How to navigate expensive markets where all asset classes are at their peak?
Global stocks hit several new all-time highs during 2021, with the global benchmark stock index nearly doubling from its pandemic March 2020 lows. Despite bond yields rising this year, government bond yields and corporate are still trading for nearly a decade. low, which implies high ten-year bond prices. With most of the major asset classes near peak and seemingly expensive, how should an investor consider investing in such a market?
The six-step guideline below could be a starting point for investors looking to navigate expensive markets:
Rebalance your portfolio
In the midst of a strong bull market, it is important for an investor to constantly review their existing asset allocation and analyze whether it has deviated significantly from long term goals and risk tolerance. For example, a simple 50% equities and 50% bond balanced portfolio starting in March 2020 would be significantly overweight equities today, simply because of the strong gains in the equity market over the past two years. . Any significant deviation in an investor’s risk profile increases their potential for loss. Thus, a prudent approach would consist in reducing exposures as close as possible to the target asset allocation.
Reset future expectations lower
Investors tend to extrapolate recent returns into the future. We believe equity markets are likely to move towards a more sustainable rate of return over the next several years, albeit with higher volatility, due to three factors. First, compared to previous cycles, stock valuations are now at a much higher starting point. Second, history suggests that stock market returns normalize to high single- or double-digit returns after the initial strong recovery from a receding market bottom. Third, the limited scope for lower interest rates and bond yields suggests modest stock returns over the medium term.
Be aware of the macro environment
Asset markets follow cycles strongly influenced by the macroeconomic context. However, many investors tend to overlook the importance of macroeconomic variables on investments. Being aware of the macroeconomic environment helps investors not only to grasp various sources of growth, but also to mitigate significant downside risks. For example: (i) the largest corrections (index declines of 20% or more) are usually triggered by concerns about impending recessions, (ii) business cycles and political environments have a different impact on various business sectors and investment trends and (iii) macroeconomic analysis can help identify multi-year and 10-year structural themes.
Bull markets are typically characterized by surges that are difficult to explain in different market segments or themes. Investors are missing the hottest theme of the month, creating a feeling of FOMO (Fear Of Missing Out), forcing them to continue this trend with potentially disastrous results. Amos Tversky and Daniel Kahneman partially demonstrated FOMO through loss aversion theory, where people have a strong tendency to avoid loss – psychologically, losses are thought to have twice as much of an impact on people. as the gains. With this in mind, it is almost impossible not to get carried away by the âlost opportunityâ by standing on the sidelines during a raging bull market. However, having an investment strategy based on your goals, liquidity, and risk appetite could go a long way in squeezing FOMO.
Diversify across assets and markets
Diversification is a key tool for investors to overcome expensive markets. Diversification can be achieved in three general ways – (i) Diversify the allocation between different asset classes, such as stocks, bonds, commodities, cash, real estate and alternatives, depending on the ‘asset allocation, (ii) Invest in international markets to avoid a single market bias and (iii) Diversify within an asset class, for example, by investing in different market segments, sectors and styles within equities and by allocating bond exposures according to duration, credit quality and sensitivity to interest rates. The basic principle of diversification is to have assets that have a low correlation with each other, so that any weakness in one particular asset class can be offset by gains in others.
Average cost in dollars
The dollar cost averaging is a strategy in which an investor spreads out his asset purchases over time to reduce the impact of market volatility, to ensure that the asset is not bought near. of a peak. Taking a phased approach to investing in bull markets is very important as buying a lump sum and holding long term is easier said than done. Long-term studies of investor behavior show that it is generally difficult for anyone to time the market. Additionally, the average investor tends to panic when the market goes down and often sells after the market has gone down significantly (and then stays out of the market). From a behavioral standpoint, averaging cost in dollars eliminates the emotion of investing because it reduces the risk of panic selling during times of significant market weakness – typically the main cause of long-term performance.
– The writer is Chief Investment Strategist at Standard Chartered Wealth, India.