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Martin Pelletier: U.S. households now have 11% of their gains driven by one tech stock — think about that

Published Oct 21, 2024  •  Last updated 6 days ago  •  4 minute read

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When it comes to understanding risk, there really is only one true definition. It isn’t portfolio variability or standard deviation but rather the permanent loss of capital. One of the main reasons this can happen is because of human emotion, which is correlated with volatility.

“I define risk as the chance of permanent capital loss adjusted for inflation. Volatility, I believe to be just price changes based on market perceptions of risk. Risk does not equal volatility.” — Bruce Berkowitz, founder of Fairholme Capital Management in Florida

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One of the most common flaws is to want what others have, leading to performance chasing and going all-in on whatever segment of the market is doing the best. In today’s environment, this is quite rampant. It has reached the point where U.S. households now hold 48 per cent of their assets in equities, the highest since the 2000 dot-com bubble peak.

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Looking back over the past 12 months, cumulative global sector fund flows have almost entirely gone into just one sector: technology. Traders have also built the largest U.S. Equity Futures position in history, according to Goldman Sachs.

Investment advisers and fund managers find they cannot stray too far from whatever is leading the charge, resulting in less and less diversification. For example, did you know that just one stock, Nvidia Corp., accounted for 22 per cent of the gains in the Bloomberg 500 (a proxy for the S&P 500)? Taking this a step further, U.S. households therefore have 11 per cent of their household gains driven by just one stock. Let that sink in for a moment.

The problem is when such a crowded market unwinds, and it ultimately will, loss aversion kicks in and when investors can’t take it anymore, they start selling, potentially triggering a permanent loss of capital.

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Fortunately, there are alternative options that money managers can deploy that offer downside protection in such events, but this means being willing to give away some of the upside capture. This isn’t too sexy when it comes to feeding into investors’ fear-of-missing-out (FOMO). Why would you invest anywhere else, including alternatives, when the tech-heavy U.S. market has performed so well?

The investing world isn’t that binary, as there are many different paths an investor can take, and our job as money managers is to be their guide. This often includes helping protect them against themselves, especially those who just don’t do well with seeing large swings in their portfolio.

This is why we’re huge fans of the goals-based investment approach, whereby we set a return goal specific to a client’s financial objectives while trying our best to minimize the standard deviation from this targeted mean annual return. So, for example, this may be as low as five to seven per cent, if that makes the client happy and protects a large portion of the capital they’ve built over many years of hard work.

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This means, at times, exploring strategies using alternative investments.

I recently was a guest speaker at the Canadian Association of Alternative Strategies & Assets (CAASA) event in Vancouver last week. The conference provided an overview of liquid and illiquid investments, how they might perform for investors, and how they can be used in a portfolio setting, including a discussion around risks and their use in portfolio construction.

We have made use of both private debt and private equity instruments. Both of these are illiquid investments focused on delivering consistent longer-term returns targeting superior alternatives to similar public markets. Additionally, because they are not marked to market on a daily basis like public markets, there can be less variability in that allocation, resulting in less of an emotional reaction from the investor. (However, this doesn’t mean you shouldn’t stay on top of what is happening within those investments.)

Interestingly, we’ve even seen some family offices (the wealth management firms of wealthy families) take this a step further as a multi-generational capital preservation strategy. They may purposely lock in some of their wealth, such as direct investments in operating companies, real estate or even land.

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Finally, we make extensive use of structured notes, which could be considered liquid alternatives, and have made an excellent replacement for our fixed income and bond allocation, where those segments of public markets have performed poorly.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.

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