Nothing wrecks portfolios quite like fear.
The fear-based failure mode we know best is the whipsaw. An investor suffers a drawdown. He liquidates his portfolio when the pain and frustration become too much. He just can’t take it anymore. Then the market rallies. Our investor becomes paralyzed by indecision. He is afraid the rally will unwind. So he sits in cash. Maybe for months. Maybe for years. Finally, after a period of stability, he gets invested again. Just in time to eat another drawdown. This is a Behavioral Investing 101 case study. It’s a failure mode strategic asset allocations are intended to mitigate.
Other fear-based failure modes are more subtle.
One I frequently see among professionals is the fear-based tactical trade. At any given point in time, financial product marketers and the financial media are usually pushing at least one major fear-based tactical trade. Right now it’s all about inflation. Fear-based tactical trades are the pro and pro-am version of the archetypical whipsaw. These are highly discretionary trades. They’re usually based on some high attention macro narrative.
Macro narratives lend these trades credibility, and perhaps more importantly, Very Serious optics. But make no mistake. Fundamentally, these are emotional, fear-based trades. They just come with more sophisticated-sounding rationales (and sophisticated-looking charts).
So, it’s not that portfolios shouldn’t be positioned to withstand inflationary regime changes.
It’s that if you’ve never spent any time developing a process for handling macroeconomic regime changes, you’re sure as hell not going to develop one reading “timely,” thinly-disguised sales pieces about such-and-such assets as inflation hedges.
At my day job, I often get emails about whether it is time to add TIPS to portfolios, or gold miners, or crypto. My response is almost always some variation on the following:
What are you trying to achieve here?
What role does this asset play in the context of the overall asset allocation?
What process will you use to size and adjust the sizing of this position over time?
Most importantly, how will you know if you’re wrong?
And if it does turn out you’re wrong, what are you going to do about it?
Making highly discretionary trades with a finger in the air based on salesy whitepapers and/or financial doom porn is not a process.
Fear is natural. Occasional bouts of fear are inherent in risk-taking. As long as fear is not persistent, or debilitating for decision-making and daily living, it is a healthy emotion. In a financial context, fear is a signal to revisit strategy and process. Consider fear in the context of the game(s) you’re playing. Much of the time, you’ll conclude that it’s just part of the game. Occasionally, however, careful consideration may trigger an adjustment.
Risk tolerance is not easy to measure. Nor is it static. There is a dynamic element to it. Sometimes fear signals you are taking too much risk relative to emotional or even financial tolerance.
Fear may also point you to vulnerabilities in a strategy you may not have considered previously. This is an opportunity! The inflation example is instructive here. In my experience, “mainstream” portfolios tend not to be well-balanced to highly inflationary regimes (particularly stagflationary regimes). In this case, fear may lead to some introspection that results in a more robust overall strategy.