This Netflix hit is a warning to overly optimistic investors

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An unpleasant reality is hurtling toward us, but most people don’t want to acknowledge the impending collision.

If you think this sounds suspiciously like Don’t Look Up, you are absolutely correct. The much-watched Netflix epic does an outstanding job of showing what happens when society confronts any large shared risk – be it a cosmic disaster, a pandemic or climate change. (Warning: spoilers ahead.)

As the characters played by Jennifer Lawrence and Leonardo DiCaprio discover in the movie, the first reaction to any warning of such dangers is a shrug. Then comes denial, along with appeals to look on the bright side.

This classic pattern is playing out in markets now. Look at indicators of investor optimism, such as the TD Direct Investing Index or the American Association of Individual Investors Sentiment Survey, and it seems many investors are upbeat about what lies ahead. After the big returns of the past few years, it is easy to see why.

Unfortunately, though, the prevailing optimism means that many expert warnings are being brushed aside, much like the shunned astronomers in Don’t Look Up.

Consider Vanguard, the giant asset manager. A month ago, it declared that U.S. stocks are now more overvalued than at any time since the dot-com mania of the late 1990s. It also said investors are underestimating how high interest rates will climb over the next couple of years – bad news for bond investors, since rising rates steamroll bond prices.

Other authorities struck a similar tone in notes this week. David Kelly, chief global strategist at J.P. Morgan Asset Management, wrote his expectation for the long-run return on a plain-vanilla 60/40 U.S. stock-and-bond portfolio has now dwindled to less than 4 per cent a year. David Rosenberg of Rosenberg Research in Toronto warned, “time has run out for this bull market” amid “a massive price bubble across all asset classes.”

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Blinkered optimism for bullish markets is dangerous

Could these experts be wrong? That depends on how you define “wrong.” If today’s largest-in-a-generation surge of inflation ebbs quickly, while near-zero interest rates defy expectations and bump up only slowly, Wall Street could coast for a while. It is also true that most stock markets are nowhere near as frothy as Wall Street.

The essential point, though, remains. At a time when most bond yields struggle to keep up with inflation, and most stock prices are at the high end of their historical valuation ranges, investors should prepare to be underwhelmed. You don’t have to count on an economic apocalypse or a market crash to make this prediction come true. You simply have to figure that valuations will, at some point over the next few years, fade back to more normal levels.

Fortunately – and contrary to Don’t Look Up – a stretch of underwhelming returns is not the end of the world. Markets have always gone through good patches and bad patches.

The bad patches are more common than you may think. In Canada, the S&P/TSX Composite spent eight years, from 2008 to 2016, going nowhere after accounting for inflation. Similarly, the U.S.-based S&P 500 endured a 12-year stretch, from mid-2000 to early 2013, in which it bobbed up and down, but made no real progress.

The trick is navigating these extended doldrums without sustaining permanent damage to your portfolio. Three strategies may help.

The first is diversification. Markets are correlated to one another but don’t bob and weave in perfect unison. Holding a constant mix of stocks and bonds from different countries and different industries helps even out your returns. A number of low-cost exchange-traded funds such as the Vanguard Balanced ETF Portfolio (VBAL) and the iShares Core Balanced ETF Portfolio (XBAL) now automate this process and make it simple to hold a global portfolio of stocks and bonds.

A second strategy to keep in mind is conservatism, especially when it comes to withdrawing money in retirement.

For years, the 4-per-cent rule served as a rule of thumb for many retirees. The rule instructed seniors to spend no more than 4 per cent of their original portfolio value every year, adjusted for inflation. But today’s low bond yields and high stock valuations suggest retirees may want to be even more cautious. A study by Morningstar last year argued a 3.3-per-cent withdrawal rate is now more realistic.

Finally, there is patience. Individual investors sabotage themselves by chasing what is hot. A more fruitful strategy is to choose a reasonable, well-diversified asset allocation and stick to it. A well-balanced portfolio won’t protect you from an asteroid strike, but it will shield you from your own worst impulses.

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