“You cannot manage outcomes, you can only manage risks.” – Peter Bernstein
Last week Josh Brown laid out a really unique theory at The Reformed Broker with The Relentless Bid, Explained.
The main takeaway from that piece is that there always seem to be a bid under the market when stocks drop because the investment advice business model has shifted from commissioned brokers to fee-based advisors in a big way.
Here’s Brown with more:
It means that, almost no matter what happens, each week advisors of every stripe have money to put to work and they’re increasingly agnostic about the news of the day. They’ve all got the same actuarial tables in front of them and they’re well aware that their clients are living longer than ever – hence, a gently increased proportion of their managed accounts are being allocated toward equities. And so they invariably buy and then buy more.
As more portfolios are guided by the principals of longer-term thinking and asset allocation as opposed to trading the next hot new product, there is simply more demand for stocks.
I also think the concentration of asset ownership at the top allows the rich to make this decision with their capital because they aren’t forced to sell or will be leaving money to their heirs so the time horizon gets extended even further.
Because the complexities of the market are never easily explainable, you could make the case that there are a few other forces at work here.
No need, because Brown wrote a follow-up the very same day with The Trouble with Relentless Bid Theories where he offers further explanation along with the caveat that this behavior cannot last forever and could lead to market imbalances:
I am describing what has been going on as relentless, not endless. I am also not projecting it out indefinitely into the future.
(Side note: This is why Josh Brown is one of the best in the business. He crafted an extremely original idea to explain the current dynamics in the market. At that point he could have dropped the mic, but instead decided to look at both sides of the argument and describe the possible side effects and alternatives to his own theory. It is extremely rare to find this type of an honest, balanced approach in the financial industry.)
The increasing demand for index funds and the advent of robo-advisors have caused some in the investment world to share Brown’s concern for potential imbalances that could result from these changes.
Financial advisor Allen Roth wrote a column exploring the possibility that Vanguard, the king of long-term investors, could possibly grow too large.
Roth pointed out that the fund behemoth has $2.3 trillion in assets, nearly as large as its next two competitors combined, along with roughly 20% of the assets in the industry.
Many active managers have rushed in to make the claim that once this idea takes hold, they will be able to clean up because there will be more inefficiencies in the markets and no one left to perform fundamental analysis.
The academic rebuttal to this argument is the zero-sum nature of one buyer for every seller means that half of all investors outperform while the other half underperform no matter what kind of strategy is used. Index investors would still outperform the average after costs.
I think the best hope for active managers in this scenario would be greater outperformance by the best investors but horrific underperformance by the rest for a greater dispersion of results.
However this plays out, I am a huge proponent of long-term thinking with your investments, so on the margin, these industry shifts are great for investors.
Yet regime changes can get messy when going from point A to point B.
Roth discusses some worries from investor and author William Bernstein:
Bernstein worries that Vanguard’s size is a concern. He points to a phenomenon known as “normal accidents,” which occur when systems become so complex and tightly linked that catastrophes are inevitable.
This is why the ever-evolving financial markets are so fascinating to me. Even good behavior can potentially lead to problems.
But what does this all mean for you as an investor?
Imbalances have always been part of the stock market. Yet the specific reasons are different every time. You can’t really predict how or where or when they will form or the extent to which the pendulum will swing in either direction with any precision.
You have no control over the movements either way. Since you can’t predict exactly how the future will play out, you must prepare yourself for the possibilities that this theory advances.
It’s easier to become a long-term investor after markets move higher so many new investors to this model will jump off the bandwagon at the first signs of trouble.
That means the risk management involved in your process is now more important than ever for the investors that would like to hang on.
Some in the industry will try to sell you complex forms of portfolio insurance or new investment products. Don’t get caught up in this game. Keep it simple. The original common sense stuff should work just fine for the majority of investors.
Stick with your plan sounds almost cliche at this point, but does switching your strategy from diversifying and rebalance to market timing ever turn out well for individual investors?
Your asset allocation and diversification guidelines are still going to be the most important risk controls in your portfolio.
There are asset allocators out there that will tilt their portfolio one way or another between the asset classes. A select few can do this well. Most cannot.
So periodically rebalancing back to your predetermined asset allocation weights is another one of the best ways to control risk and possibly increase performance by taking advantage of mean reversion.
I’ve never been a fan of individual investors that go with the binary outcome game of trying to go all in or all out between cash and a fully invested position. Playing chicken by trying to time the market is no way create a sustainable investment process.
Choose an allocation ahead of time that suits your needs and you shouldn’t have to worry about jumping in and out of the market.
I can’t say how things will turn out if the relentless bid theory continues to play out. I have an idea based on past events, but preparing yourself for a variety of market scenarios such as this can help you deal with the potential fallout.