Bored Investors Beware

 |  Includes: DIA, SPY, TLT
by: John Taft

[Originally published on 7/30/2014]

This month, my home city played host to Major League Baseball’s All-Star Game. Over the course of five days, thousands of fans descended upon Minneapolis to celebrate America’s favorite pastime and, ultimately, to watch some of the best players in the game square off against each other.

Almost as popular as the All-Star game, of course, is the Home Run Derby where baseball’s power hitters compete to see who can knock the most balls out of the park. Unlike the patience and restraint these players would show at a regular season game, those that step up to the plate at the Home Run Derby swing at just about anything that comes their way – whether the ball is in their strike zone or not.

That’s a fine strategy for Home Run Derby hitters, but not for investors. And the longer the market bumps along without much movement in either direction, the likelihood that investors will start swinging at pitches outside of their strike zone increases. That for me, and for a growing number of leaders in the financial realm, is cause for some concern.

As Fed Chair Janet Yellen recently told the Wall Street Journal: “I am... mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk.”

After losing so much of their wealth during the financial crisis, U.S. investors are anxious to rebuild. The problem, however, is there is no easy or fast way to do that today, particularly at a time when interest rates are at historic lows and yields on cash deposits are close to 0%.

The S&P 500 is sitting at an all-time high with very little fanfare. And the CBOE’s Volatility Index (VIX) reading continues to hover under 12. (The VIX is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.)

The last big spike in volatility occurred in late summer 2011, around the time the U.S. lost its AAA credit rating and in the midst of the European debt crisis. Since then, the S&P has rallied 80 percent.

If you believe the teachings of the late financial economist and professor Hyman Minsky, financial crises are caused by investors taking on additional risk during bull markets. They take on so much risk, in fact, that they tip the balance and instability ensues.

In many respects, increased risk appetite is a good thing. Increased risk appetite is what prompts entrepreneurs to start a new business and gives established business owners the confidence to expand. Improved risk appetite also gets investors off the sidelines and back into the market again.

To gauge risk appetite, our sister organization, RBC’s Global Asset Management division (RBC GAM) combines many different measures into a single risk appetite index. Last fall, that index showed risk appetite at historic average levels. Investors were neither seeking risk nor shying away from it.

But risk appetite spends very little time around its average level. Instead, risk appetite tends to sit either at well-below average levels – as was the case during the last financial crisis – or at moderately above-average levels during periods in which extended favorable market conditions prompt investors to shift into what we call “risk-seeking” mode.

So it’s not surprising that RBC GAM’s index shows that investors have ventured into the risk-seeking zone since last fall.

The market may not be doing much now and volatility may be low, but what if that changes? What if we see a rise in interest rates? Investors should step out of the batter’s box once in a while, and think ahead about how such changes could impact their current portfolios. Higher interest rates, for example, could hurt bond values as well as “bond-like” equities like utilities.

It might be tempting to swing outside of your strike zone right now because you are bored. But before you stretch too much for yield, understand what your strike zone really looks like today. Many investors don’t understand their risk tolerance or how certain risk factors can impact them on a short- to immediate time period.

You may want to try to knock one out of the park. But your best chance of doing that is to remain patient, stay disciplined, hit singles and doubles and wait for what Warren Buffett famously calls “the fat pitch” before swinging for the fences.

John G. Taft is CEO of RBC Wealth Management - U.S., and author of Stewardship: Lessons Learned from the Lost Culture of Wall Street (Wiley, 2012). RBC Wealth Management-U.S. is a division of RBC Capital Markets, LLC, a member of NYSE/FINRA/SIPC.