Stick with Stocks for the Majority of Your Holdings

How much money should you keep in the stock market even if you’re worried that it’s now significantly overpriced? The answer: probably a lot more than you think. Even when the U.S. stock market is significantly overvalued, long-term investors may be better off keeping the bulk of their portfolios in stocks, according to research conducted on behalf of a Cambridge University endowment. That’s based both on the long-term returns from equities, which have beaten alternatives such as cash or bonds, and the comparative difficulty of capitalizing on stock-market movements over the short and medium term.

By many measures, U.S. stocks indeed appear overvalued. Shares are very expensive by historical standards when compared with annual dividends, or average per-share earnings of the past 10 years, or the country’s gross domestic product. Yet the stock market still remains the best investment around, especially for anyone looking to save for a horizon of 10 years or more.

In 2008 Andrew Smithers and London University economics professor Stephen Wright conducted research into long-term investment strategies on behalf of Cambridge’s Clare College, which was founded in 1326. His conclusion: Investors with long-term horizons should maintain a minimum of around 60% in stocks, even during equity bubbles.

The reason is threefold. First, he says, average returns from stocks have historically been so much better than alternatives that even overvalued stocks are likely to prove a reasonable bet. That may be especially true in the current environment, where both bonds and cash offer very low yields. (Using data on U.S. stocks since 1801, Mr. Smithers says stocks have produced compound average annual returns of 6.8% above inflation—compared with around 3.5% for bonds and 2.8% for cash.)

Second, Mr. Smithers says, history has shown that overvalued stock markets often become even more overvalued before correcting back down. Investors who get out first miss out on further gains along the way. And they may have to wait many years before markets return to long-term trends. For example, those who got out of stocks in 2000 had to wait until 2009 before share prices hit their lows.

Third, he says, investors who try to move completely into cash when markets are up usually intend to buy back in when stocks have fallen to more appealing levels, but they often don’t. Such an approach involves too much emotional stress, he says.

To be sure, all of this applies only to long-term investors who are able to withstand the stock market’s volatility, Mr. Smithers adds. All financial experts agree that those who have shorter-term horizons, or who cannot handle too much risk, should hold a much smaller portion of their money in stocks.

Limiting your exposure to stocks to 60% isn’t the only way to cap your risks. Financial research has also shown that stocks of larger, higher-quality blue-chip companies have entailed lower risk than those in smaller and more speculative “growth” companies, and have also often produced better long-term returns.

Many analysts also believe that international stock markets are now a better value than the U.S. and may produce better long-term returns as a result, although the historical data for most markets are much thinner than they are for the U.S.