Thoughts On The Stock Market and Investor Behavior
As of February 21st, the S&P 500 Index has returned approximately *5.05% year to date. At the current pace the total return will be over 30% in 2017. Some investors may think these returns will continue. It’s certainly possible for the S&P 500 to return over 30%, it has happened in the past. However, it is well above the annual average return of the S&P 500 index. This article serves as a reminder of what not to do when markets are quickly accelerating.
When stocks tend to perform very well or very poorly, it’s natural for investors to question if they have the correct allocation. In a bull market, an investor with a balanced portfolio (stocks, bonds, alternatives) will usually underperform a 100% equity market. In a stock bear market, that same investor will underperform a 100% cash/cash equivalent/bond portfolio. Therefore, he may be tempted to move from a balanced portfolio to a more aggressive portfolio close to the peak of a stock market cycle, and sell that same portfolio and move to cash at the bottom of the cycle.
I wish there was a way to know when an investor should place all his capital into stocks, and when to diversify into other assets. However, that would require predicting stock performance over short time horizons which is impossible to consistently do.
I believe the best way to pursue capturing as much upside as possible in a bull market, and seek to preserve your assets in a bear market is through diversification. I don’t define diversification as owning small, mid and large cap stocks. The reason is because many types of stocks tend to exhibit high correlation. Owning different types of stocks, bonds and alternatives will most likely increase diversification.
Perhaps, it’s tempting to liquidate bonds, alternatives, and cash and move into stocks. I do anticipate some investors going down this path, and then selling their stocks when they decline. Essentially, they would have bought high and sold low.
I highly recommend maintaining a long-term time horizon, and not letting sharp stock movements (in either direction) dictate how you decide to invest. Maintaining a balanced portfolio is what I believe to be the best path to pursue a reasonable return with an emphasis on managing risk.
Philip B. Snyder, CFA