The late stages of market cycles are particularly difficult for investors to navigate. We share our market views and investment insights to help keep your investment plans (and focus) moving forward, and leave the mistakes in the rear-view mirror.
Key investment strategies for late-stage market cycle investing:
- Decrease equity overweight positions and don’t abandon fixed income positions
- Shift toward lower volatility, actively-managed solutions
- Reduce high-risk credit exposure and focus fixed-income selection on high-quality credit positions
- If you have near-term income needs (i.e. 3 years or less), de-risk a portion of your portfolio into cash
From underestimating equity risks and ignoring the benefits of active management, to stretching for yield in risky fixed income instruments and chasing performance because ‘this time’ is different; mistakes are being made that could hamper near and long-term investment plans.
Here’s how you can recognize, and more importantly avoid, four common mistakes investors are making right now – even in difficult market conditions.
1. Remember what’s normal
Underestimating equity market risk
Low volatility, high returns – who doesn’t like that? Unfortunately, by definition, double-digit returns and record low measures of volatility are not normal. Markets shift, change, and move through cycles – that’s normal, but easy to forget. Investors can quickly become disenchanted with what they consider lackluster returns in some areas of their portfolio, which can lead them to decrease exposure to these ‘disappointments’ – effectively undoing good diversification strategies by avoiding blue-chip investments and overweighting high-growth, higher risk equities on the hope that the recent past performance will dictate future results.
Investors with equity to fixed income ratios beyond their risk tolerance and outsized portfolio weightings in selected, or higher risk regions of the market, such as emerging markets, US health care and info tech have probably chased good performance. Either that, or they let their portfolio mix drift with strong returns on the assumptions that the same things will keep on working.
Don’t double-down on bets with unrealistic performance expectations just because they’ve had a stellar run recently. As explained in our Opens in a new window2018 Capital Market OutlookOpens a new website in a new window we think it is the right time to position yourself for modest return expectations and align to your time horizon.
2. Re-examine the benefits of active management
Counting on passive investments to be all things all the time
The increased volatility typical of late cycle investing creates specific challenges for passive investment strategies while enhancing the benefits for active portfolio management strategies. At the core of every passive investment strategy is the premise that there will be no selective insight, or tilt for any given company, industry, sector or region. Thus passive investment strategies work best in low volatility, upward trending markets, but not in down or sideways markets.
In down markets, passive investments offer no control, stop-gap or interventions to prevent you from bearing the full brunt of market correction pain. They move with the specific market or sector they target. That’s what they are designed to do (i.e. the performance will always be almost as good on the upside, and always slightly worse on the downside). Furthermore, the prevalence of algorithmic and automated sell-triggers in today’s market can exaggerate the speed and force of a sell-off and spark a self-perpetuating tailspin – a frequently quoted factor in February’s market sell-off.
In sideways markets, passive ETF products and index funds offer no potential to select ‘good’ over ‘bad’ investments. You won’t be taking advantage of volatility to buy good stocks on the cheap and take profits in stocks as they rise (generating alpha or excess return in financial speak). To the contrary, by design, passive investing strategies are driven by momentum, increasing exposure to securities that have elevated prices.
Moving assets to passive investment options (eg. ETFs, index funds) on the assumption that returns will always be better than actively managed portfolios.
Don’t discount the benefits of active management strategies. Expertise, contrarian views, the ability to exercise patience and/or pounce on opportunities through active decision making can translate into real value through better returns and/or a smoother ride – benefits we see as well worth it for the current market conditions and outlook.
3. Avoid the temptations of FOMO
Chasing hot performance
The fear of missing out (FOMO) is part of our human psyche. It’s normal and if this is you, you are not alone.
We all love a success story, and it’s fun to be a part of something new and exciting, but investing money that you can’t afford to lose in the latest investment ‘golden-child’ (think hot tech stocks, pot stocks, crypto-currencies and related stocks) means taking on significant risks.
For some time now GLC’s investment professionals have highlighted the risks of stocks whose meteoric stock price rise appears to be based on investor sentiment rather than the company’s ability and outlook to make money and turn a profit (see exhibit 1.0).
Allocating funds that would have otherwise been destined for your core investment strategy into narrow sectors of the market where performance has been particularly hot.
