Record-High Stocks and History's Lessons

The human mind is a lousy device to rely on when it comes to managing money. Numerous studies have detailed how we humans are predisposed to overweight the recent past—a phenomena known as recency—when predicting how the future will unfold.

That helps explain why investors piled into tech stocks before they blew up in 2000 and into housing shortly before that market melted down in 2008. It also explains why many people had little or no exposure to those markets as they neared multi-year lows. Buying high and selling low, in other words, is a natural human trait.

In hard numbers, a St. Louis Fed study over the dozen years through the first quarter of 2012 shows that an investor who bought and held onto equity mutual funds during the entire period studied would have earned average annual returns of 5.6 percent. In contrast, real-live investors earned 35 percent less, or 3.6 percent annually, thanks to the value they destroyed via their personal decisions about when to buy and sell.

Our predisposition to make the wrong moves at the wrong times can prove especially damaging to our finances at times like this, when the S&P 500 has risen 195 percent over the past five years and is breaking record highs. With so much good news flooding our minds, our fear of missing out on future gains tends to drown out our memories of the pain we felt as our savings evaporated during past crashes.

That’s unfortunate. Despite what our hearts and minds are telling us, financial math suggests that as the market rises, the risk-reward balance tilts in the direction of rewarding caution and punishing aggression.

One of the most discussed measures among the wing-tip crowd that debates such matters is Yale professor Robert Shiller’s cyclically adjusted price-earnings ratio, or CAPE. It measures price-earnings ratios over the past decade, rather than the past 12 months, to smooth out short-term bumps.

Shiller’s CAPE is now approaching 26 times, which is more than 50% above the average going back to 1881. Eventually, history suggests it will revert toward the mean, likely leaving a path of stock losses in its wake.

As BloombergView’s Barry Ritzholz wrote on last week, CAPE is a lousy yardstick for the short-term and may be better at warning of market bottoms than tops.

But trying to squeeze those last points out of the S&P is risky business. And in case you’re in doubt about what the current market resembles, consider this: the annualized returns of 24.5% since March 2009 is close to the 27.1% over the equal amount of days ending March 24, 2000, the peak of the Internet stock rally, Bloomberg data indicates.