The Best Investments to Hold During Market Concentration Are The Ones That Help You Sleep At Night

On this episode of The Long View, Cullen Roche, founder and chief investment officer of Discipline Funds and head of Orcam Group, discusses sequence-of-returns risk during market concentration, why you should be diversifying by time horizons, and more lessons from his new book, Your Perfect Portfolio: The Ultimate Guide to Using the World’s Most Powerful Investment Strategies.

Here are a few excerpts from Roche’s conversation with Morningstar’s Christine Benz and Ben Johnson.

Why Investors Should Be Cautious of Sequence-of-Returns Risk During Market Concentration

Christine Benz: So sticking with AI, I wanted to discuss the market implications, the implications for investors. A topic we’ve been chatting about with our guests has been the concentration at the top of the US market today. How concerned are you about that? And how do you think investors, if you are concerned about the potential overvaluation in those types of companies, how should investors approach it? How should that guide what they do with their portfolios?

Cullen Roche: Well, it’s a weird one because it’s not a problem in the sense that there’s always been some level of concentration. This level of concentration maybe appears a little unusual. In the aggregate, the gains are the gains. And so even though the gains are concentrated, if you own, if you’re an indexer, as I’m sure many, maybe the majority of listeners to this podcast are, and I’m a big advocate of indexing as well. That’s kind of the point of indexing, in fact, is that you don’t have to pick the winners and the losers. You don’t have to own—there was a famous study that came out a few years ago that said that 4% of all corporations generated the vast majority of all the gains over the last 150 years in the global stock market. And part of the point of indexing is that you don’t have to know what are the 4% that are going to be the outsize winners. You just have to own, as John Bogle would say, just own the haystack. You don’t have to find the needles.

And so, that’s a good thing in that sense is that you can kind of own the haystack and not have to worry about these needles. I like to think of this more from a financial-planning perspective—I think that the risk of concentration is the potential that there is greater sequence-of-returns risk that when you have this sort of concentration and you have, especially this sort of sectoral concentration, you have an environment that probably isn’t like the Nasdaq bubble. But if it’s even a fraction of the Nasdaq bubble, and you have that sort of sequence-of-returns risk due to the concentration and the really high expectations that are concentrated in a particular sector, well, you could go through a big, big downturn that creates a lot of angst in the short term. And the interesting thing about the Nasdaq bust is that if you bought the exact top and rode it all the way to today, you’ve generated something like 8% per year, which is phenomenal.

So in the long run, the Nasdaq bubble wasn’t wrong. In the short run, obviously you had to wait 10 to 15 years to even break even. So you went through this really traumatic sequence of returns that caused a lot of problems especially for financial-planning needs. And so from that perspective, I think it’s reasonable to look at certainly the US market relative to foreign markets and even other pockets of the US market and say, from a planning perspective, I think it is reasonable to look at that and say, there is the potential that there is a much higher risk of a negative sequence of returns if you have a lot of concentration. And so for me, I just tell people, if you’re concentrated in AI positions or the Nasdaq 100 or something like that, or even the US domestic market, you maybe have to prepare to be a little bit more patient with that position than you otherwise would be.

How Diversifying by Time Horizon Can Help Mitigate Concentration Risk

Ben Johnson: Cullen, I want to pull on that a bit. In light of this concentration, in light of current valuations across key sectors of the market, folks are asking, do I ignore maybe the late John Bogle’s advice, which he often said, “Don’t do something, just sit there.” And if they’re tempted to do something, what are the levers that they might pull? You mentioned foreign markets might look from a valuation perspective, relatively more appealing. Certainly there’s a push into all form of private assets. And I think the other key vector you mentioned too is a sort of different form of diversification, which is almost temporal, if that makes sense. So the sequencing looks like it might go askance. Is there anything that folks can do to address that potential risk?

Roche: I’m sort of on a mission to, I guess, preach the benefits of what Christine would call a bucketing strategy, or, I call it my strategy is to find duration investing, whatever it might be. But it’s a time-aware portfolio allocation where we often talk about the benefits of diversification across assets. But what’s lesser talked about is the benefits of diversifying across time horizons. And so I’m not a huge advocate of trying to diversify your stock market risk away with the stock market itself. So, I generally believe that if, for instance, in this environment, if you own the global stock market and the US market goes down, let’s just be dramatic and say it goes down by 50%. Well, I think foreign stocks are going to go down a heck of a lot too. And I think value stocks probably will, no matter what it is, I think you’re going to experience a relatively traumatic downturn if you have an extreme downturn. And so, I think that the way to diversify away from that in a really effective way is you do have to own alternative types of assets, something other than the stock market itself.

And so, you can obviously diversify away single-entity risk inside of the stock market itself. But once you’re diversified enough across something like an index fund, I don’t think that owning tilting to value or foreign or whatever, it might insulate you from the really extreme volatility of the Nasdaq 100 or something, but it’s still going to be relatively volatile in a sort of traumatic way, I think. And so, I think that you have to look into whether it’s bonds or alternatives. I’m not a huge advocate of alternatives. I’m certainly not a big advocate of private equity. I do think there’s a time and a place for a certain client that I think fits. But I think for the majority of people, when you’re diversified across, especially bonds—and bonds in this environment, I think are especially attractive. And, that can range from, even T-bills, even T-bills are generating a real return. I would argue that in an environment where T-bills are generating a 1% to 1.5% real return, I’d say that in terms of portfolio insurance, it’s really hard to beat that.

Because they give you absolute understanding of what your future income is going to be, your portfolio stability. They’re the ultimate sleep-well-at-night sort of instrument. So, I would say that the no-brainer way to diversify a way this sort of a concentration risk is to own something that is going to help you sleep at night. Because that’s really what it comes down to is that value stocks are not going to help you sleep at night in a really deep bear market, whereas something like T-bills will. And of course, they’re not going to generate the same returns as value stocks or the Nasdaq 100 in the long run, but they’ll keep you insulated from overreacting in the short term.

And that’s very specifically a temporal decision because the reason T-bills are so stable across their specific time horizons is because they’re specifically short-term instruments. Whereas the stock market, I like to think of the stock market as at a minimum of 15-plus-year type of instrument that if you hold that thing, yeah, you’re going to get 6%, 7% real returns maybe in the long run, maybe a little bit lower than that, but you’ll do really well in the long run. But you’ve got to be patient with the stock market because the stock market is this inherently long-term sort of instrument. So, you have a duration mismatch if you think that the stock market is going to insulate you in the short run and that exacerbates the risk of a behavioral problem when you’re in the throes of a really scary bear market.