is unlikely that the next year and a half will see the market doubling again. In fact, some investors believe that the stock market is currently overvalued and that a correction could be considered in the near future.
If you are in this camp, you might be wondering if you should just take your money out of the stock market now. While this protects you from market volatility, it does create a few additional risks to be avoided.
When you sell your stocks and transfer more of your assets to cash, inflation will slowly eat away at the value of your holdings. Your brokerage account probably pays no interest on your cash, and even the best savings accounts pay only a fraction of a percentage point.
At the moment, we are experiencing significant inflation. The consumer price index jumped 5.4% in July from a year ago. The Federal Reserve says the high inflation rate is only transitory and expects to manage the money supply for a 2% inflation rate over the long term.
In the short term, however, the Fed is OK if inflation is high. This means that selling your shares now and switching to cash carries additional risk of a high inflation environment.
While stocks are also affected by inflation, inflation does not affect every stock in the same way. Value stocks generally perform better in high inflation environments, while growth stocks underperform. If you are concerned about current stock valuations and inflation, it may be safer to shift your allocation to value stocks rather than cash.
What will you do with the money?
If you sell your stocks and hold cash, you pay the opportunity cost of your lost investments. If you have a plan to generate a positive return on that money, such as a down payment on an investment property or switching to another paper asset like bonds or cryptocurrency, then selling shares may not be. not be the worst thing.
But investing in a broad-based index fund has always been one of the best investment returns you can get over long periods of time. While there are periods of highs and lows, the long term trend is for the market to continuously rise, producing positive returns for patient investors. And it’s much simpler than investing in real estate, cryptocurrency, alternative assets, or even individual stocks.
If you are just planning to hold cash and wait for market valuations to go down, you can hold onto it for a while. The market could continue to climb higher, defying expectations, and you will miss out on potential gains. And even if the market goes down, you need to be sure you know when to reinvest your money in stocks.
Synchronizing the market by moving between stocks and cash is impractical and often leads to missed returns on investment. Additionally, there are transaction costs to consider, including capital gains taxes.
Think about rebalancing
Instead of taking money out of the stock market in cash, a better strategy is to rebalance your asset allocation. If your portfolio is all-stocks and you’re worried about prices, this is potentially a sign that you should have more bonds and other less volatile assets.
As you age and move closer to your expected retirement age, you should move more of your assets to less volatile asset classes in order to preserve capital. Balancing your holdings of stocks with assets with a negative price correlation, such as Treasury bonds, is much more effective at preserving capital than holding stocks and cash. This is because if stocks fall, the value of other assets will generally rise. Cash generally loses value over time due to inflation.
Make sure you have an appropriate asset allocation for your goals, and you won’t wonder if it’s safer to take your money out of the stock market. Maybe it’s time to rebalance after the massive rise in stocks.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Questioning an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.