The first half of 2014 has been an unusually quiet, but profitable, period for investors. Asset prices in virtually all major asset classes have gone up with very little disruption since the beginning of the year. Even as prices have climbed, volatility and trading volumes have declined to levels near historic lows. During periods such as these, investors can get caught in one of two traps. But before we discuss such traps and how to avoid them, first consider the nature of the bait.

High Returns, Seemingly Low Risks
While investors expect to earn attractive returns only if they are willing to endure risks, the recent and persistent increase in asset prices has rewarded investors who have seemed to experience almost no measurable risk whatsoever. For example, the S&P 500 Index closed the second quarter having run 55 consecutive sessions without a loss greater than 1 percent. In addition, the Volatility Index recently hit a low not seen since 2007. Overall, the S&P 500 Index has climbed approximately 7 percent year to date without a significant decline since January. Moreover, this is in large measure a continuation of stock price movements evidenced throughout almost all of calendar year 2013.

In fact, this trend of positive returns with few pull-backs is not just happening within the U.S. stock market. International stocks (both developed and emerging market), bonds, commodities, and real estate have also all gone up this year with very few declines along the way. In fact, the volatility in 10-Year Treasury bond yields recently hit a 35-year low and the volatility of the Euro/US dollar exchange rate was recently the lowest in the history of the Euro (*).

Periods of positive returns and low volatility can tempt investors into stepping into one of two traps. The two traps are similar in nature in that they are two sides of the same coin.

This Has to Continue
The first trap is an overconfident belief that the wonderful, low key party will just go on and on. In this scenario, investors come to believe the risk of investing is low and will stay that way into the foreseeable future. Investors who fall into this trap may decide to increase the risk of their portfolios, either by shifting to riskier assets or adding leverage. The risk of this trap is lower returns for those investors who increased the risk in their portfolios just before a correction or increased volatility. Current mutual fund flow data suggest that some investors are falling into this trap right now, deploying cash into riskier assets. While there has been a net outflow of $140 billion in money market funds so far this year (**), all other riskier asset classes have experienced net inflows. Additionally, margin debt, which is money borrowed against brokerage accounts, hit a record level earlier this year (***).

This Can’t Go On Forever
The other trap is the assumption that a long-lasting trend must surely stop soon. In this scenario, investors believe markets have come too far, too smoothly and thus a correction is surely imminent. These investors begin to reduce the risk of the portfolio either by selling riskier assets or trying to hedge their portfolios. The risk of this trap is also lower returns, in this situation due to the cost of hedging and/or missing a continued rise in securities prices through a more conservative portfolio.

However, in contrast to the first trap described above, there does not appear to be strong evidence that risk reduction or hedging activities are significantly on the rise. This is despite the fact that, just as we might expect, more strategists and pundits have been calling for a correction. That investors would be inclined towards increased optimism rather than increased pessimism is not unusual in an extended bull market.

Have a Plan
These traps are best avoided by those who prepare for them ahead of time. By developing a long-term investment plan and reviewing it regularly, investors are well-equipped to avoid the temptation of falling for the various traps that can compromise long-term investment success.

Alas, no one knows with certainty when this quiet bull market will end, though the queue of those saying that “I knew this was going to happen” will surely be as long as ever. As such, stay disciplined and beware the traps on either side of you.

(*) Goldman Sachs; Slide 3, presentation at 2014 Sanford Bernstein Strategic Decisions Conference
(**) JPMorgan Guide to Markets 2Q 2014
(***) NYSE Market Data (www.nyxdata.com)

Filed under: Investing

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