Investing in the stock market has become increasingly popular in recent years. Indeed, around 15% of all retail investors only purchased their first shares in 2020.
They may have been attracted to stocks for a variety of reasons. Chief among them is a record low interest rate that has caused assets such as bonds and cash to offer extremely low returns. Conversely, low interest rates have contributed to the current bull market that has seen the S&P 500 double since its March 2020 crash.
In addition, lower commission charges may have attracted smaller investors to the stock market. Meanwhile, the increasing prevalence of investing apps has allowed tech-savvy individuals to quickly and easily purchase shares.
Potential challenges
While the stock market’s increasing popularity has been good news for holders of stocks due to its likely positive impact on their prices, it also brings potential challenges. Notably, higher demand for stocks can cause a disconnect to occur between share prices and the intrinsic values of companies.
Indeed, a number of stocks now trade on valuations that are significantly above their long-term averages. This situation may be compounded by recent stock market gains that empower investors to purchase an even greater volume of shares because they are seeking to replicate recent gains. The end result of this could be a lack of buying opportunities for long-term value investors.
Buffett’s view
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) has previously discussed the challenges of investing in stocks when everyone else is doing likewise. He said, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
Buffett’s words of wisdom may be especially relevant at the present time. As well as causing a lack of buying opportunities, the rising popularity of investing in shares could cause severe losses for their holders over the medium term.
Certainly, the current 21-month bull market is younger than the historical average of around three years. However, its 100% gain is similar to the 110% average recorded in bull markets since 1928. And with none of them having lasted in perpetuity, the chances of the current bull run bucking the trend and going on forever seems extremely remote.
A prudent strategy
Adopting a "prudent strategy" may seem plain wrong to many investors at the moment. It could realistically mean missing out on further capital gains as buoyant investor sentiment and the growing popularity of stocks relative to other assets lifts valuations over the coming months.
However, investing now while margins of safety are relatively slim could lead to significant losses further down the line. A more logical approach could be to ensure any new purchases have a wide margin of safety that factors in the potential for future risks.
Should there be no such opportunities currently available, temporarily holding cash could be a more profitable plan over the long run. It will allow an investor to follow Buffett’s advice to purchase shares when they are less popular. At such a time, their lower valuations may provide significantly greater scope for long-term capital growth.
