Why you should be careful of these high valuations

The market isn't cheap right now.

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The share market is the best place to generate good long-term returns in my opinion.

However, that doesn't mean that you should carelessly buy shares at any value.

The only thing that truly helps your returns is the price that you buy your shares at. The lower the price you pay, the more margin of error you give yourself and you also create a bigger dividend yield too.

Every major share market in the world is trading expensively, particularly with how much actual earnings growth is being generated on a per share basis.

Investors shouldn't underestimate how important growth is to justify high price/earnings ratios. Look at how far the share prices of Domino's Pizza Enterprises Ltd (ASX: DMP) and Ramsay Health Care Limited (ASX: RHC) have fallen after expected future growth won't be as high.

What about interest rates?

Warren Buffett himself has said that the current environment of very low interest rates is a big reason why prices are so high. If investors are making the comparison between interest rates and wealth generated from shares then the share prices are completely justified.

It's hard to argue with this line of thinking, particularly because every investor invests for different reasons and can justify buying at different prices.

However, I view interest rates as another reason to be cautious. The Federal Reserve in the USA is increasing rates again. Our banks are increasing interest rates. The RBA has spoken about the need to 'normalise' interest rates, which could be at least 1.5% higher than today.

If interest rates keep rising then that could put asset prices under pressure. Even more reason to be careful.

What to do?

I'm not suggesting sell everything and hide under a rock. Shares outperform cash over long time periods, even including times like the GFC.

I think investors just need to be prudent and strategic about the shares they buy and only buy when it really is good value.

Motley Fool contributor Tristan Harrison owns shares of Ramsay Health Care Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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