Should You Buy Index Funds Now, in an Overvalued Market?

So it's no secret that on the back of the Magnificent 7, all this hype around AI, the stock market has gotten pretty darn expensive.

Now, of course, we can argue that point depending on whether you're a growth investor or a value investor, but just objectively we're currently staring down the barrel of a Shiller PE of around 35. That's roughly double what the historical average is, and what that means is that investors right now who are buying into the market are willing to pay 35 times the earnings of the stock market just to own it.

If you rewind back to 2009, for example, after the GFC, investors that were scared out of their wits were only willing to fork out 14 times the earnings. Now, there's probably an argument to be made that the historical average doesn't quite apply to modern times, but still having a look at the Shiller PE here, it seems reasonably obvious that 35 is still pretty high. In fact, it's the third highest point in history behind 2021 and 1999, and we all know what happened in both of those occasions.

But this begs the question: if you're a passive investor, that being someone who just buys index, what do you do? Is it a wise idea to still be putting lots of money into the market when it's clearly quite high? Is it better to reduce the amount of money you're regularly investing or even stop until the market and the Shiller PE normalizes a little bit?

Well, that's what I want to cover in this video. And to help answer those questions, I want to introduce this guy. He is the grandfather of passive investing, Mr. Jack Bogle. The reason why you might know him is because he is the founder of the Vanguard Group. It's kind of sad when we talk about great investors of history, we talk about Ben Graham, Warren Buffett, and Charlie Munger, and so on, but Jack Bogle rarely gets a mention.

However, truth be told, he is probably responsible for more wealth generation around the world than any other investor. He sadly passed away in 2019, but all throughout his life, he was a huge ambassador for simply tracking the market.

What's interesting is, back in 1997, as the stock market was forming into one of its biggest ever bubbles, Jack actually gave a speech on investing during an overvalued market. To be honest, it's kind of crazy how well that lines up to today's conditions. In short, it seems to me that speculation, betting on higher and higher valuations, is in the driver's seat. Investment, betting on the fundamentals of dividend yields and earnings growth, is in the back seat—probably even in the rumble seat.

But when speculation drives stock returns in the short run, while it drives stocks returns in the short run, it's the crystal clear lesson of history, at least for the past 200 years, that in the long run, fundamentals drive returns. Just like he was saying in the runup to the tech bubble, we too face the situation today where a lot of the stock returns we're seeing are based on speculation as opposed to fundamentals.

I mean, we've seen the Magnificent 7 rise to incredible valuations based on a future promise that we're unsure will eventuate. We're seeing Meta and Google at a PE of 27, Apple at 29, Microsoft at 37, Tesla at 45, Amazon at 50, and Nvidia at 62.

But as Jack notes, in the long run, it's always the fundamentals that drive returns. So that leaves us with two possible outcomes: a world where AI lives up to the hype and earnings rise to justify the new valuations, or a situation where AI fails to deliver, in which these big stocks that support the market get repriced.

And funnily enough, that's basically the exact point Jack talks about in this next clip. So that tension has to be resolved. Let me give you two extreme possibilities: one, a market drop of 35%. This would lower price-earnings ratios to a more normal level of about 13 times. This is hardly a doomsday scenario.

Two, we're in a new era in which stock returns average 15%—in short, a new era of boom times and high valuations that would justify today's price levels. Now, of course, it could happen, but I wouldn't bet the ranch on it. The US stock market, however, seems to be betting the ranch on it. It's priced, I think, for the best of times and only for the best of times.

This speech, actually from 1997, is a little bit scary how well all of that lines up to what we see today. I think many investors would agree with Jack's statement today: the stock market is pricing in the best of times and only the best of times. And while the best of times may eventuate, Jack certainly wouldn't go betting the ranch on it.

But with that said, that obviously makes it a lot harder psychologically to put money into the market right now. Right? For example, I am in part a passive investor and in part an active investor. But when it comes time to add more money into my chosen ETFs on my dollar-cost averaging plan, I always have this grimace when the market is at all-time highs.

There's just something about it; it just doesn't feel great sinking a lot of money into your long-term investments when you kind of know in the back of your mind that the market is pretty expensive. It's kind of like paying full price for a bit of furniture a few weeks before Black Friday. You feel bad paying full price knowing a sale will likely come along in the not too distant future.

So, with that setup, that leads us to the question: should we actually be buying our market-tracking ETFs when the market is at all-time highs? Should we try and time the market just a little bit in this case? Well, this is what Jack had to say all the way back in 2001: "I don't know anybody who has ever been successful in timing the market, and I don't even know anybody who knows anybody who has ever been successful in timing the market."

So, if you want the short answer, no, you should not at all deviate from your passive investing strategy just because market conditions have changed. In the same way that you wouldn't sell your investments if all of a sudden the market fell 30% tomorrow. As Buffett would say, "Our favorite holding period is forever." The more you start messing around with your market tracking investments, the higher the probability that you'll lose.

That's quite literal—a study way back in 2000 studied 664,652,700 earned an annual return of 11.4% while the market returned 17.9% annually. The truth of the matter is, if you start messing around with your portfolio, you will likely lose out.

Last month on The Riser, you summed up your investment philosophy as "buy everything and hold it forever." Do you still subscribe to that in light of what the market has been doing, or would you unload some things now?

"No, I—my theory is not subject to the ups and downs, the unpredictable paginations of the stock market. It's painful to do, but I think the idea of owning the stock market is the best approach to equity investing. Perhaps I didn't make that thoroughly clear there."

