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I love chatting with taxi drivers. These philosophers of the road are an interesting source of wisdom and knowledge, and — occasionally — the casual, off-color remark. No matter where I go in the world, I strike up conversations with cab drivers to learn something about the local culture or the current political climate.
Recently, my wife and I took a taxi to the opera in London and our driver greeted us with the words: “Today is one of the most dangerous days to drive.” In disbelief, I looked out the window to check if I was dreaming, but it was still the glorious London summer day I remembered from 10 seconds before. I asked the driver what was so dangerous.
Today was a Saturday and the sun was shining, he said. The only thing that could make it more risky to his mind was if it was the first day of a school holiday. That’s when traffic accidents really increase, he said, in particular accidents that involve pedestrians and cyclists.
I would have thought that a rainy or snowy rush hour would be the most hazardous time to drive. But in busy traffic, with rain or snow, we are naturally cautious because we know that the conditions are treacherous and so are more alert and aware. On a sunny day with little traffic, we tend to let our guard down and are easily distracted by the beauty of nature or the people around us. The same is true for daydreaming pedestrians who may walk into the road and potentially into oncoming cars with equally distracted drivers. Accidents happen not because the environment is more dangerous but because people are lulled into complacency and don’t pay attention to risk.
And the same patterns hold true in investing. In the first six months of 2019, the MSCI World Index was up 15.6% in US dollars, the MSCI Emerging Market Index was up 9.2%, the Bloomberg Barclays US Aggregate Bond Index was up 6.1%, emerging market bonds were up 9.4%, the Bloomberg Commodity Index was up 5.1%, and the HFRX Global Hedge Fund Index was up 4.1%. I could go on.
Practically every asset class has registered strong gains in the first half of 2019, even long-suffering commodities and emerging markets. If you were running a fund and you sold everything today and invested it in the money market, I doubt any of your investors would complain about the end-of-year performance. In the markets, it is clearly Saturday and the sun is shining.
Now is the time for investors to fight complacency. Of course, we should enjoy the good weather and the robust returns on our investments. But we should also be aware that other investors might lower their guard and contribute to the financial markets equivalent of a six-car pile-up.
Economic growth around the world has slowed this year, and tensions between the United States and China and the United States and Iran have increased. Nevertheless, many investors are acting like the current bull market will go on indefinitely, that the central banks will support it with interest rate cuts, that the current cyclical slowdown is so shallow that a real recession will never occur again. But my take on the current situation is that:
- Central banks are cutting interest rates because they fear a much more pronounced economic slowdown than the one we have experienced so far.
- Every recession starts with a little slowdown. And every time, some people argue that this time there won’t be a recession.
Of course, I cannot forecast recessions and I don’t know if the current hiccup will end up in one, but as more people enjoy the Saturday sun, it is wise to prepare for the possibility of a sudden thunderstorm or some cyclist careening into your passenger door.
Today, investors have a variety of tools to safeguard against such situations. Maybe sell risky assets or hedge the downside risk with options and other derivatives. This way, if markets crash, the portfolio is fully protected. But metaphorically speaking, selling all risky assets is like staying at home and shutting the windows and blinds. And buying put options or other derivatives to hedge against downside risks is like strolling in the sunshine with an umbrella: It might give you some shade but you still look silly. And you’re missing out on the nice weather, which in a city like London is rare enough anyway.
Beyond staying inside or wearing rain gear, there are other, less drastic ways to reduce your risks. If you want to enjoy a balmy summer day, you can sit outside in the shade. You’ll get the sunshine, but you won’t be quite as hot and you’ll reduce your potential for sunburn. In investment terms, it’s the equivalent of shifting from cyclical to defensive stocks, say, in health care or food. You access the upside of the stock market but have a margin of safety if markets take a downward turn.
Similarly, you could slather on some sunscreen to ward off sunburn and protect yourself from cancer-causing UV rays while letting the warm infrared radiation through. This is like having stop-loss orders on your risky assets in place that are 10% or so out of the money. You can fully enjoy the good times but guard against the worst drawdowns if the bull market turns into a bear market.
And finally, while most people relax on a sunny Saturday, investors should be particularly vigilant now. Others may make mistakes that could impact the whole market. A sudden change in sentiment can trigger a significant sell-off as investors stampede towards the exits. Alert investors may observe signals of a pending mood swing ahead of time and mentally prepare themselves for the possibility of a sudden drop in markets.
Of course, there is a risk involved in paying too close attention to bull markets. Enthralled by our investment returns, we can give in to greed and throw caution to the wind. Behavioral finance tells us that it is all too easy to get swept away in the positive emotions that strong performance triggers. So remember to focus on what might go wrong in the future instead of what has gone right in the past.
I usually remind myself of the story told by Abraham Lincoln in 1859:
“It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘And this, too, shall pass away.’ How much it expresses! How chastening in the hour of pride! How consoling in the depths of affliction!”
For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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