In recent years, the monetary easing policy has suppressed interest rates and increased the money supply in an effort to promote increased lending and liquidity. What it has effectively done though is encourage passive investors to speculatively seek yield in overvalued securities by giving them the illusion that this bull market will continue forever.
Following the trend of passively investing in indexes may be the path of least resistance, but investors need to realize the risks involved in doing so — especially those in the high-risk window. The strategy of passively investing assumes investors have the stomach to weather significant downturns in their portfolio, but as seen numerous times before, this is usually not the case.
The current trend for most individuals is to choose a mix of equity and bond indexes, normally based on the best past performance, with little to no research involved, and continue to purchase those holdings regardless of the valuations. Their decision is based solely on the assumption that past performance will continue into perpetuity. But as John Hussman said in his October 17th Weekly Market Comment, “passive returns look glorious in the rear-view mirror precisely because Fed-induced yield-seeking speculation has driven nearly every asset class to rich or obscene valuations in recent years.”
So what will happen when there is a breaking point and the trend reverses? Unfortunately, we’ve seen this scenario play out numerous times before. During market downturns, these price-insensitive buyers lose emotional control and begin to exit the market. This chart from William Bernstein’s book, Rational Expectations, estimates the number of investors who will abandon their strategy depending on the magnitude of a market decline.
These mass sell-offs trigger more and more investors to panic, eventually leading to a market collapse, or as Mr. Hussman says,
by the time trend-followers are all-in, value investors are out, and attempts by trend-followers to exit require prices to decline until skittish value-conscious investors are willing to absorb the shares being offered for sale. (October 10th Weekly Market Comment)
Our philosophy at Precedent Asset Management is to stay ahead of market trends — not follow them. We know that taking less risk leads to higher returns because recovering from a large loss of capital can be difficult. If you are worried about your long-term wealth, schedule an in-depth portfolio analysis and let us help you uncover any risks present in your portfolio.