Safeguard your core investment portfolio – the nest egg you’ve worked hard to build. Stick with the foundational pillars of long-term investing and ensure you are diversified by geography, sector and asset class. Excitement is rarely seen as a good thing in investing, so here’s where it’s perfectly okay to be boring! If you want a ‘slush fund’ of ‘extra play money’ to invest in a stock or sector you really believe in, that is just fine to do and can make investing an enjoyable pastime. But when it comes to meeting your overall financial plan, unnecessary risks are just that, unnecessary.
4. Don’t try to be someone you’re not
Taking on more risk than you can handle
As markets roll forward, investors tend to gain a false sense of confidence in their ability to remain comfortable with volatile investment results. These emotions often lead investors to remain overweight riskier assets (including within fixed income investments) well into the late stages of a market cycle.
For some time now, narrowing spreads in credit products (especially high-yield bonds) have offered relief from the headwinds of rising bond yields. As a result, investors may not appreciate the excess risk and volatility that come with high-yield bonds. At this later stage of the market cycle, we believe high yield bond credit spreads have declined to a point where their ability to continue to offer this benefit is limited, and we see the current risk-reward trade-off in high yield bonds as unattractive. In other words, we believe there is little remaining upside, but a significant amount of downside. In a risk-off event when most investors turn to the stability of the fixed income portion of their portfolio to mitigate equity market volatility, high yield bonds will not provide investors with the downside protection that high quality, investment grade bonds will provide.
Safeguard your core investment portfolio – the nest egg you’ve worked hard to build.
Failing to rebalance a portfolio to your appropriate risk tolerance is typically accompanied with having no set plan to avoid suffering outsized losses and the panicked selling of risky positions in the midst of a market correction. Watch for signs you are trying to convince yourself that your tolerance for risk (a mix of your investment time horizon and comfort with swings in your portfolio’s return) is higher than it actually is; typically characterized by talk of ‘letting things run a little longer’, ‘this time will be different’, and ‘if things get bad, I can handle it’.
Reset your portfolio to be at, or approaching, your neutral asset mix based on your time horizon and risk tolerance. Everybody can brush off one or two days of bad markets. But how are you going to feel after a few months or even a year of bad markets? Know the answer to that question, and chances are you’ll know what the right ‘neutral asset mix’ is for you.
What does it mean for you?
Investors at differing life stages will have varying needs and concerns. Consider the following investor scenarios:
1. For those with sufficient time horizon and risk tolerance (i.e. still in the accumulation phase of investing)
Sticking with a more moderate to aggressive, diversified portfolio of equities and fixed income and continuing to add regularly to your portfolio makes sense. You’ll be taking advantage of the lower equity and bond prices that higher yields and market corrections bring, while still mitigating your exposure to any one given market through diversification.
2. Investors on the conservative end of the spectrum
You are most at risk of drifting and/or stretching for income and returns during the late stages of a market cycle – even though you can ill afford to withstand significant declines in capital. With bonds, the challenge of rising yields will create some short term pain but will eventually put the ‘income’ back into fixed income. During this stage of the market cycle we argue that high-quality investment grade government and corporate bonds remain appropriate and a powerful risk mitigation tool, while high-yield bonds (i.e. junk bonds) do not offer this same benefit. Rising bond yields are part of the diet at this late stage of the market cycle, but bond yields will fall when the cycle eventually slows, or ends and high quality bond prices will rise, providing a lift to balanced portfolios that do not abandon these positions.
3. Investors with immediate (less than 3 years) income needs
If you need income from your portfolio to meet immediate lifestyle needs, set aside a comfortable nest-egg of cash in safe, short-term vehicles (like money market or GIC’s). This will allow you to ride out weak bond returns and overall capital market volatility that typically accompanies late-cycle investing. This allows for assets meant for further down the road (3-5 years out and longer) to be kept in a diversified portfolio with some exposure to equities. If equities display late cycle strength, you still have ‘skin in the game’ to benefit and generate growth for your portfolio. In the event of a risk-off scenario, your core fixed income positions are there to help out. Ultimately, this builds flexibility for the future, avoiding the necessity to tap either asset class at a disadvantageous time.
4. All investors
Whatever type of investor you are, if you truly believe that a move up the risk spectrum is appropriate, take incremental steps and examine where you may be taking on excess risk. Shifting your portfolio mix significantly from fixed income to equities and/or domestic to foreign, or from government and investment grade bonds to high-yield, real return and/or floating rate notes, suggests there has been a fundamental change in your time horizon and/or tolerance for risk. Ask yourself if this is really the case – it will help you avoid some of the most common investment mistakes happening right now.