Sam Lee wrote a very awesome piece last year titled “Waiting for the Market to Crash is a Terrible Strategy“. The basic gist of the post was that you shouldn’t wait around for market crashes trying to time when you will invest in the markets. That summary is a disservice to Sam’s thoughtful post so go give it a full read.
As the stock market booms and Donald Trump touts the market’s record highs every day there is a palpable feeling of missing out. Many people are now jumping in and waiting for a surge in stocks. In a recent note Jeremy Grantham discussed the prospects of a “melt-up”. This is something I’ve discussed ever since Trump was elected – he has all the right ingredients for creating a stock bubble:
- Trump is pro-business to a fault.
- Trump is exploding the deficit (which adds to corporate profits).
- Trump is talking up the market.
- Trump’s policies probably won’t deliver the lofty results he expects.
Now, I hate to attribute too much of the stock market boom to politicians because the fact of the matter is that the market and the economy move mainly because regular people go to work every day and do amazing things. Politicians might influence the speeds and quality of the roads, but let’s not mistake them for the engines powering the progress of the vehicles on those roads. Still, someone like Trump is a bit like injecting nitrous oxide into the car and when you’ve already been moving along at a fast clip for 8 years, well, that looks like a pretty good recipe for a destabilizing boom in asset prices.
But here’s the kicker in all of this – THIS IS SHORT-TERM SPECULATION AND HAS NOTHING TO DO WITH A SOUND FINANCIAL PLAN.
Let’s try to bring things back to operational facts. Now, the operational fact of asset allocation is that the stock and bond markets are inherently long-term instruments. The bond market is about an 8 year instrument on average and the stock market is best thought of as having a duration of at least 25.¹ When we take our savings and allocate them into these instruments we are engaging in an inherently long-term endeavor. You can try to squeeze returns out of them by being super short-term, but in the aggregate they will generate whatever return they are designed to pay out.² That doesn’t mean we need to be irrationally long-term, however, we also shouldn’t be irrationally short-term. Planning for a “near-term melt-up” is an irrationally short-term expectation. And just like it’s silly to plan for a crash it’s equally silly to position your portfolio for a boom.
The problem with constructing your portfolio around a “near-term melt-up” is that you’re timing a very bullish short-term outcome. So, let’s say you’re the kind of investor who has a conservative risk profile and you read the Grantham note and you alter your allocation to something more aggressive. If you’re wrong then you’ve created a huge behavioral conflict in your portfolio. Since we know that predicting the short-term is a negative sum game with low probabilities of accurate outcomes, we know that trying to predict and benefit from the melt-up will add significant behavioral risk to your portfolio.
More importantly, if the market does “melt-up” then that implies that it could “meltdown”. So, if you alter your portfolio from a conservative profile to an aggressive profile then you will benefit from the melt-up, but you also need to time the market to account for a potential meltdown. This all-in or all-out type of mentality reduces the potential for behavioral alpha because it creates a conflict between your portfolio and your actual risk profile.
Most people should ignore these types of short-term narratives because waiting for the market to boom or bust is an inherently short endeavor that will only creates conflicts between your financial needs and your behavioral profile. Instead, establish your financial needs, find a realistic profile, construct the appropriate portfolio and stick with the plan through melt-ups and meltdowns. In the end you’ll guarantee that you save money on taxes and fees all the while adding the only type of alpha that matters – behavioral alpha.
² – As a simple example of this consider a AAA rated 10 year bond paying 2%. That instrument will pay 2% every single year for 10 years with near certainty. No matter how much you trade it over those 10 years it will not pay more than 2% per year. Of course, some people might trade it more successfully than others, but over the course of that 10 years all of that trading only reduces the aggregate return that investors on the whole will earn as the instrument literally cannot pay out more than it was designed to pay over its lifetime.
NB – If you have money to burn and want to speculate I guess there’s nothing wrong with that, but for most of us who are investing our literal savings, this sort of short-term speculation should play no role in the way we allocate assets.