There’s a massive disconnect between advisers and
investors today, and it’s reflected in both declining
investment activity as well as a general fatigue with the
consultant-client conversation. Consultants continue to preach
the faith of diversification, and their clients continue to
genuflect in its general direction. But diversification as
it’s currently proclaimed is perhaps the most oversold
concept in financial adviser-dom, and the sermon isn’t
connecting. Fortunately, behavioral economics offers a fresh
perspective on portfolio construction, one that lends itself
?to what we call adaptive investing.
Investors aren’t asking for diversification, which
isn’t that surprising after five years of a bull market.
Investors only turn to diversification after the fire, as a
door-closing exercise when the horse has already left the
burning barn. What’s surprising is that investors are
asking for derisking, similar in some respects to
diversification but different in crucial ways. What’s also
surprising is that they are asking for derisking rather than
the rerisking that you’d typically expect at this stage of
such a powerful bull market.
Why is this the most mistrusted bull market in recorded
history? Because no one thinks it’s real. Everyone
believes that it’s a by-product of outrageously
extraordinary monetary policy actions rather than the result of
fundamental economic growth and productivity — and what
the Fed giveth, the Fed can taketh away.
This is a big problem for the
Federal Reserve, as its efforts to force greater risk
taking in markets through large-scale asset purchases and
quantitative easing have failed to take hold in investors’
hearts and minds. Yes, we’re fully invested, but just
because we have to be. To paraphrase the old saying about
beauty, risk taking is only skin deep for today’s
investor.
Risk aversion is also the root of our current
adviser-investor malaise. How so? Because derisking a bull
market is a very different animal from derisking a bear market.
As seen through the lens of behavioral economics, derisking is
based on regret minimization (not risk-reward maximization like
diversification), and the simple fact is that regret
minimization is driven by peer comparisons in a bull
market.
In a bear market your primary regret — the thing you
must avoid at all costs — is ruin, and that provokes a
very direct, physical reaction. You can’t sleep. And
that’s why derisking rule No. 1 in a bear market is so
simple: Sell until you can sleep at night. Go to
cash.
In a bull market your primary regret is looking or feeling
stupid, and that provokes a very conflicted, very psychological
reaction. You want to derisk because you don’t understand
this market and you’re scared of what will happen when the
policy ground shifts. But you’re equally scared of being
tagged a panicker and missing the greatest bull market of this
or any other generation. And so you do nothing. You avoid
making a decision, which means you also avoid the
consultant-client conversation. Ultimately, everyone —
adviser and investor alike — looks to blame someone else
for his own feelings of unease. No one’s happy, even as
the good times roll.
So what’s to be done? Is it possible to both derisk a
portfolio and satisfy the regret minimization calculus of a
bull market?
In fact, our old friend diversification is the answer, but
not in its traditional presentation as a cure-all bromide.
Diversification can certainly derisk a portfolio by turning
down the volatility, and it’s well suited for a bull
market because it can reduce volatility without reducing market
exposure. The problem is that diversification can take a long
time to prove itself, and that’s rarely acceptable to
investors who are seeking the immediate portfolio impact of
derisking, whether it’s the bear market or bull market
variety.
What we need are diversification strategies that can react
quickly. That brings me back to adaptive investing, which has
two relevant points for derisking in a bull market.
First, your portfolio should include allocations to
strategies that can go short. If you’re derisking a bull
market, you need to make money when you’re right, not just
lose less money. Losing less money pays off over the long haul,
but the path can be bumpy.
Second, your portfolio should include allocations to
trend-following strategies, which keep you in assets that are
working and get you out of those that aren’t. The market
is always right, and that’s never been more true — or
more difficult to remember — than now, in the golden age
of the central banker.
W. Ben Hunt is the chief risk officer of asset
management firm Salient and the author of Epsilon
Theory, a market commentary resource for investors and
portfolio managers.