And while Jack is, of course, a little bit biased on the topic, he's not wrong. The idea of dollar-cost averaging into low-cost index funds that track, say, the S&P 500, and then consistently buying them and holding them over a long period of time, and never selling has proven to be an exceptionally successful strategy over recent history.

I mean, since 1957, which is the year that the S&P 500 adopted its 500 stock structure, well, that index has returned an average of 10% per annum. That's a phenomenal long-term return considering what you might get elsewhere in, say, savings accounts, gold, or bonds.

I will say, despite it feeling painful to buy the market when it's visibly high, remember there is actually an inbuilt mechanism into the dollar-cost averaging strategy that protects investors against really high prices. Remember the dollar-cost averaging strategy, which is the approach implemented by almost all passive investors, is the process of buying a fixed dollar amount of shares in a low-cost market tracking index fund and then repeating that purchase at fixed time intervals over the course of your investing career.

For example, you might choose to invest $1,000 every three months, and as the quarters go by, you just keep showing up. Well, as I said, this has an inbuilt mechanism to protect you when the market is high. Say the market crashes, and the ETF shares you're looking at buying are now $100 each. Well, in that case, with your $1,000, you'll buy 10 shares.

But then what if the market goes on a rampage and the ETF shares are soon worth $200? Well, guess what, now that the market is expensive, you're only going to buy five shares. When the market is high, the strategy keeps your buying low, and when it's cheap, you're naturally going to load up the truck. It's genius.

So, not at high prices, you should not abandon your tried-and-true passive investing strategy. It's much more important to stay in the habit of constantly investing—just showing up, rain, hail, or shine.

If you are not a speculative investor, if you're a long-term investor, and yet there are these speculative investors buffeting your returns about, what should your reaction be? Should you be doing anything differently?

I think basically you should not be doing anything differently. I mean, investment is a pretty simple thing. Investment is owning businesses, or I would say being an inveterate index fund person, owning all of American business, owning every company in America, letting capitalism do its work.

Those companies will grow at probably around 7% a year; they'll pay you about a 2.5% dividend yield—somewhat lower than history—but a 2.5% dividend yield. That should, over time, bail you out of anything that happens because of the wild swings.

I mean, if you visualize investment as growing in kind of a steady line, which it does, and visualize the crazy market as being all these jags up and down around this steady line—upward, upward, always upward—I think then you've got to say, I know I'm not smart enough to get out at the high; I know I'm not smart enough to get back in at the low. So I'm just going to stay the course, as we would say at Vanguard, and hang on through all that.

Importantly, if I'm trying to accumulate money for retirement or to buy a home or to educate my children, what you want to do is keep investing—keep investing, rain, hail, or shine. Passive investors are better off if they just keep going without messing with their strategy.

But there is one key to actually putting this theory into practice, and this gets glossed over a lot because it's not as glamorous as showing a compounding chart or talking about how soon you could be a millionaire.

The point is finding the right plan for you. While we know we buy the market and we buy it consistently, it's really important that you actually nail down your plan into hard numbers. What's your current savings rate? What percentage are you willing to devote to investing? How much money will that mean that you save each fortnight?

How frequently are you going to invest that money? How do you make sure you won't fall off the train? As Jack is about to discuss, you need to really nail down an achievable plan for you to ensure you can implement this strategy over the long term for yourself.

But I think the idea of buying and holding forever and not trying to make adjustments requires that you've gotten it right in the first place. You can only hold tight if you've bought right, if you will. And that is to say, have an asset allocation that has something to do with how many years you have to accumulate money, how many resources you have at stake, how much income you need, and how much courage you have to ride out the fluctuations of the market.

So you've got to take all that into account. From that simple statement—and I know it sounds boring—but in my experience, you really do have to come up with a plan that works for you specifically to be able to execute the strategy successfully over a long period of time.

As Jack spoke about in the clip, you have to understand how much you can comfortably set aside for investing without something coming up that could force you to sell your investments. You have to know how long you plan to be in the market. For example, you wouldn't be dumping large sums into an overvalued market if you were looking to retire in two years.

And then from there, you also have to know yourself. How comfortable are you having money at stake? If you're someone who frequently stresses about your investments and has a tendency to make snap decisions, then maybe the stock market isn't for you. Maybe you might prefer government bonds or perhaps paying down your mortgage instead.

A lot of times with passive investing, the investor is their own worst enemy. So I'm definitely big on setting up a plan that genuinely works for you that isn't stressful to continue with. Ultimately, for this strategy to work, you need to set aside money that you won't need to touch for decades. You need to invest often, and you mustn't be tempted into messing around with your portfolio.

So you need to understand what amount you can easily set aside, what investing schedule you can stick to, and you need to mentally commit to the long term to ensure you don't end up as just another failed investor. Remember that step from before: the studies show, the more you mess around with your investments, the more likely you are to lose.

But if you're relatively young, if you are investing money that you don't need, and you're properly spread across the market through something like a market tracking index fund, then you can be reasonably confident, as Jack says, that you've bought right.

So that's the deal with index funds when the market is at all-time highs. Now, if you're interested in getting the full breakdown in a simple step-by-step manner, definitely check out "Stock Market Investing For Beginners" over on New Money Education. That is a full in-depth course that will get you up to speed on the passive investing strategy, no matter where you are in the world.

So big thanks to everyone as well who has supported the courses too, as they are the main way that we fund this YouTube channel. But apart from that, please do leave a like if you enjoyed the video, guys. Subscribe if you've made it this far and you'd like to see more videos similar to this, and I'll see you guys in the next one.