I am fond of aphorisms – short little sayings that tell a story in just a few words. One that I have been returning to frequently of late is “Don’t pay attention to the yelling in the fish market. Pay attention to the price of fish.”
Without a doubt, the 24-hour news cycle means there is a lot of yelling in the fish market. As an investor, it can be nerve-rattling to watch the daily news and wonder, is this IT? Is this the news that drives the rally to new highs or breaks the markets irrevocably? As advisors, our business requires that we keep abreast of any and all news developments that might affect the capital markets. This is our job. So, one of the first things I tell our new clients is to let us do the worrying for you. This is especially true for clients who have trouble reacting to news developments in a dispassionate and objection manner. It’s best to turn the TV off, review with us every quarter and by all means, let us do the worrying. We’re good at it!
Of course, for those who prefer to do their investing without the benefit of an advisor, it is generally true that the informed investor is the successful investor. However, staying informed involves listening to a lot of fish-market yelling, and this process can be befuddling if not maddening at times. An example in recent weeks was the market volatility associated with the political developments in Italy. As the third-largest economy in the Euro-zone, Italy carries considerable weight in the region. As such, the political uncertainty led to significant selling in both the bond and stock markets in portions of Europe. As is usually the case when these flair-ups occur, German and US government debt benefit from a “flight to quality”, while debt issue by the “PIGS” countries (Portugal, Italy, Greece, and Spain) saw large investment outflows. What unnerved market professionals about the Italian “crisis” (and I use the word advisedly) is the possibility that the new Italian government would move to withdraw Italy from the Euro. Italy’s departure would surely be a precursor to the unraveling of the entire European monetary union.
Fortunately, the volatility in European bond yields subsided quickly, and the markets stabilized within a matter of days. In this case, the fish-market yelling was represented by the political negotiations surrounding the formation of a new Italian government; the price of fish was represented by bond prices in the EU. But it needs to be acknowledged the episode is emblematic of some serious underlying concerns regarding the European economy. Are we as investors expected to completely ignore threats like these when they occur? Of course not. But reactions to events like these need to be measured and guided by a steady and dispassionate hand. Moreover, investing on the basis of a very low-probability, high-impact “black swan” event is nigh impossible. Ultimately, the black swan event is part of the systemic risk that investors must assume if they are to enjoy returns superior to those offered by government-insured bank deposits or US Treasury bonds. Having said that, though, market risks can and should be minimized through the process of diversification. By being broadly diversified across asset classes, industry sectors, geographies, individual companies, and even strategies, it is possible to get better returns without taking on unnecessary levels of market risk.
This brings me to another mantra I’ve been repeating more and more these days: “Know what you own and why you own it.” With the rise of passive investing through exchange-traded funds (ETFs), many investors have unwittingly assumed outsized risk exposures. For example, following the massive outperformance of the so-called “FANG stocks” (Facebook, Amazon, Apple, Netflix, Alphabet, and we’ll also include Microsoft for kicks) in recent years, many of the broad market indices (and the ETFs that track those indices) now contain very large concentrations in these individual stocks. Even the very broad S&P 500 now has a nearly 16% weighting in the FANG stocks and a 26% weighting in the Technology sector, with the latter well above the historical average and over 12% higher than the next largest industry sector (Health Care). So buying one of the ETFs that tracks the S&P 500 very possibly violates one of the most basic rules of investing: “buy low and sell high.” You are essentially buying outsized positions in the stocks that have already gone up the most!
The market in bond ETFs has exploded as well in recent years. ETFs trade like stocks, but the bond market behaves very differently than the equity market. A sudden spike in interest rates or defaults could send bond prices down (and yields up) sharply. If there is a rush to sell bond ETFs in response, the bond market could face a serious liquidity crisis. I fear that retail investors are not familiar with the liquidity risks inherent to the bond market, and indeed due to the rise of corporate debt packaged into ETFs, no one is quite sure how the markets will respond in a crisis.
To be clear, I am not arguing that investors should ignore all news developments and/or avoid altogether exchange-traded funds. I am simply stating that there is risk in emotional investing, and there is risk in not knowing what you own and where your risk exposures lie. It is often true that news flow, especially with regard to economic developments, can profoundly affect an investment thesis and therefore should be acted upon. It is also true that ETFs can provide a valuable way to gain exposure to a segment of the markets that otherwise was not possible. But these considerations add to the complexity of investing in already complex global capital markets.
Our best advice is to keep a level head and a focus on the long term. If you’re a client, thank you; you’re in good hands. If your not a client, why not have us do a complimentary review of your holdings and hear our thoughts? Until next week . . .