KEY POINTS:
Finance intermediaries get a lot of flak, some of it deserved, but putting aside the all expenses-paid conferences, secret commissions and trail fees, it can sometimes be a tough job.
Clients expect you to tell them if stockmarkets are cheap or not with the (unreasonable) expectation that if
it's expensive you will either advise them not to buy or point them in the direction of something that is better value.
Yeah, right. The reality is that whether or not a market in a financial asset is good value usually only becomes apparent after it has risen.
The price of most of the conventional risky assets move up and down together, and for most financial advisers operating under either a commission-based or fee-based business model, income from new clients is an important source of revenue.
But there is an easy way around this problem for the finance industry, which is good for business and easy to implement.
It is called denial. When asked whether stocks are expensive or not, one just needs to confidently declare that "it doesn't matter" and then fervently recite the mantra that "time in the market" is more important than "timing of the market".
This is consistent with the consensus view, satisfies most clients, and if events like 1907, 1927 or 1987 destroy the financial plan and the clients come looking for you, you can say that they haven't invested for long enough and "things will get better".
It is certainly great for business but, unfortunately, even with increasing life expectancy, the extended investment horizon required to underwrite an investment strategy heavy on low-yielding, growth assets means that many investors may not have the time to break even.
Local examples of the folly of ignoring valuations abound. When experts talk about investing for "the long term", the long term more often than not is around 10 years.
Look at the AMP Winz fund. In many ways, it was an ideal investment - low fees, passive management, diversified over all the major Western stockmarkets - yet someone who ignored the high price and took the plunge seven years ago at its all-time high of $2.53 on August 1, 2000, is nowhere near getting their money back.
In fact, if they sold at $1.40 last week they would be showing a loss of 45 per cent. The NZ Super fund reckons international stocks will return 8 per cent a year from here, which means Mr and Mrs Winz unit holder probably have another eight years to wait before they break even. That will be 15 years since they bought - a long time with next to no dividends.
They might be getting a bit tired of "buy and hold". Common sense tells you it is illogical to ignore the cost of something you are buying. We look at prices when we buy gumboots - a bargain at $11.99, but not such a great deal at $100 a pair.
Why should shares be any different? Anything can become overpriced, especially if the consensus view is that "you can't lose with shares".
The poor performance of Winz has nothing to do with bad management; it is an index fund which tracks the market. The problem is simply that shares were expensive in August 2000.
The notion that it might be a good idea to check the price of stocks before buying is argued in a paper entitled What Did We Learn From the Great Stock Market Bubble that was published in the August 2005 issue of the US Financial Analysts Journal.
The author, Dr Clifford Asness of AQR Capital Management in the US, is a frequent contributor to the journal and the Journal of Portfolio Management. He has a PhD in finance from the University of Chicago.
In the paper Asness looks at the valuation of the US sharemarket for every 10-year period between 1927 and 2004 and sorts each of these into six categories according to their average price/earnings (P/E) ratio, then calculates the real return in the following 10 years.
Price/earnings is one of the most common and simplest valuation measures - it is the price of the stock divided by that company's profit per share.
His data shows that as the valuation of the US stockmarket rises, the return over the next 10 years falls. At a price/earnings multiple of 10-12 times, the average real return for the next 10 years is a very respectable 10.7 per cent per annum, and the total real return in the worst of those 10-year papers is 32 per cent.
If, however, you buy into the S&P 500 when it is much more expensive, at an average multiple of 20-32 times earnings, the average real return falls to a loss of 0.1 per cent per annum, with a total return in the worst decade of minus 35.5 per cent.
The minus 35.5 per cent return involved buying at the top of the market in 1964, just before the highly inflationary Vietnam War really got started, then selling out when sentiment was at rock bottom in late 1974. Investors bought into the market at an elevated P/E of 23 and sold out at nine times.
Asness comments: "Next consider the hallowed property of equity returns; that stocks never lose if held for the long term. Well, if a decade is your idea of the long term, then this is only true when prices start out at or below average. When they start out expensive, there are decades where stocks not only lost to inflation but lose big."
Today, for comparison, the S&P 500 is selling at a P/E of 26 times.
