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Bull Session: How to Derisk in a Bull Market

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.