Market Peaks – The Intersection of Paralysis, (Over)Confidence and Complacency

SnowbirdOn a recent trip to Park City, Utah, we ventured over to the most intimidating ski terrain I have ever been to – Snowbird Resort. The mountain is littered with steep grades and cliffs, exposed rock, narrow cat tracks and some of the highest ski lifts I have ever been on.

If you take any of the lifts to the peak of the hill, you can see very little in any direction except the edge of the narrow ridge you are standing on and other mountains off in the distance. There is – quite literally – nowhere to go but down…and fast!

As US markets linger near all-time highs, many investors are starting to feel like they are standing at the peak of Snowbird.

For some, this produces a desire to retreat and search incessantly for the safest way out. They sense an imminent danger, freeze in place, and seek to eliminate that feeling as quickly as possible.

The safest way down from the top of the mountain is to hop back on the aerial tram and ride it to the bottom. You are technically safe, but you miss the point of being there in the first place.

For others, this experience provides an adrenaline rush, as they have an opportunity to stretch themselves and take a more interesting path on the next run.

Each time they make it down safely, they begin to forget about all the rocks and cliffs they passed on the way up. Their past success breeds confidence and reduces the perceived threat.

In a perfect world, saving and investing would lead to a slightly new high each day. Unfortunately, markets do not work that way.

Like the skier that falls numb to the risks over the next ridge, investors who stretch too far expose themselves to potentially devastating results. Conversely, investors who seek shelter miss out on future gains.

One of the fundamental cornerstones of our investment philosophy is having a strong understanding and appreciation for the level of risk being taken in a portfolio. We understand the consequences of stretching too far in any direction, seeking only to take as much risk as is necessary to meet your objectives.

The world of Alpine skiing has developed a similar approach, designating each run with a green circle (easy), blue square (moderate), or black diamond (hard). A skiier that chooses a path misaligned with their desire, need or ability ends up with a suboptimal result.

In the example below, we have two portfolios going through a market rise and subsequent market decline. Portfolio B is invested more aggressively than Portfolio A.

Everyone wants portfolio B when markets are rising, but Portfolio A when markets decline. We all know that consistently achieving that result is nearly impossible in the investment world, yet many people can’t help themselves from trying.

Portfolio A is a diversified portfolio and earns 10% during the market rise, then declines 10% when the market drops.

Portfolio B is a concentrated stock portfolio that earns 50% during the same market increase, then falls 50% when the market declines.

To the untrained eye, the simple average return for those two periods is identical.

 

 

Period 1

Period 2

Simple Average

A

+10%

-10%

0%

B

+50%

-50%

0%

 

During period 1, investor B gives himself a pat on the back and is praised as a genius at cocktail parties. Everyone wants investor B’s advice and he can’t talk about his investing prowess enough.

Investor A, meanwhile, is overlooked as being a conservative, “vanilla” investor. What she understands, however, is what really happens during period 2.

 

 

Period 1

Period 2

Simple Average

Actual Return

A

+10%

-10%

0%

-1%

B

+50%

-50%

0%

-25%

 

If each invested $100, portfolio B gains $50 during Period 1, leaving him with $150. A subsequent 50% loss then leaves him with $75, or a loss of 25%.

Portfolio B, on the other hand, gains a “modest” $10 during period 1, leaving her with $110. Her subsequent 10% loss leaves her with $99, or a loss of 1%.

The mathematics of compound interest are almost universally discussed in the context of upside. Earning 7% for 30 years will yield you “x” and earning 9% will yield you “y”.

The more important discussion, however, should center on the impact of large losses and how the volatility of returns impacts the actual result.

A 10% loss requires an 11% return to break even, a 20% loss requires a 25% gain, and a 50% loss requires a 100% gain.

Skiing off a cliff just 0nce can erase all the positive experiences leading up to that point in time.

Big negatives impact performance far more than the equivalent upside.

Stretching for yield in a low rate environment, abandoning underperforming asset classes, or making guesses about what lies ahead are sure ways to increase the potential for a large loss.

Diversified portfolios have recently lagged the widely followed US stock indexes, but they should still be providing a nice blend of horsepower and stability to provide a very enjoyable ride. Stay in your comfort zone and remain committed to the level of risk appropriate for your personal goals and objectives.