The current bull market has been steaming ahead since the market bottomed in March 2009. Consumers of investment advice have noted that passive, buy and hold strategies have outperformed most active strategies over this time period, giving some the false impression that ‘risk management,’ in the context of tactically changing portfolio asset allocation to defend against bear markets, is a fools game.
I shouldn’t be surprised: As I’ve written in the past, managing risk is a thankless task when viewed in the rearview mirror. All that you can see looking backwards in time is the certainty of what has been. Any tactic employed to defend against potential bear market scenarios in the past looks silly when viewed from the perspective of a new market high in the present.
This phenomenon is called “hindsight bias,” and it occurs whenever we think we should (or could) have predicted something that occurred in the past. The fact is, we have remarkable clarity of vision about variable outcomes… once the present obliterates the probability of the negative consequences we faced in the past.
The current bull market provides a good example. The market has steamed ahead to record highs, so does it matter that…
- Banks don’t have to mark their securities to market.
- Derivatives are still a huge part of the economic landscape.
- Europe’s experiment with the euro is tenuous at best.
- Central Bankers can create trillions in liquidity with the push of a button.
- Global debt levels will be reduced at a cost of lower growth.
Perhaps these things will matter in the future, but we can acknowledge with the help of our rearview mirror that they didn’t matter in the past.
Managing the Risky Unknown
Modern finance gives us “alpha,” a way of measuring how well we do in managing risk relative to the returns we earn. Alpha risk-adjusts returns so we can compare them to a benchmark; in our case, Pinnacle portfolios earned positive alpha over the past five years, a statistic that gets lost when focusing on returns. There’s an old and very accurate saying about alpha: “You can’t eat risk-adjusted returns.” How true. When the dust settles and it’s time to spend your money, the risk or volatility you experienced on the journey doesn’t matter. All that matters is the size of the pot.
Today Pinnacle analysts are sweating over a landscape of risks. The bull run has now taken the market to a place where it is expensive by many traditional measures. In the U.S., liquidity is no longer being actively pumped into the system, as the Federal Reserve is no longer buying bonds and mortgage debt. This has been a long bull market by just about any standard, and the gains are already above average. Volatility is very low, suggesting that investors are complacent. Meanwhile, geopolitical risks abound. Investors must ask themselves if it’s less important to manage risk after a five-year bull market run than it was after a disastrous market decline? Put another way, is now the time to chase investment strategies that did well for the past five years, or is it time to look ahead?
There will always be investors who get swept away by the moment, and my counsel to them remains the same: Evaluate your portfolio returns in the context of a full market cycle, when fear becomes just as important as greed. Hindsight is a lousy method for identifying winning strategies in a risk-filled future.
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