Q&A: "I'm 66 with an Adequate, Stable Income. I Have $500,000 in my Credit Union IRA, Roth IRA, and 401(k). How can I Protect Myself in These Investments Given the Overextended Stock Market?"

Question and background: 

I'm 66 with an adequate, stable income. I have $500,000 in my credit union IRA, Roth IRA, and 401(k). How can I protect myself in these investments given the overextended stock market?

Larry's answer: 

I think you're wise to be concerned about an overextended stock market.

Your IRA, Roth IRA, and 401(k) aren't actually investments themselves. Rather, think of them like financial boxes into which you can put different types of investments. As long as the investments (or cash) remain within the financial boxes, they are sheltered from taxes. 

So then the overextended stock market would only be an issue if you hold stocks or stock funds in your IRA, Roth IRA, and 401(k). With interest rates nailed to the floor, bonds of various types are also overpriced and will take a hit once interest rates rise in earnest. But stocks are considerably more overpriced, in my view.

If your retirement accounts hold stocks or stock funds, here are some protective ideas:

• Reduce your equity exposure by selling a healthy portion of stocks/stock funds. For now, redeploy the proceeds into money market or short-term high quality bond funds within the respective IRA, Roth IRA, or 401(k). Depending on your overall asset allocation and your needs, you may wish to buy back in when good equity investments can be had at better prices than today. (DO NOT withdraw the liquidation proceeds from the retirement plan to reinvest elsewhere as that would trigger taxable income.)
• If you hold stocks instead of stock funds, consider putting in place stop-loss sell orders. These are trades you set-up now that will automatically sell the stocks if their respective price drops through a certain level. The computerized trading system will keep track. You'll want to set a limit on them and consider making the sell order Good-Til-Canceled (GTC) by you.
• If you prefer not to sell your stocks or stock funds (or even if you do), you might consider buying some "portfolio insurance" with long-dated Put options on one or more of the stock indexes. These can increase in value if stocks drop before the option's maturity date. Since options contracts are leveraged, a relatively small portion of your portfolio can be used to hedge against a market downturn and help buoy your portfolio in that event.

If these ideas are a bit foreign to you, consider seeking out a good financial advisor to manage your portfolio. You'll be looking for one who actually engages in portfolio management. And with your concern about an overextended market, you'll want to find a tactical portfolio manager (we're in the minority). Most advisors will set you up in model portfolios and periodically rebalance. But those models are not tactical...they ignore when investment classes are overpriced (like today) or underpriced. 

Some background on the financial markets . . . .

Most financial pundits today focus on stock market valuation in light of the last 12 months of earnings or the next 12 months of projected earnings. The trouble with that is we're not in any kind of a normalized, sustainable environment. Global central banks have goosed asset prices through monetary policy on steroids. Corporate profits are around 70% above long-term averages. We're now five years into a cyclical bull market recovery that has had no significant pullback. While the economy is recovering vs. the 2008-2009 recession, it's been moving at a glacial pace and nothing like the typical historical recovery. Even now, it's as if it still has a "low-grade fever," not quite bad enough to land in the hospital, not quite good enough to get up and dance. 

In this context, I pay more attention to those analysts who measure current stock levels in light of longer-term historical valuations. And history indicates that, when US stocks are this overpriced, the next 7 to 10 years generally result in abysmal average annual returns (1% to 3%, for example).

Of course, that doesn't mean we're going to have an imminent crash, nor does it mean the markets can't (irrationally) march yet higher. It sure seems they want to push higher. However, it does imply that future returns have already been pulled into the present and there's significant risk in equities (and in bonds and other income investments) at current levels. So why accept the current level of risk when commensurate reward is unlikely to materialize? 

Nobody can precisely or consistently time the markets, that's a given. But that's the answer to the wrong question. The question is not one of timing or trying to outperform the markets, but rather of paying attention to investment valuations--avoiding those that are overpriced and owning those that are underpriced (and there aren't many of those today). This is a tactical approach to portfolio management and it's a minority perspective, but I believe it's the best approach in the current environment.

Hope this is useful. Feel free to get in touch if you have questions or I can be of any help. All the best.

Originally posted on NerdWallet's Ask an Advisor on June 11, 2014.