The writer is an adjunct lecturer at William & Mary and author of the forthcoming book “The Confidence Map”
After the sharp sell-off in stocks, bonds, real estate and most other major asset classes this year, many investors will be asking hard questions about their portfolios.
Even for conservative investors it isn’t a question of if they lost money, but how much despite recent rebounds. Money managers have plenty of exogenous events and macroeconomic factors to point to to help explain this: the war in Ukraine, soaring inflation, a European energy crisis, a global slowdown, not to mention the lingering supply chain impacts of Covid-19, a soaring dollar and rising geopolitical tensions. There’s a long and all-too-familiar list of “who could possibly have imagined” reasons.
Likely to be missing from this summer’s discussions, though, will be any mention of 2021. Consumed by this year’s challenges, we’ve all but forgotten the wild excesses that preceded them: the retail investor frenzy that drove up obscure stocks such as GameStop to extreme heights, how some $18tn of bonds were trading at one stage with negative yields, the rush to invest in blank-cheque Spac investment vehicles. Remember dogecoin, a cryptocurrency designed as a joke that surged 15,000 per cent before crashing?
This may seem like an uncomfortable walk down memory lane, but it wasn’t all that long ago that pundits were suggesting we were at the climax of an “Everything Bubble”. And there are reasons we should keep such times in mind.
The first is the possibility that this year’s well-rationalised market drop is nothing more than the beginning of the Everything Bubble Burst, with recent gains an interlude in a broader bearish trend. Most of the investments that were most severely punished this year were the very last arrivals to the party. Bubbles have a funny “last in, first out” quality to them. The last in tend to leave first violently. We’ve seen plenty of that. If this is the beginning, there will be further well-rationalised declines ahead.
The second reason has the potential to be even more pernicious. Today’s balanced portfolio construction practices presume asynchronous markets — that stock and bond prices, for example, move in opposite directions. They never anticipated a synchronous peak in stock and bond prices, let alone in most major asset classes and in most markets around the world at once, like we just witnessed. There was supposed to be a diversification benefit in those bright-coloured multi-slice pies served up to investors, as different asset classes moved up and down independently. Balanced portfolios were meant to hold a mix of correlated and uncorrelated assets.
While balanced investors thought they did, in terms of investor sentiment last year, they owned but one asset: euphoria. Every piece of the pie was piping hot. There was no “confidence diversification”. Moreover, this year’s No Place to Hide sell-off and across-the-board rally suggests that remains the case. It’s still an all-one-mood market.
The lockstep price action we’ve seen cautions that the real benefit of portfolio diversification may arise not from the mix of assets investors hold, per se, but from the mix in investor sentiment underlying those assets. To successfully create confidence diversification, then, a balanced portfolio needs investments that reflect a wide mix of feelings from euphoria to despair — where individual pieces of pie are warming and cooling at the same time. If investor confidence is mirrored in valuations, the result should be a portfolio balanced not by asset type, but by its composition of cheap and expensive assets
This may feel like a fool’s errand, especially given the extreme emotion and impulsivity we’ve seen recently in the markets. What’s hot one day suddenly seems ice cold the next. But these “all-in or all-out” actions only add urgency to the need to reconsider what provides portfolio balance. So does the risk of a continued synchronous sell-off in equities and fixed income. Investors who once thought they would be protected by a balanced portfolio will be punished by it.
Asset managers are hoping that the recent rebound in stocks and bond prices will continue, lifting all ships anew. They need to be careful what they wish for. Those who live by a lack of confidence diversification run the risk of being impaled by it should investor mood turn down anew.
The future may be unknown, but what is certain is that investor demand, asset prices and investor confidence move as one. For balanced investors to better navigate whatever is ahead, they must mix up the mood in what they now own.
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