The past few weeks have made me reflect on conditions that felt somewhat similar to 1998. We have all watched in amazement at how a large group of young investors threw a massive curveball at the hedge fund community by squeezing the shorts on names like GameStop and Nokia. The reasons for the short positions could have been a legitimate position taken based on weak fundamentals, but there is also a history of these hedge funds squeezing the capitalization of companies like these down to nothing in the name of making a buck. Regardless of which reason the shorts were in, the lesson learned here was that nobody can accurately predict the price of a stock on any given day, which direction it will go on any given day, and that arrogance always gets punished. A group of investors (who I assume are day traders) who convene on Reddit decided to punish a large group of hedge fund managers by buying and holding large positions in these stocks. They squeezed the shorts.
Long-Term Capital Followed by the Dot-Com Phenomenon
In 1998, Long Term Capital (one of the largest hedge funds ever) went through a similar, painful lesson that nearly brought down the world’s banking system. Long Term Capital built their reputation for enormous profits through the trading of derivatives but were also surprised by the Russians defaulting on debt and announcing a devaluation of their currency. Although the Federal Reserve negotiated a deal to save the company from causing global banking chaos by having a number of banks buy into the company for $3.5 billion, this lesson did not deliver behavioral change among “the smart people.” It is important to note that almost any retail investor who had a couple of bucks was dumping money into the market blindly because we were living in the age of the dot com. Most retail investors never really paid attention to the Long-Term Capital story. All they knew was their pets.com stock was rising for no good reason at all. As we know, 1999 was another good year for the market (although it was the last year of the dot com phenomenon.) The following three-year period was so painful that many people who had retired in 1999 had to go back to work due to the massive losses in their portfolios.
Post-Pandemic Growth Prior to Inflationary Environment
Fast forward to 2021 and we see a similar level of enthusiasm among investors regarding the assumed return to prosperity in a post-pandemic world. Despite the slow rollout of the vaccines to the general population, the market continues its ascent in anticipation of strong economic growth after the restrictions on businesses have been totally lifted. Other factors driving the market include the anticipation of $1.9 trillion in economic stimulus from the federal government and a near zero interest rate environment inspired by the Federal Reserve. I do believe this market will continue to look strong due to these factors, but we must look for those curveballs that have made so many smart people look foolish. The most obvious risk from all of this is an inflationary environment that becomes a noteworthy consequence looking into 2022 and beyond. I’m sure there are some other risks out there that nobody can see at this moment.
In any event, it is more important than ever for retail investors to think about risk management and how it should be applied to their unique family needs and circumstances. Unfortunately, most risk profile questionnaires ask questions about how investors feel at the time the questionnaire is completed. Because of the strong rebound in the market in 2020 after the pandemic shock, and the ongoing increases in stock prices, many retail investors are becoming agnostic to downside risk again. Investors are showing a level of confidence that may not accurately reflect how they might behave in an extended bear market. This conversation is particularly important because most institutions use the answers from the risk profile questionnaire to build portfolio allocations and systematically rebalance back to these allocations. When the bear market becomes a reality, the investor screams that the allocation they are in is too risky while the advisor tells them to “stay the course.” The advisor uses that document as cover and reminds the investor they are in it for the long haul.
Deploy Aging Process to Manage Risk
There is a better way. Although it is a requirement that a risk profile questionnaire be completed by any investor, it is not a requirement to “set it and forget it.” I recommend families identify the distribution dates for each of those high-priced life events (college tuition funding, retirement, paying for our children’s weddings, etc.) and apply an aging process to manage risk. This process allows for the construction of purpose-based portfolios that are uniquely managed to those distribution dates. Risk is applied at the point farthest from the distribution date, then gradually moved toward an income-producing allocation, and ultimately to a highly liquid safe allocation among short-term U.S. treasuries. By applying this risk-management practice, there will be no need to “unretire” because of a painful and surprising bear market. Dynamic Mapping is the name of the human-based financial planning method that embraces this risk management method. It also encourages the assignment of 18 months’ worth of income to a bear market reserve account which would prevent investors from selling stocks when their prices are most depressed. Whether or not you use an adviser to manage these risks or you do it yourself, this more human-centered method of managing risk will enable you to endure the sticker shock of a quarterly statement during a bear market. Most importantly, these milestone life events won’t need to be postponed or cancelled! This date-driven method of risk management will prevent us from attempting to be “smarter than the market!”
Jeff Mount is President of Real Intelligence LLC. Jeff has been active in the financial services business for the last 25 years.
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