Stocks have done well in recent years, and the result is stock market indices at record levels. May 22nd was the 10th time so far in 2015 that the S&P 500 index of large US stocks has closed the trading day at its all-time high. How should you react to this spate of new milestones?
Despite the common tendency for many investors to assume that “what goes up must come down,” historically stock market highs have actually been a bullish indicator. Over the past 40 years, the average one-year gain for the S&P 500 index following a new all-time high is about 2.5 percentage points greater than the overall average one-year gain. So selling stocks simply because the market reaches a new high probably isn’t wise.
But using a new market high as a buying opportunity isn’t necessarily a good idea either. When one particular asset class (such as US stocks) performs well for an extended period of time, this asset class often grows to become a larger portion of your portfolio. This change can substantially alter your portfolio’s riskiness, even if you haven’t intentionally reallocated your investments. When this occurs, buying more of the asset class that has recently done well will just further skew your portfolio’s allocation.
Instead of using a market milestone to try to guess whether the streak will continue or reverse, a better idea may therefore be to use the opportunity to assess whether the market’s movements have distorted your portfolio. If they have, rebalancing back to the risk level you’re comfortable with may be the best action to take.