July 2016: Monkey See, Monkey Do (Money See, Money Do)

 

“Monkey see, monkey do” refers to someone mimicking another’s actions despite having limited or no understanding of why they are doing so, and without concern for the consequences of doing so.  In the investment world, we often see occurrences of “monkey see, monkey do.”  In those instances, however, we prefer a slight difference in spelling the phrase—we omit the letter “k.”

Money see, money do describes investors (using the term “investor” loosely) that merely follow the herd—neither thinking about why they’re doing what they do, nor considering what the consequences may be.   This is the stuff that enables a departure from rational investing.  This is the stuff that feeds bubbles.  This is the stuff that manifests itself in investment decisions that lack reason, logic, or historical foundation.

For you that have been parents (or recall your own childhood), what is the common response when a child is called-out for doing something stupid, reckless or irresponsible?  “But everybody was doing it!” Of course, as parents we also have a common response, “If Johnny jumped off a cliff, would you do it, too?” 

It seems that many investors would enthusiastically answer, “Yes, I’d jump off the cliff with Johnny… if I thought I would make money!”  As for Johnny, despite reason or rationale, perhaps he genuinely believed he would fly.  And, well, technically, he would fly.  Or, at least temporarily it appeared he was flying… until the ground below abruptly shattered his delusion.

We calmly watch while the Johnnys of the investment world are in flight.  It’s grand while it lasts.  However, history has repeatedly shown that the inevitable outcome is shattered delusions and the Johnnys get really hurt.

Two current examples of money see, money do:

1. Chasing yield. Here, an investor thinks only about the income an investment might provide, turning a blind eye to risk of principal. A classic example of chasing yield is selecting bond investments based on, “How much will it pay me?” without considering the risk associated with the bond. In response to years of near-zero interest rate policies, chasing yield has become all too prevalent.

Investors chasing yield commonly and increasingly take on two types of risk in the quest to boost income:

a.  Lower credit worthiness (less ability to pay interest and principal of the bond investment), and
b.  Heightened price volatility from accepting longer bond maturities (the number of years until the principal is scheduled to be repaid). The longer the maturity of a bond, the more sensitive is its value to changes in interest rates.

Taking on more credit risk and/or extending the maturity of a bond portfolio are two ways to subject your capital to more risk.

As the result of years of radical monetary policies, investors have been forced to endure miserably low interest rates.  In response, some formerly risk-averse investors have ventured into low-rated (risky) junk bonds or longer-maturity bonds.  Previously, prior to interest rates being pushed to record low levels, most of these investors would not have considered buying low-rated junk bonds or bonds with long maturities! Now, desperate for more income, investors are turning a blind eye to risk.  They chase yield, and they buy riskier bonds.

"I'm not as concerned about the return on my money as I am about the return of my money." — Will Rogers

Making money on your investments is not easy but, unfortunately, losing money is! Further, you can lose money a whole lot faster than you can make it. One of the surest paths to The Land of Investment Regrets is chasing yield—that is, investing capital for income without regard for the preservation of capital.

2. Believing the Myth. In this version of money see, money do, investors believe that the Federal Reserve (“the Fed”) will come to their rescue and will not allow the stock market to decline significantly. These investors mistakenly believe that their stock investments are “safe” from large declines. Implicit in this folly is the assumption that the Federal Reserve is capable of propping up artificially inflated assets indefinitely.

We know, however, that market forces can be manipulated temporarily, but never indefinitely. If the Fed truly were capable of manipulating markets indefinitely, we would not have seen the stock market plummet by half in the last 16 years—and not once, but twice (March 2000 to October 2002, and October 2007 to March 2009).

Relying on the false assumption that the Fed can and will protect investors from stock market declines is like relying on Johnny to protect you if you jump off the cliff. Yes, the Fed wants investors to believe they can fly!  The Fed wants your investment activity to buoy markets to give the appearance of economic well-being. Still, unfortunately, the Federal Reserve will not be able to protect you if you jump off the cliff. And neither will Johnny.

As is always the case with money see, money do, people choose to rely on a falsehood because they want to believe it’s true. Despite historical evidence, despite reason or rationale, when enough people believe the same falsehood, it becomes an investing norm. Still, we know that money see, money do is the antithesis of critical analysis and independent thinking, and it is counter-productive to safe-guarding your capital.

What we’re doing instead. We are independent investment advisors; you pay us to think on our own, not blindly follow the crowd.  Desire, hope, and delusion (i.e., acting like Johnny) are not constructs of long-term successful investing.  Instead, we rely on logic, reason, financial history, and our judgment and experience to manage your portfolio. That’s why our “moderate allocation” client portfolios and our company pension have the same investments.

At this time, your portfolio (and our pension) is positioned defensively with:

*  Lower than average allocation to stocks (49% vs. the 57% for the moderate allocation benchmark), and
*  Above average allocations to bonds and convertible bonds (40% vs. 36%) and cash (11% vs. 7%).

How this benefits you as an investor.  The stock market has essentially been treading water for the last 16 months.  At the end of the most recent quarter, June 30, 2016, the Standard & Poor’s 500 stock market index stood at the same level it reached on February 17, 2015. For our investors, a lower-than-average allocation to stocks has maintained stock market participation, while shielding their portfolios from much of the stock market’s risk and volatility.

Fortunately, in contrast, bond investments have not been flat, but have profited during that same time period.  And our investor portfolios have included above-average allocations to bonds. This benefits you two ways.  First, your bond investments balance your portfolio, softening the impact of stock market volatility.  Second, in the past year, bonds have out-performed stocks.

As we look down the road, we know that high stock valuations will not last forever.  There are two ways (or a combination thereof) the stock market can go from here:

  1. Prices will fall enough to justify current fundamentals and earnings, or
  2. Earnings and fundamentals will improve sufficiently to warrant today’s high prices.

Down the road, we see the inconvenient truth of simple arithmetic.  That is, a future decline in stock prices to normal valuations is what will make stocks attractive investments with solid prospects for high-returns. 

At that time, when stock prices reconnect with fundamentals (that is, when valuations are once again attractive), our investors will have the cash and bond reserves needed to buy stocks and take advantage of improved valuations.  Our plan is to add significantly to your (and our) stock allocations when those opportunities arrive.

We realize that no amount of data, reason, experience, or history is likely to thwart the speculative juices of some investors.  Yet, our clients are not speculators.  Even so, we and they must remain vigilant to avoid seduction by the investment risks that quietly overtake others. ***

 © Asset Allocation Advisors, Inc. 2016