INSIGHTS

On September 24, 2018

AAM Viewpoints - Behavioral Finance: Dialing Down the Anxiety

“Have you ever noticed anybody driving slower than you is an idiot and anyone going faster than you is a maniac?” -George Carlin

Psychology tells us that our own viewpoint is within a range of acceptable selections while behavior outside of this subjective optimization increases the use of a binary switch between good and bad. The switch has no dimmer and is a simple black or white designation with little regard to the potential for subjective criteria. Simply put, your personal choices are optimized while others are lacking the balance of all potential information to make an informed opinion or decision.

In relation to the investment environment, those who are too pragmatic or too leveraged are often classified in lesser harsh categories as George Carlin relays above. However, I have come to realize that in 25 years in the industry, the veracity of information and strikingly changing directions of the driving forces for the market increases doubt in the investors’ minds that the proper allocation may be erroneous. The anxieties build until one finds that they are out of balance and a significant flip of the switch to risk off becomes the only logical solution…often at the worst possible time when opportunity cost is the highest.

The Federal Reserve released its quarterly Fed Flow of Funds which updates a myriad of macro asset, income and debt measures. There were some not so discreet adjustments to the upside of the certain liquidity measures, especially regarding the household sector. We have addressed some of the saving metrics that were changed and how that altered some of the historic perspectives, as well as increase the eye squinting of economists and strategists. Since this is a quarterly report on broad based macro trends, most metrics are not earth shattering. There are however, some trends that have accelerated to points that should be noted. These also correspond to the behavioral spirals or ruminative thinking we discussed initially.

Cash Deposits and Net Worth have increased steadily both recently and in the long term. Since 1983 total deposits for Households and Non Profits (NPOs) have increased on avg 5.0% annually while the Net Worth has averaged an increase of 6.1% annually. The trough set since the end of the Great Recession has seen net worth increase slightly more than average at 6.81% and total deposits grow right near the long-term average. So, while the nominal numbers point to large wealth and cash deposits, they are in line with the longer-term averages. The fear of the length of this expansion and assets setting all-time highs have rekindled the fears and anxieties…this has shown up one area for households.

The amount of holdings of government debt has skyrocketed as rates have moved higher. The move appears to by multifaceted and not purely a risk off play, though that is a contributor. The benchmarking of such a low return on high quality assets since the Federal Reserve moved rates to 0% has caused a period where picking up nickels in front of a steam roller seems safe. If one is staying extremely short in maturity in these high-quality securities, one could agree with this assessment.

Historically the chart above shows the longer-term trends of households/NPO (nonprofit organizations) government debt holdings relative to the 10-year Treasury. At its peak interest rate, the holdings of government securities were $170 billion. We currently hold $1.8 trillion in government debt while interest rates are closer to the all-time lows. The percent of the government holdings to total net worth are the same now as it was when interest rates were all time highs. Most wish they could go back in time invest everything in the 10-year Treasury from 1981 – 1990 for a 12.4% annualized return but often forget about the landscape of high inflation, energy crisis’ and political instability. Many also forget that the over the same 10-year period that the Dow Industrials had an average annualized return of 13.24% despite the biggest one day drop in history (at the time) on Black Monday in 1987 where the losses totaled 22.6% in one day.

While we see merit in the move to higher credit at the higher rates of return in this uncertain period, it also is based on the risk and reward as it relates to the overall debt market. As we have noted, the cycle is in the later stages and allocations should be looked at from that perspective. We don’t flip switches, but rather use dimmer switches to various allocations across debt, equity, currency and commodities. Being vigilant in monitoring longer term forces within short term anomalies creates an environment where tweaking is the longer goal of balancing risk and reward. The French moralist Joseph Joubert said, “never cut what you can untie.” Dialing up and down allocations based on perceived subjective probability helps to mitigate the risk of being out of whack with allocations based on emotions ranging from idiocy or maniacal.