There are some similarities about purchasing goods and investing. In both instances there is a specific price for what is being bought. In addition what is being purchased can change in price over time.
The main difference between investing and consuming is that investing enables one to consume in the future. One invests in a retirement account, so you will be able to purchase goods and services in the future, when you are no longer working.
As consumers we are certainly aware that some people are better at getting bargains versus others. On an airplane flight two people sitting next to each other could be paying considerably different prices for their seat. In purchasing a car one person may wind up paying thousands of dollars more for the same vehicle versus someone else.
When it comes to investing some people do better versus others. Earning interest on a bank account is a good example. While most financial institutions offer similar interest rates, there are differences. Getting a half of a percent more on a money market account on a $100,000 investment will result in an extra $500 for a year.
Investing in stocks and bonds is not as straightforward as investing in a bank account. If someone purchases a one-year CD you will know what the value will be after the year is up, while there is no way to know what the stock or bond investment will be a year in the future.
There are some parameters to use to help determine if stocks and bonds are reasonably valued at a point in time. For example if inflation is at 2%, and the interest you are earning on a bond fund is also 2% that is not a good return. For bonds to be relatively attractive you would want to be earning a return somewhat higher than the inflation rate.
For stocks there is a calculation called the price earnings ratio, or PE, which compares the annual earnings of a stock, or the overall market to its price. Over time this PE ratio has averaged around 15. Currently this ratio is about 18 based on expected earnings for 2017. While this number is higher than historical figures, it is normally higher in a low interest rate environment, which we are currently in.
The PE ratio can also be applied to real estate investing. If someone purchases a property for $1,000,000 and collects $5,000 in annual rents, this ratio would be 20, which is rather high. The lower the number the more attractive the investment becomes.
Looking at the current environment someone can easily surmise that there are no apparent investment bargains. However, this does not imply that someone should not invest at all.
What this implies is that someone needs to establish reasonable expectations. When both the stock and bond markets are higher priced, it is not reasonable to expect 10% plus annual returns to continue indefinitely.
Certainly there will be some 10% plus return years, as we saw last year, in the future. However, longer term expectations of 5 to 8% would be more reasonable, which is still considerably better than what someone might earn on a money market account.
It is tempting for people who are investing in a retirement account to have their contributions go into a money market account when prices are higher. However, this would involve market timing, which few people can do well.
For people with retirement accounts it is best to maintain one’s normal mix of new money being committed to stocks and bonds. For money already invested, someone might want to bring down one’s percentage in stocks, if the strong stock market has brought the stock percentage above one’s targeted level.