Investment Markets and the Economy at large typically follow a cyclical business pattern that moves up and down like a sine wave as it trends upward over time. This is a cycle that has weaved its way through many expansions, peaks, recessions, and troughs that can be clearly seen in the numerous booms and busts of the 20th century. In fact, some experts estimate that since 1929 there have been 28 distinct market cycles. Expansionary periods generate substantial optimism, while recessionary periods play into our fearful side. This range of emotions can work to an investor’s detriment if a long-term perspective is not maintained.
This outlines the need for two specific disciplines to be applied to your investment approach. First, a stay the course discipline that includes a long-term view with an understanding that downturns will occur as part of the natural cycle. And second, a disciplined review of where we sit today within the market cycle. Said another way, our investment approach should be informed by a continual review of where we believe we are within the cycle, leading to a grounded perspective regarding where we should potentially be overweight and underweight. It is important to note that an opinion as to where we are in the cycle should not drive whether or not to be invested, but rather how to prudently be invested given our perceived location on the curve.
As much as we may try to emotionless and rational decisions, investing involves emotion. Studies have shown that most people have a more pronounced negative response to loss as compared to the intensity of their positive response to gains. In other words, most of us feel the losses more than we celebrate the gains. At the same time, there are factors such as FOMO (Fear Of Missing Out) that can draw investors into too aggressive of a posture at just the wrong time. This is where a trusted advisory team can bring value in helping investors to see the big picture and adhere to a long-term investment approach.
Because investing involves emotions we have to manage and prepare for the emotional side of investing. The graphic to the right illustrates the roller coaster of emotions that most investors experience during the average market cycle. These emotional swings can be dramatic and include Optimism, Euphoria, Fear, Panic, Capitulation, Depression, Hope and back to Optimism. Our team has carefully analyzed 20+ years of historic data in an attempt to optimize allocation adjustments based on the market cycle within both our Fixed Income and Equity models. In our study of history we identified five key emotional phases of the market cycle that we use to guide us in transitioning our portfolio through the emotional ups and downs. These five phases are outlined in detail below. It is important to note that our approach does not require that we correctly call the timing of each phase of the cycle but rather, as long as we are generally within a phase of where the market is then we will be in a reasonable posture for what may follow.
It is important to reiterate the fact that we will not call each emotional phase of the market precisely. In fact, there will be times when we entirely miss a phase, that is to be expected. We thoughtfully selected five phases so that we create buffers between the strongest movements within the market cycle. Our goal is to stay within one step. For example, we may be in Euphoria, and the market has entered Panic. That is acceptable because Euphoria prepares us for Panic. We would not want to be in Optimism or Depression when the market enters Panic, as our risk exposure would be larger than what we desire it to be.
This discipline of active portfolio adjustments is all about preparation for tomorrow based on an objective and thoughtful view of where we sit in the market cycle today.