How to navigate expensive markets where all asset classes are at their all time peak?

Global equities have hit several new all-time highs over the course of 2021, with the global benchmark stock index almost doubling from its pandemic lows in March 2020. Despite this year’s rise in bond yields, government and corporate bond yields still trade close to decadal lows, implying decadal high bond prices. With most major asset classes close to peak and apparently expensive, how should an investor look at investing in such a market?

The below six-step guideline could be a starting point for investors looking to navigate expensive markets:

Rebalance your portfolio

In the midst of a strong bull market, it is important for an investor to consistently review one’s existing asset allocation and analyse whether it has deviated sharply from long-term objectives and risk tolerance. For example, a simple balanced 50% equity and 50% bond portfolio starting out in March 2020 would be significantly overweight on equities today, just because of the strong equity market gains over the past two years. Any significant deviation in an investor’s risk profile increases one’s loss potential. Thus, a prudent approach would be to trim exposures closer to one’s target asset allocation.

Reset future expectations lower

Investors tend to extrapolate recent returns into the future. We believe equity markets are likely to transition to a more sustainable pace of returns in the coming few years, albeit with higher volatility, due to three factors. First, compared to previous cycles, equity valuations are at a much higher starting point today. Second, history suggests equity market returns normalise to high single- or low double-digit returns post the initial sharp recovery from a recessionary market trough. Third, the limited room for interest rates and bond yields to fall further suggests modest medium-term equity returns.

Be aware of the macro environment

Asset markets follow cycles heavily influenced by the macroeconomic backdrop. However, many investors tend to overlook the importance of macroeconomic variables on investments. Being aware of the macro environment helps investors not only to capture diverse sources of growth, but also mitigate significant downside risks. For instance: (i) most deep corrections (index declines of 20% or more) are usually triggered by concerns about impending recessions, (ii) business cycles and policy environments impact various business sectors and investment trends differently and (iii) macroeconomic analysis can help identify structural multi-year and decadal themes.

Avoid FOMO

Bullish markets are typically characterised by hard-to-explain run-ups in different market segments or themes. Investors rue missing out on the hottest theme of the month, creating a sense of FOMO (Fear Of Missing Out), making them chase that trend to possibly disastrous results. Amos Tversky and Daniel Kahneman partially demonstrated FOMO through the theory of loss aversion, where people have a strong tendency to avoid any losses - psychologically, losses are believed to be twice more impactful on people than gains. Given this, it is almost impossible to not get carried away by the “opportunity loss” by standing aside during a raging bull market. However, having an investment strategy based on one’s goals, liquidity and risk appetite could go a long way in succumbing to FOMO.

Diversify across assets and markets

Diversification is a key tool for investors to tide over expensive markets. Diversification can be achieved in three broad ways – (i) Diversifying allocation across different assets classes, such as equity, bonds, commodities, cash, real estate and alternatives, according to one’s asset allocation, (ii) Investing in international markets to avoid a single-market bias and (iii) Diversifying within an asset class, for instance, by investing in different market segments, sectors and styles within equities and distributing bond exposures based on duration, credit quality and interest-rate sensitivity. The basic tenet of diversification is to have assets that have low correlation with each other, so that any weakness in a particular asset class can be offset by gains in others.

Dollar-cost-averaging

Dollar-cost-averaging is a strategy wherein an investor spreads out one’s asset purchases over time to reduce the impact of market volatility, to ensure that one is not buying the asset near a peak. Adopting a phased approach to investing in bull markets is very important as buying lump-sum and holding for the long-term is easier said than done. Long-term studies of investor behaviour show that it is usually hard for anyone to time the market. Also, the average investor tends to panic when the market drops and often sells out after the market has significantly declined (and then stays out of the market). From a behavioural perspective, dollar-cost-averaging takes the emotion out of investing as it reduces the risk of panic selling during periods of significant market weakness – typically the number one killer of long-term returns.

-- Writer is Chief Investment Strategist at Standard Chartered Wealth, India.