It’s a natural human emotion to not want to miss out on something that could be potentially great.  In the investment world, this FOMO may show up as an investor foregoing bonds with modest returns for stocks that have had stellar returns. It’s also natural that some investors choose to ignore developed international and emerging market stocks in favor of U.S. stocks, which have dominated over the last decade.  

But chasing performance by only going after “hot stocks” or the latest investment trends can hurt your portfolio returns. 

Here’s why: you may be placing your money into overvalued investments that may not experience such great returns in the future.

So how can you assure a long-term investment strategy that helps you achieve your retirement planning and other goals?

What is Valuation?

The performance of your investments can depend heavily upon the valuation of the assets. To understand the importance of valuation in retirement investment planning, we want to first define what exactly valuation refers to. Stock valuation is the method of determining the worth of a company’s stock relative to its share price.  

While many different valuation models can be used,  they mostly boil down to earnings expectations (current and future) and what the market is willing to pay for those expected results.  
 

Let’s consider the S&P 500 index's valuation as an example: 

The S&P 500 index contains the 500 largest stocks that trade in the U.S.  As of 9/30/2024, the S&P 500 index stood at a value (or price) of 5,762. Next, in order to figure out the valuation for a given investment, we need to know the current and expected earnings for that investment. 

As it relates to the S&P 500, aggregate member consensus analyst earnings for the next twelve months (as of 9/30/24) stood at $268. This means that investors were content to hold/buy the S&P 500 at a Forward 12-month Price-Earnings (P/E) Ratio valuation of 21.5x expected earnings.  (We got this by dividing the current value of the S&P of 5,762 by its expected earnings of 268.)

Understanding Valuation Metrics for Retirement Planning
 

So what can valuation tell you as it relates to your investments and retirement planning? 

Once you have a current valuation, you can compare it to historical valuation levels to see if it is considered “cheap” (below average) or “expensive” (above average).  

Following is the Forward 12-month P/E Ratio valuation for the S&P 500 over the last 30-years:

You can see that the September 30th, 2024 valuation of 21.5x was higher than the 30-year average of 16.7x and thus would be considered “expensive.” This means you are investing money at a premium and should expect more modest returns as a result.  

Valuations can also be used to compare alternative investment options.  For instance, you can compare the S&P 500 valuation to similar indexes that represent international stock markets to see where relative value exists.  

Following is a chart from J.P. Morgan Asset Management showing Global Forward 12-month P/E Ratio valuations over the past 25 years:

The grey bar represents the 25-year range, the purple bar represents the 25-year average, and the blue dot indicates the current valuation.  We’ve already seen that the S&P 500’s valuation of 21.5 was above its long-term average.  

Here, we can see that Japan, Europe, Emerging Markets, and China currently offer investment opportunities at valuations below or near their historical average levels.

Why Valuation Matters in Your Portfolio

Valuation matters greatly in investing, and it should probably be the only thing that matters in an efficiently functioning free-market economic sense.  Investors risk their capital to earn an economic return.  

It should make sense that an investor will earn a better return on an investment if they pay less for it (i.e., buy it at a lower valuation).  You can see in this chart by J.P. Morgan Asset Management that subsequent five-year annualized returns are higher when the S&P 500 starts at a lower valuation (as well as where we sit as of 9/30/2024):

Another great chart by J.P. Morgan Asset Management highlights the S&P 500’s inflection points, or high and low valuations, since 1996:

This chart provides some rich context.  You can see that the S&P 500’s valuation stood at 25.2x before the “Tech Bubble” bursting in March of 2000 before falling 49% by October of 2002 when it reached a low valuation of 14.1x.  

You can further see the S&P 500’s valuation at the bottom of the Great Recession in March of 2009 reached 10.4x before it grew by 401% and reached a valuation of 19.2x in February of 2020 before Covid took us on a quick roller coaster.  
 

Why Investors Should Chase Valuation and Diversification, Not Performance

While valuations can help provide context in current market conditions, they cannot tell us precisely when things will change or how things will play out.  

This is why active managers so often fail at market timing (which research backs).  

Valuations give you a sense of the intermediate to longer-term return potential that an asset class presents.  Yet today, so many investors choose to ignore valuations and the principles of diversification and instead rely on past performance to inform their portfolio construction and asset allocation decisions.   

Chasing performance can leave a near-retiree or retiree with investments at valuations driven up by recent positive performance and expose them to greater risk of volatility (i.e., investment risk).  This investment risk can be compounded further by not holding assets that offer uncorrelated return potential (i.e., bonds).  

The greater a near-retiree or retiree’s investment risk, the greater the exposure to a negative Sequence of Returns Risk event that can exponentially deplete a portfolio.  

Another unintended consequence of chasing performance?  Overly optimistic retirement planning modeling.  

Most financial models carelessly project the recent stellar past returns into the future, leading to optimistic retirement planning outcomes and overconfidence in sustainable spending levels.  

If you need help de-risking your portfolio’s construction and asset allocation, we stand by to help. Click here to get a complimentary Thrive Assessment or schedule a call with our team of retirement planning specialists.