Introduction
It is quite easy to get caught up, and quite hard to avoid getting caught up in a great bull market like the one we are currently in. However, it’s important to remind ourselves that: “everybody is a genius in a bull market.” In my experience, the hardest thing for investors to do is to go against the crowd. Although Warren Buffett’s advice “be greedy when others are fearful and fearful when others are greedy” is sound, it is simultaneously almost impossible for people to do. Instead of going against the grain, people tend to rationalize about how it’s different this time, and fundamentals don’t really matter.
Another insidious aspect of a great bull market is that people love a rising stock price and hate a falling one. Consequently, regardless of valuation levels, people consider a stock with a current rising stock price a good stock and a stock with a current falling price a bad stock. However, common sense would dictate that you will not find bargains investing in hot or popular stocks. Although it is often true that a stock with the rising price might generate great short-term returns, in the long run valuations inevitably and rightfully so revert to the mean.
Nevertheless, it is almost impossible to argue against a rising stock price over the short run. Investors get overconfident which leads to complacency. A great mentor of mine once asked me if I knew the definition of appreciation. As I started reciting a financial dictionary definition he immediately stopped me. Instead of the dictionary version, he simply pointed out that all too often the definition of appreciation is when others appreciate what you own more than you do. Unfortunately, investors should beware that short-term gain often leads to long-term pain. This is especially true when valuations are above what fundamentals would rationally suggest and/or support.
Importantly, nothing that has been said thus far would suggest that stock prices cannot remain excessively valued for relatively long periods of time. In truth, this happens quite often. Therefore, I am not trying to suggest that you cannot make money by investing in an overvalued stock. In truth and fact, a stock with good momentum can be an excellent investment over several months or even years – especially in a long-running bull market like we have today. However, investors should be fully aware of the amount of risk they are assuming by investing in excessively valued stocks. Therefore, I suggest that recognizing excessive valuation is more about risk assessment than it is about possibly losing money – at least over the short run. Stated differently, as an investor, how much risk are you willing to take? Or better yet, are you aware of the amount of risk you are currently taking?
