We all have our preconceived notions of what asset classes should do for us, how they should behave, and why they exist in the first place.
Bonds are there to provide stability and income, stocks are there to provide return, and alternatives are there to do a combination (plug and play).
But what are the differences between corporate bonds and government bonds, US stocks and international stocks, and real estate and private credit. How and why do each of these asset classes behave the way they do.
I’d say 90% of my asset management work is related to this concept. The question is always how do I build portfolios that will provide clients with the income, return, and stability they require.
And to make this even harder, in finance nothing is natural law, it’s all theory. Many psychology majors would be just as suited as finance majors to become financial professionals.
The reason why finance is theory is because much of the financial markets revolve around people’s individual decisions. If one day you decide to sell Apple because you are worried about the future of Apple stock. Then you tell all of your friends who tell all of their friends. What happens is Apple’s stock price will fall, even if there are no material issues with Apple stock, theoretically Apple could be in its best business position in its history and still have a 100% drawdown.
That is what we call a Black Swan, something unforeseen caused by human nature (generally).
In 1987 in the midst of rising interest rates, global conflict, and a weakening/weak dollar. The sell orders started to rush the floor, which is not that uncommon. What is uncommon was in 1987 we were in the early stages of algorithmic trading, something that would take gains and sell losses inside of a program. There was also a substantial amount leverage and margin (borrowing against your stocks and bonds).
The algorithms started selling to stop their losses, which caused the market to fall further, then the borrowers called called on their debt, needing to sell to cover their debt, sending the market down further.
This was a black swan, it quickly spiraled out of control because of human psychology. It was also the introduction of circuit breakers, the things that shut off the exchanges for a moment to keep the algorithms from repeating 1987 again. Those breakers have gone off a numerous number of times over the last couple of years, whether on the whole market or on single securities.
The UK had the same problem. A black swan caused by human psychology. The new prime minister issued inflationary policy and investors loss confidence in one of the strongest economies in the world in a day. If it wasn’t for the Bank of England stepping in a buying those bonds, they would probably still be in crisis.
The point I am trying to make is asset class characteristics work until they don’t. What you buy it for may not be the way that it acts in the future.
Take bonds for example, generally bonds provide comfort and stability. That worked until it didn’t. In 2022 bond yields only had one way to go, up, that meant prices had to go down, a lot. The Bloomberg US Aggregate, which is the most common bond benchmark, fell over 10% in 2022. That is the third time we’ve seen stocks and bonds fall both in the same year and the first time we’ve seen them fall more than 10% in the same year.
This does and doesn’t mean change your strategy it means change the way you think about your strategy.
Ask yourself, did the math change or did the psychology change.
If its the latter your strategy generally doesn’t need to change substantially, because overtime psychology tends to revert back to averages.
I have wrote several posts in the last couple of weeks about sentiment and sentiment variables. One part I left out is that there are two parts of the market. You have the economy, what is actually happening in the real world, and you have the financial market, how the people in the real world feel about that economy.
What makes this exceedingly hard is the sheer number of economic variables that people are watching. In our current environment it’s not too crazy to say that the tech & media industries are in a recession along with the housing market.
But honestly market participants care more about what will happen versus what has happened. They are looking to interest rates, inflation, and employment. Those three things take the economy by storm.
The best thing you can do for your portfolio and future is keep in mind why other people hold assets and why they might change their mind. Here are some examples:
The main thing to take away is that you should know what you own, why you own it, and what other people own and why they own it.
I’ve had a lot of conversations with asset management companies about what other advisors are doing, not because I want to steal their strategy but because I want to understand their strategy for the betterment of our clients.
I know why we/I own the funds and stocks we own, and I know why and what other financial advisors own. It’s a key advantage in financial markets.
Feel free to email me at firstname.lastname@example.org for questions or suggestions on future topics.