Bubble talk is a hardy perennial. The latest installment comes in a recent column by Jason Zweig, who provocatively inquires: “Can you spot a bubble?”
It’s a loaded question, of course. If the answer is “no,” well, then you’re a chump. If it’s “yes,” then the natural follow-up is to ask how you’ve profited by spotting bubbles? Did you sell in late-2007/early 2008? Did you then jump back in at some point in, say, January 2009?
The assumption is that the persistence of bubbles lays the foundation for easy profits. “Bubbles always implode, since by definition they involve non-sustainable increases in the indebtedness of a group of borrowers or non- sustainable increases in the prices of stocks,” Charles Kindleberger advised in Manias, Panics, and Crashes. That leads to the idea that a savvy investor can always profit from the event by looking for signs of excess before the crowd catches on.
It’s a reasonable assumption, in part because there’s a sea of research that tells us that expected return fluctuates. Some of the fluctuation, perhaps most of it, is bound up with fundamentals, such as dividend yields for stocks and credit spreads for bonds. In other words, highly valued securities imply low or negative expected returns, and vice versa. The details vary, of course, but the general concept is widely recognized. And for good reason. For instance, the link between current yield and future return in the equity market is conspicuous through time (see, for instance, the first chart in this post)
But if bubbles are so prevalent, and there’s ample techniques for indentifying bubbles, why do so many investors (and institutions) have such a hard time cashing in? There’s no single answer, but surely one of the challenges is distinguishing between recognizing bubbles in real time and deciding when (or if) it’s timely to act. Bubbles may be obvious, but that’s only half the battle. The bigger question: Is the bubble poised to pop? There’s a lot more uncertainty hanging over the second question. The market, as Keynes warned, can remain irrational for longer than you can stay solvent.
No wonder that a broadly diversified mix of the major asset classes has been a resilient competitor over the long haul. You can earn decent if unspectacular returns over time by holding a proxy for “the market”—i.e., a portfolio that holds all the major asset classes. But don’t bubbles pose a risk? Yes, of course. But the first line of defense is to ignore bubble talk per se and focus on risk management with a systematic rebalancing strategy.
Simple, mindless rebalancing has a history of modestly boosting return with little if any additional risk (volatility). Consider my Global Market Index (GMI), a passive, unmanaged mix of all the asset classes. Over the last three years through the end of last month, GMI earned 11.6% a year. Rebalancing the index every December 31 to the previous year’s weights added 100 basis points to performance. And if you equally weighted the mix (and rebalanced back to equal weights at the end of each year) the annualized total return jumps nearly 400 basis points.
Yes, these are benchmarks and so they’re not necessarily appropriate for any one investor. But they provide a sample of the opportunities that are available through a) diversifying across asset classes and b) exploiting price volatility and the tendency for mean reversion in asset pricing.
By contrast, the game of trying to identify bubbles in real time and deciding if it’s timely to act (or not) is a misguided way of thinking about money management for most folks and institutions. Instead, your time is better spent in designing a dynamic asset allocation framework and letting relative changes in the asset mix guide your portfolio management decisions. You can and should design this framework to reflect your particular risk preferences, expectations, and financial circumstances. In addition, you can and should stick with ETFs and ETNs to build your asset allocation.
Successful investing is closely related to seeing money management as a financial engineering challenge. It’s easy to get caught up in chatter about when and where the next bubble will pop, but there are more productive ways to oversee assets. Broad diversification, rebalancing and maintaining a contrarian mindset are a powerful mix. Let someone else decide if there’s another bubble lurking. And if they insist on telling you otherwise, ask to see their (audited) performance results that present returns in a risk-adjusted context.