Updated: Sep 2, 2021
"Amateurs think the world should work the way they want it to. Professionals realize that they have to work with the world as they find it." - Shane Parrish, The Knowledge Project
The perfect set-up.
A well positioned lay-up to a par 5.
A crisp pass that hits you in rhythm for a corner 3.
An ideal fishing hole without another person in sight.
Getting a hanging, breaking ball right in your wheelhouse and not swinging.
It's almost cringeworthy to think about the perfect set-up, whatever your version is, and not pouncing on the opportunity. Yet, I've seen this time and again when positioning investment portfolios.
Meet our imaginary investor, Homer.
Homer is skittish about current market levels. He's convinced equities are overvalued and wants to wait for a correction to get invested. Homer realizes that cash is yielding next to nothing, therefore, he's okay with getting started with a conservative portfolio of 20% stocks and 80% bonds. Homer prefers to wait for his perfect set-up to get more aggressive.
On paper, this seems like a reasonable plan. Start conservative. Market drops. Shift into a more aggressive allocation. Easy game.
Homer doesn't have to wait long for his opportunity. The market tanks. 10%. 20%. This is Homer's chance. The sell-off he's been waiting for is here. What does Homer do?
"It's going to get worse"
"I'm going to wait this out until I get more clarity"
Homer is paralyzed. The market rebounds. His perfect pitch came and he didn't swing. He's back to square one.
Unfortunately, Homer's experience is all too familiar.
I've never seen the conservative to aggressive plan work in practice. Not once. Ever.
When the very thing Homer is waiting for happens, in this case the market going down, his original pessimistic disposition takes over.
Homer was right about the market pulling back. Now things have to get worse. Let's wait it out.
Homer's original plan developed during a non-crisis-time is sound. It's rational. There is an objective calmness about the optimal course of action.
Executing that plan during a crisis-time when those around you are losing their minds is much harder. It's impossible to recreate fear and emotion, until you're in the moment of fear and emotion.
Psychology of Money author Morgan Housel likens investing to an old pilot's saying...
"Hours and hours of boredom punctuated by moments of sheer terror."
In other words, it's not what you do during the calm market environments that matter. It's how you react during the moments of chaos that can have a huge impact on your investment outcome.
Homer could have put in place hard and fast rules to get more aggressive. For example, if the market sells off 10%, Homer might increase his equity exposure by 25%. Better still, Homer could have accepted a hard truth. The time to get more aggressive is often when it feels the worst.
Whenever Homer felt sick to his stomach, that's the time to get more aggressive in his portfolio.
This isn't just a theory, empirical evidence backs up this assertion.
Source: Bespoke Investment Group
The above chart shows investor bullish (optimistic) sentiment and future S&P 500 returns. When the bullish reading is lowest (investors feeling the worst), 0-10%, future returns for the next three, six, and 12 months are positive 100% of the time. Conversely, when investors are the most optimistic, 70+%, future returns are often negative and only positive around 35% of the time. Current bullish sentiment is highlighted in gray.
If you find yourself waiting for a market drop to be more aggressive, know it's easier said than done. We've seen many Homers wait for their perfect pitch only to freeze when it comes.
Acknowledging the "conservative to aggressive" blind spot can help you pull the trigger and shift into your optimal portfolio when opportunity arises. If you feel sick to your stomach while adding equities, you're on the right track.