Are investors throwing caution to the wind?

December 11, 2024

Financial plans map a strategic course to meet an investor’s goals and cash flow needs. These plans are the blueprints of a disciplined investment process.

Financial plans are created for two reasons. First, they help protect investors from their fear. Second, financial plans focus on the longer term and keep portfolios appropriately invested in equities when markets are turbulent or after a bear market.

Second, and equally important, financial plans help protect investors from their greed. When markets are ripping and overenthusiasm builds, financial plans dampen investors’ risk-taking by limiting equity exposure to predetermined prudent allocations. This is called rebalancing, and we do it twice a year for you.

Investment opportunities at the beginning of the bull market in 2009 were significant but fear-dominated portfolio construction.

By adhering to a financial plan and raising equities through rebalancing to a preset normal allocation, investors might have benefitted from the early stages of the bull market instead of fearfully avoiding the stock market.

By contrast, in the 16th year of the secular bull market, investors’ greed today has eliminated normal bounds on risk-taking. They are shunning prudent financial planning and ignoring basic investment concepts like diversification and valuation. Some are now even using leverage to buy riskier momentum stocks. We are not.

Returns are not unprecedented, but risk-taking is

There seems to be a growing chorus that stock market returns are unprecedented. Returns aren’t unprecedented, but investors’ enthusiasm and willingness to take risks might be.

Tables 1 and 2 show the total returns of the S&P 500® and S&P 500® sectors for the first year of the bull market (March 2009 to March 2010) and the last 12 months (through November 15th). 2009’s S&P 500® returns were better, and the market was much broader (see Chart 1), but investors at the time thought stocks’ nascent bull market a mere fluke within the context of a scarier secular bear market. Investors are more enthusiastic about the stock market today than at the beginning of the bull market, even though narrow stock markets typically connote more risk and less return.

Risk-taking is the difference

Investors were scared in 2009 despite the numerous opportunities that came with the beginning of a bull market. Today, they fully embrace a very narrow stock market and take near-historic risks.

Chart 2 shows Bank of America’s private client investors’ (Individual investors, not institutional investors) equity beta through time. Beta is a measure of non-diversifiable market-related risk. A beta of 1.0 implies a portfolio has the same risk as the overall market. A beta of less than 1.0 suggests less relative risk, whereas a beta greater than 1.0 indicates more.

At the beginning of the bull market in 2009, private clients’ equity beta was 0.75, according to this study. Investors were conservative because they feared the post-Global Financial Crisis equity market. Today, their equity beta is a whopping 1.45, signaling that investors are very willing to take a lot of risk. In fact, private clients’ equity beta is higher than at any time during the bull market. [1]

A related study revealed that private clients had an equity allocation of only 39% at the beginning of the bull market in 2009, but today, they have 63%. So, individual investors had only 39% in equities at the beginning of the bull market, and their beta indicated that the equities they did hold were conservative (i.e., a beta of 0.75 indicating less risk than the overall market). Today, the combination of 63% in equities and a beta of 1.45 suggests many investors are throwing caution to the wind with more money allocated to stocks and owning riskier stocks.

Individual investors’ metamorphosis from overly cautious risk-avoiders to avid risk-takers is rather remarkable. If they had followed their plans, neither extreme would have existed. Those plans would have boosted equity weight and equity risk earlier in the bull market and would be pared back today. Our semi-annual rebalancing allows us to add low and trim high, acknowledging that huge portfolio moves are fruitless when trying to time the market. This is our more realistic version of buy low, sell high.

Different seems to be a very good diversifier

The marginal overweight of equities in our multi-asset portfolios reflects our often-stated view that the disproportionate weight of the Magnificent Seven[3] stocks and the concentration of risk make equities less attractive as an asset class. The Magnificent Seven stocks currently comprise roughly 33% of the S&P 500® and over 50% of many growth indices. More money in a smaller number of stocks means higher variability of returns and more significant portfolio swings, which we try to avoid.

Extreme concentration calls for diversification, but many investors are shunning it because diversifying assets’ returns are less than those of the more exciting Mag 7. Unfortunately, at this point in the cycle, diversification is viewed more as a drag on returns than a worthwhile risk reduction tool.

We continue to believe that additional strategies with different types of stocks are the best route for diversifying equity portfolios.

More importantly, private client beta is now higher than the Mag 7’s, demonstrating individual investors’ eagerness to concentrate portfolios, reject diversification, and take excessive risk. We believe the typical non-Landsberg Bennett client is taking on more risk than they know and will continue to see larger swings, both ways, than our clients.

Don’t shun diversification

Because investors are eager to take risks and because no one can pinpoint when the bull market will end, many believe diversification is simply a performance drag. The general feeling is that if one can’t determine when the bull market will end, then diversification equates to missing big returns.

We think such reasoning is highly imprudent because diversification is a vital risk tool precisely because one can’t pinpoint the timing of the market’s peak or trough. If one had perfect foresight regarding the market’s moves, there would be no need to diversify. We just have to look at 2022 and see how poorly the Mag 7 did that year to know that having all your eggs in one basket is not a smart move for most clients, specifically clients either nearing or in retirement.

When investors were fearful of equities at the beginning of the bull market, our portfolios accentuated equities. When municipal bonds were unfairly punished in the early 2010s, our portfolios accentuated munis. Our portfolios had no emerging markets when investors were over-enthusiastic about emerging markets and we owned them in 2023 when they were out of favor. We added money to small and medium companies when no one wanted them.

Today, we view the role of a diversifier as best exemplified by owning more of what you don’t own. Investors are shunning virtually any risk-averse strategy and only wanting more Magnificent 7. Adding diversification via another strategy is the most effective and prudent route to undiscovered opportunities and reducing overall portfolio risk.

We manage six distinct portfolio strategies: Dividend Growth, Growth, Small-Mid, International, Distressed, and Next-Gen. I have listed them in terms of the amount of client assets in them, with Dividend Growth having the most and Distressed and NextGen having the least. As we come to the end of a very strong year in terms of performance, it may make sense to take a look at adding some of these other strategies you may not have to your mix for 2025. You can ask your relationship manager whether this makes sense for you and your specific goals.

[1] This chart measures the beta of private client top ten holdings through time. Because portfolio beta is a weighted average of the betas of the individual holdings, we think this is an adequate representation of risk preferences. Whereas the actual beta might be questionable, the trends seem indisputable.

[2] Copyright © 2024 Bank of America Corporation (“BAC”). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided “as is” and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.

[3] The Magnificent 7 (Mag 7) are a group of 7 widely traded companies classified in the United States and representing the Communications, Consumer Discretionary and Technology sectors as defined by the Global Industry Classification Standard (GICS®) developed by MSCI Barra and Standard & Poor’s. These consist of AAPL, AMZN, GOOGL, META, MSFT, NVDA and TSLA.