Focus on risks, return potential
Rising market creates artificial investor security
Equity markets have ascended to new highs as have complacency levels while volatility is at record lows, which is all causing a bit of concern for investors wondering what to do next.
Unfortunately, professional market participants have not been much help in providing whatever outlook investors need to plow even more money into the market and the permabears are telling investors to go to cash or gold pending an upcoming market correction.
The market, of course, rarely acts in a linear fashion and it is impossible to predict: Unexpected random events can cause a correction at any time or markets can simply ignore near-term risks and continue their upward trajectory, as they are in today’s environment.
The one thing an investor should be able to control is the level of risk taken on.
Emotion can have a major influence on a portfolio
But the structure of the investment industry is conducive to taking excessive risk, leaving limited options for investors who want to manage the risk in their portfolios.
Since most investment managers have their funds marketed through stock brokerage and investment advisor channels, they end up living and dying by the latest performance of their funds. This means those funds with the highest near-term returns will grab more new capital than those lagging behind.
As a result, each fund manager is highly incentivized to take excessive risk in order to make it to the front of the pack. Why would a manager take profit or employ risk-management strategies in a bull market when it means potentially underperforming and not being able to attract new capital?
We believe we’re seeing this idea playing out today with market dips being quickly bought up to put a near-term floor in the market. This may appear to be a very positive development, but it is also creating an artificial sense of security for investors.
Investment advisors for the most part are not acting any differently. They, too, are encouraged to take excessive risk by the very nature of their commission- based compensation structure since most are only paid upon the completion of a sale of a financial product.
When advisors are questioned on what is being done to manage risk, a common response is that everything will be fine if you invest for the long term and own those funds that have a strong performance track record.
Selecting the mutual fund with the highest near-term performance creates the perception that a fund man- ager who can pick the right stocks protects the investor. The problem is that recent performance has nothing to do with future performance, as plenty of studies have indicated. More so, it does nothing to protect against correcting markets.
An investor’s time horizon is certainly a very important consideration when it comes to managing risk, but emotion can have a major influence on a portfolio during a large market correction, such as in 2000 or 2008, as can an outside unexpected event, like losing one’s job.
A good advisor can provide a lot of help in keeping a client’s emotions in check by being proactive rather than reactive to market events. For example, undertaking a low-cost hedging strategy in a rising market can help protect against some of the risk of that market falling.
By focusing on risk and return potential, investors can avoid chasing returns by taking on excessive risk and have a much better chance at achieving greater stability and predictability in their portfolios.