Be prepared for anything - this is an important lesson that all investors have to learn sooner or later. Moreover, there will be times during one's investing career when one must be more vigilant - and that is when assets are trading at historically high valuations. As veteran credit investor Howard Marks (Trades, Portfolio) likes to say, "The most frightening sentence in investing is 'too much money chasing too few deals.'" In a recent webinar with the Wharton School of Business, Marks explained why investors need to pay attention to valuation.
You need to know when the risk outweighs the potential reward
Marks said that while he, of course, didn't know exactly when a market correction would take place, he and his colleagues at Oaktree Capital did think that valuations were too high earlier this year. He believes that the driving force behind this risk-seeking behavior among investors has been the lowering of interest rates and the erosion of cash as a realistic option for savers. It is, therefore, easy to understand why he felt like it was a bad idea to be fully invested in the market:
"We came into 2020 with a cautious portfolio. We didn't know what would go wrong, but we thought that the markets were vulnerable to a shock, and of course they got a shock...I still think we have uncertainty, and even lower prospective returns than we did a year ago, thanks to the Fed taking the funds rate to zero. We have high asset prices and the re-emergence of risky behaviour. Your typical defined benefit pension plan needs 7% [annually]. Cash pays zero, and Treasuries pay less than 1%, high grade bonds pay less than 2%, high yield bonds pay less than 5% and stocks are expected to return 5% or 6% - you can average those numbers any way you want and not get 7%!"
In other words, investors have been moving into riskier asset classes than they otherwise would have wanted to be in, simply because they need to meet a certain annual rate to accumulate enough savings to retire. On one hand, this is understandable. On the other hand, investors need to be cognizant of these trends and not get swept in the same mentality that drives other capital allocators to chase lower returns at higher prices. In the long run, it is not likely to end well for them.
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