How To Save Yourself From Getting Into Overvalued Stocks?

How To Save Yourself From Getting Into Overvalued Stocks?
by Priyanka Sharma 08/05/2017

We often hear people saying, “Don’t jump into the market just because others are getting rich. Invest what you can spare after expenses and stay long-term greedy! 

As the famous quote goes, ‘Precaution Is better than cure’ it’s best that we prepare ourselves by examining all our existing investments. One has to be careful while investing in the market.

What are overvalued stocks?
These stocks have a current price which is not justified by its earnings outlook or price/earnings ratio and is expected to drop in price. This may happen due to emotional buying spurts, which in-turn inflates the market price, or from deterioration in the company's financial strength.

How to prevent it?

1) Ensure diversification
Diversification mitigates the impact of market fluctuations on your portfolio by balancing your performers and underperformers. Diversification may preclude whopping gains, but you'll avoid whopping losses. Diversify among asset classes, sectors and geographic regions.

2) Buy bonds 
Bonds provide stability and capital preservation. During a market low, they also fuel your income stream. Although bonds are less risky than stocks, that doesn't mean they're devoid of risk. You need to gauge several types of risk when evaluating bonds, notably interest rate risk.

Interest rate risk accounts for the chance that interest rates will increase in the future, making your bonds less valuable. Your portfolio needs the safety of bonds, and not all bonds get crushed, when market spirals out of control. 

3) Trim your growth stock allocation. 
Credible research studies have found that asset allocation explains nearly 100% of the level of investor returns. At the heart of asset allocation is the risk/return trade-off. Many investors make the mistake of setting their asset allocation just once and then walking away. It's not a one-time task; it's a life-long process of fine-tuning.

If you have just started your career, you could possibly have more of equity and stocks however, if you are nearing retirement, having debt assets more than stocks would provide better security. Thus, tuning your growth stock allocation according to your life goals would be one way of saving yourself from investing in overvalued stocks.

4) Invest in gold
Gold isn't always about the glitter. It also provides a worthy hedge to inflation. The simplest, safest and most cost-effective way to gain exposure to the yellow metal is through the Gold Shares ETF (GLD). Having it as a part of your portfolio would ensure that you don’t get affected as much from overvalued stocks. 

How to find these?
Comparing the company's earnings to its stock price is the easiest way to know which stocks are overvalued. For instance, a company that's trading at a price 10 times its earnings are considered to be trading at a much higher multiple than a company trading at 2 times its earnings. In fact, the company trading at 10 times its earnings is most likely to be overvalued.

There are a lot of strategies that can be considered while making the decision. Make sure to do your own research or seek help from a consultant or investment advisor.