Asset Allocation Planning: Should I Buy Stocks?

When creating an effective retirement portfolio, several important questions must be answered. One of these questions surrounds the amount of money that should be invested in stocks. The most important factors in answering this decision include the investor's age, the amount of time before retirement, and that person's tolerance for market fluctuations. While these factors are not the only items that need to be taken into consideration, one other factor needs to be considered. This factor surrounds the notion of the stock market being evaluated based on the dividend to price ratio of the S&P 500 index.

In a paper entitled "valuation ratios and the long-run stock market outlook", it was concluded that this ratio was a very strong predictor of future stock movements. It was found that each time the ratio dropped to below 3.4%, the market always declined Intel the next time the ratio rose above its historical average. During this period, that average was only 4.73%.

Evaluating the market as it stands today most investors are presented with a less optimistic view of the market. The dividend to price ratio of the S&P 500 as of November 7, 2008 was only 3.35%. Over the long term most investors cannot expect this value to rise significantly. If one includes an adjustment for inflation, a long term investment containing a majority of stocks rather than bonds and mutual fund holdings is not expected to gain more than 3-5% per year. There are two fundamental questions that need to be asked and making the decision to invest in a large number of stocks. The first involves a calculation of the rates of return of the most easily obtainable risk-free substitute. Simply put, how much can you expect to earn on a security that is comparable to the stock option, but presents a much lower level of risk. The second question involves the calculation of the equity risk premium of stocks that perform higher than your chosen alternative. This number presents the value of the return of in excess of what you would have gained should you have chosen the risk-free alternative. Simply put, this is considered compensation for accepting a higher amount of risk.

While there is no one answer that can be applied to every portfolio or personal circumstances, these tips can be used to start a very candid and inform his conversation with your investment services professional. Be sure your conversation includes topics surrounding market risk tolerance, the ability to withdraw your earnings when needed, and any possible tax implications.

References:

http://www.newyorkfed.org/research/directors_charts/ipage20.pdf

http://www.newyorkfed.org/education/econ_eduforall.html

http://www.investopedia.com

Campbell, John Y. and Shiller, Robert J. (2001). "Valuation Ratios and. the Long-Run Stock Market Outlook: An Update"