How Do Financial Advisors Invest During Irrational Exuberance?

I love the beach, but I am not a huge fan of the ocean.

Maybe I’m alone here, but after watching “Jaws,” National Geographic programming, Shark Week on Discovery, and “Sharknado” 1-6, I just cannot shake that uneasy feeling when I’m venturing into the surf. Even when I’ve had the privilege of swimming or snorkeling in those crystal-clear Caribbean waters, there’s still a bit of anxiety of what’s potentially lurking in the distance just out of sight.

As we talk to financial advisors, it’s clear my feelings about getting into the ocean are similar to how they feel as they put client money to work during this seemingly endless bull market.

We routinely encounter advisors who are struggling with how to invest in equities right now. This is particularly tricky for those who have taken a more cautious approach during the last couple of years and now face tough performance-related questions coming from clients.

Unfortunately, the question is not as simple as, “To invest or not to invest?”

You only have to look at the last two years to see enormous disparity between different equity segments. Does an advisor invest their clients in growth stocks given their long outperformance relative to value? Or, should they try to participate more heavily in the recent rebound in value? What about small caps versus large caps…foreign versus domestic…high dividends or tech?

The Questions are Endless & The Consequences of Getting it Wrong are Severe

While my fear level for the ocean is high, I can thankfully say that I have no such trepidation when it comes to investing in equities at these or any other levels.

How is that possible? In short, it’s because at Blueprint Investment Partners we have few unbreakable rules focused on the only factor that matters at the end of the day: PRICE.

Is the market overbought? Is it oversold? Is inflation transient or here to stay? Price tells us everything we need to know. And if we follow our rules, the system is designed to adapt to changing environments while also being agnostic to any particular factor. We do not have to wonder which factor we should tilt toward because once we get started, we rely on the trends to tell us where to concentrate or whether we should be invested at all.

Focusing on price also helps us with downside protection. In our view, following trends consistently reduces volatility and drawdowns while also improving risk-adjusted returns.

Two additional – and underrated – benefits of our process are the ability to invest boldly no matter the conditions and to stay invested. After all, there’s a reason for the saying, “The markets can stay irrational longer than you can stay solvent.” Using another beach analogy, we want to ride the waves, not crash into them.

Freedom to Ride the Wave

Let’s use the current environment as an example. For the last 12 months, our strategies have enjoyed nearly maximum exposures to equities, and will continue to do so until things change.

If things change, we can be fully defensive in as little as 30 days. We will not catch the top – nor is that our goal — but we can avoid the bulk of the most significant market declines by becoming defensive when we start to see a downtrend in the intermediate or long-term timeframes. Using those timeframes, historical data shows that we would start to react when the S&P 500 experiences a decline of between 6-10% from its previous high. To provide some concrete examples:

• Until Q3’20, we have been predominantly invested toward growth. But, when the price trends began shifting away from favoring growth and toward value, our rotation began.
• The same principle applies to market cap, large vs. small.
• Who would have predicted that public REITs would nearly double the return of the S&P 500 so far in 2021? We didn’t, but with our process “predictions are trash.” We had a maximum allocation to real estate entering the year based on price alone and have benefited accordingly.

When money needs to be put to work, financial advisors have a tough enough job without having to face the expectation of perfectly timing the market. With every new contribution or rebalance, advisors face renewed scrutiny from their clients about how those dollars are invested. Sitting in cash is also rarely a suitable option, limiting the amount of time advisors have to decide on the best course of action.

A strategy that doesn’t require market timing because it can protect downside and capture upside regardless of the market environment can be a solution for advisors.