Retirees are not the only ones who make mistakes when markets soar, but they have to be more aggressive in protecting their nest eggs because they don’t have as much time to wait for markets to recover.
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When stocks surge, retirees should be extra vigilant about avoiding mistakes that can cause long-term damage to portfolios. Here are some of the most costly.
For most investors, the recency effect has real sway. When stocks rally, it can feel like they will continue going up forever. This can make it hard to stay disciplined and within the confines of your original asset allocation.
The problem is that strong market rallies can cause stocks to grow into a larger percentage of a portfolio than originally intended. This increases exposure to equity risk at precisely the time when valuations are at their highest. Research from Vanguard shows that rebalancing helps maintain a consistent risk profile and can reduce portfolio volatility over time.
Action step: When stocks soar, review your original investment plan and the allocation targets you chose. If stocks exceed your planned percentage by more than 5%, it’s likely time to rebalance.
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Over the long run, stock prices are driven primarily by earnings. But during a sharp market rally, prices can run up far ahead of realistic expectations. Data from Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio shows that periods of higher valuations have historically been associated with lower long-term future returns.
In other words, when stocks go up too fast to justify their valuations, investors have often faced lower returns in subsequent periods.
Action step: Valuation still means something, especially for retirees. During periods of market frenzy, it’s important to maintain realistic return assumptions and avoid chasing hot stocks.
While rebalancing is a sound strategy, don’t forget about the tax consequences that come with it. If you sell appreciated investments in a taxable account, you can get hit with capital gains taxes. Long-term capital gains are taxed at preferential rates that can go as low as 0%, depending on your income. But short-term capital gains are taxed as ordinary income, which could potentially result in a big tax bite.
