Confusion tends to reign when markets hit record highs. Advisers and brokers trying to be helpful feel compelled to suggest "taking profits" largely to demonstrate that they (advisers and brokers) are being useful. Investors are tempted to act on the advice, remembering how sorry they have been in the past when the market tanked and they later regretted that they weren't sitting on cash to buy back in. Dream on.
Where we are now with stocks and bonds puts us at record highs for both. The exceptional stock market performance is a reflection of record high profits of American companies last year. As if that wasn't enough, corporate earnings are expected to further grow by as much as 8 percent this year, and today's stock prices are taking these future earnings into consideration.
Bond funds for years have experienced gains in capital values as market interest rates have dropped. Remember, the value of a bond drops if interest rates in the market go up because an existing bond paying the lower rate has to compete with new bonds paying the higher rate. A second fact affecting bond prices is the "search for yield," which has prompted investors to bid up the prices of bonds that involve more risk, such as high-yield bonds and emerging markets bonds. Both fund types have a current yield greater than 4 percent, so investors who bought those funds several years ago could sell today at a profit -- in addition to the higher yield they have been receiving for accepting the risk of possible default.
It may come as refreshing news to realize that we don't need to care about it one way or the other. The joy of being a long-term investor, which most of us are even in retirement, stems from the fact that we don't plan to cash out for any reason. Living on interest income and dividend income in retirement, or reinvesting it automatically if we're still working and building a nest egg, gives us the luxury of shrugging off all the noise regarding market highs and "the coming spike in interest rates."
If we think about it, our so-called yield or expected return should be based not on today's prices of stocks and mutual funds; but rather, on the prices we paid for the funds as we purchased them over the years. Today's dividend yield (in dollars) as a percent of our average purchase price becomes a more gratifying number to recognize. It also makes it easier to feel a little more sanguine in the event of an inevitable market correction that will come sooner or later.
If the stock market drops by as much as 20 percent and remains that low for a full year, as has happened twice in the past 39 years, the dollar amount of dividends may drop somewhat, but as a percentage of our average yearly fund purchase prices, they will still be huge. Bear in mind, American companies made more profit and paid more in dividends in 2008 than they had in 2007, but the stock market was in a free fall prompted by the collapse of the financial sector. A buy-and-hold investor focused on dividend yield could have just ignored the panic in the streets.
The same logic can be applied to bond funds. High-yield bond funds have capital values that perform more like stock funds when the economy hits rough water, but they continue to pay the interest they collect on all of their bonds each month. In the 2008 crash, these funds lost and then promptly recovered 20 percent in capital value, but interest payments remained constant throughout the period. Again, anyone who has no plans to cash out and invest the money elsewhere can ignore those swings in value. A variation on the theme is to imagine, today, that your total account value is about 15 percent less than the total number on your statements. That last 15 percent has perhaps been a gift of circumstance thanks to a five-year unprecedented bull market. If you imagine having to forego it temporarily, it won't come as a shock and won't prompt you to do something rash. For that matter, imagine you've just lost (on paper) 20 percent just to be on the safe side.