Every day, highly experienced investors and thought leaders are sounding the alarm about an impending market crash. Since the 30-year anniversary of Black Monday less than two months ago, the sirens are blaring progressively louder. With an eight-year U.S. equity bull market behind us, coupled with positive GDP growth, the sustained market rally seems too good to be true. On the surface the economy appears to be plodding along, but according to the bears, something is brewing in the depths below.
Many different factors are being cited as the impetus for the making of potentially the worst bear market. The most common concern mentioned is stretched U.S. valuations based on non-fundamental factors. The search for yield in a historically low interest rate environment has pushed both private and institutional investors to take on significantly more risk than they would have been comfortable with a decade ago. Increased flows into equity markets, exacerbated by a push into exchange traded funds, has propelled stock markets even further. Consequently, investors are now asking themselves the proverbial question: Should we not just sell all our equities and get out before it’s too late?
To answer this question, I propose examining the investment landscape from a risk management perspective. What are the risks of selling everything and investing solely in cash?
Unfortunately, keeping all your financial assets in cash does not provide immunity from all risk, as inflation and counterparty credit risk still remain. With the cost of living increasing every year, you would need to earn a rate on deposit greater than inflation just to maintain the purchasing power of your earnings. Being ultra conservative by only investing in cash or cash equivalents, whilst considered safe, would most likely prevent you from reaching your financial goals. Consequently, to prevent purchasing power erosion, taking some risk is necessary. Usually, during times of higher anticipated inflation, investors turn to real estate, gold and inflation-protected securities as a hedge. Regardless of the financial instrument held, the stability and credibility of the financial institution is also a risk factor; one more commonly referred to as counterparty risk.
The most widely discussed risk in recent times has been interest rates risk. Even well before the Fed commenced its monetary policy tightening initiatives, most investors have been positioned anticipating rate hikes. Rising interest rates have the greatest negative impact on longer dated and higher coupon bonds. For this reason, investment managers have maintained a short duration strategy for quite some time now. So why invest in bonds at all, you may ask?
That highlights another well-known investment risk: concentration risk. The potential detrimental consequences of investing one’s wealth in only one asset class, one sector or even one stock is self-evident. Surely you could sell all your bonds and only hold equities. However, this is when diversification becomes an essential element within your portfolio. There is no denying that fixed income returns are highly unattractive these days, but putting all your eggs in one basket rarely turns out well. Likewise, despite the fact that investment professionals rely on their expertise to forecast the best way to be positioned, sometimes events out of their control can impact markets faster than they can react. As such, no one would argue against the importance and power of diversification.
In addition to the few common risks highlighted earlier, the list of possible risks is endless and includes such perils as currency risk, liquidity risk, credit risk, market risk, default risk and many more. Even after accounting for the infinite types of risks, there is one type we cannot even plan for. Black swan events, the metaphor used for an unforeseen event with massive repercussions, will catch us by surprise and cannot be planned for. In the words of former U.S. Secretary of Defense Rumsfeld, “there are things we don’t know we don’t know,” otherwise classified as unknown unknowns.
Admittedly, it is impossible to completely eliminate all the risks we face. All investors – individuals and institutional investors alike – are exposed to various investment-related risks. It is imperative that one assesses these risks in an effort to determine those that are of greatest concern as there is no one-size-fits-all solution.