Setting 2022 Up for Success

What are people not thinking about enough right now, or for 2022? What's an action step people can take to set the stage for success in 2022?

Last month, I addressed what people should be thinking about as 2021 comes to a close, and I emphasized that the underlying principles of value investing remain true year after year. Today, though, I want to look at the reverse of the question: what should forward-looking people be thinking about as 2022 begins?

It’s important to remember that the economy is constantly seeing new beginnings. Transitions and shifts lead us to new places, and sometimes we have to re-think old approaches. Admittedly, you might not realize that, given how a lot of investors behave day-to-day: certain trends, if they stick around for long enough, can lull people into thinking they’re permanent realities.

Index funds – especially some of the big-name ones, like the S&P 500 – are a good example. These are passive investment vehicles that have performed really well for an extended period of time. However, we’re seeing more concentration risk in these kinds of funds (and the S&P 500 in particular) than we’ve seen in a couple of decades. This overconcentration can leave investors feeling a level of security that isn’t actually there. If the economic environment changes – if the Fed becomes more restrictive rather than more accommodative, if inflation gets worse rather than stabilizing or getting better, etc. – that increased risk could turn into losses.

Note that concentration risk can take a few different forms.

First, there’s geographic overconcentration. If most of the stocks are concentrated in businesses operating exclusively or mostly in the U.S., the index fund would be unduly exposed to risk in the U.S. economy specifically. As investment advisory site SeekingAlpha.com writes, “On the aggregate, 70% of revenues for the entire S&P 500 arise from within the U.S. markets. In simple terms, S&P 500 is extremely vulnerable to the fortunes of the U.S. economy. Or put differently, there is a woeful lack of economic/revenue sources diversification in the S&P 500 companies.”

Second, there’s overconcentration in a too-small number of companies. In other words, just because the fund says “500” doesn’t mean its holdings are equally distributed between all 500 organizations. Right now, something like a third of the S&P 500 market cap is concentrated in just nine companies. Equalizing the holdings is tricky, though. Some funds do that, and it creates its own set of problems.

Third, there’s risk when specific stocks (e.g., technology) significantly outperform other groups. “This over- or underperformance throws indexes out of whack, unnaturally tilting them toward a few stocks or industries and reducing the diversification that investors believe they are getting,” writes InstitutionalInvestor.com. “For example, at the end of 2020, the S&P 500 index was overwhelmingly tilted toward expensive growth stocks that were trading at or near record multiples according to some common measures. Investors face the potential for big losses when these stocks, which are overweighted in their portfolios, inevitably retreat.”

For what it’s worth, not everyone agrees this overconcentration risk in index funds is something to worry about, but you can put me in the camp of people who are watching this risk very carefully and urging caution and re-evaluation from investors who use index funds extensively. Ultimately, the index is only as good as its underlying components. But here’s the good news: transitions can be good opportunities, and this risk in the index fund doesn’t mean its underlying components aren’t or can’t be good investments. In fact, I’d say the average component actually looks a little (or a lot) more compelling than the index itself right now.

So, don't assume that putting things on autopilot, as with an index fund, is always going to work. Instead, be mindful of your strategies and whether changing circumstances will affect them. The new year is a good time to give not just your investments but also your investment beliefs a checkup. That’s the only way to ensure you’re thinking about the world as it exists today, embracing today’s realities instead of yesterday’s circumstances.

All of that is easier to say than do, however. We’re fighting our own human nature here. That’s why, when something seems to work for long periods, we tend to assume it’s always going to work. Unfortunately, if there isn’t an inflection point that forces you to re-evaluate or make changes, a lot of those formerly winning principles can turn into losing principles quickly. Consider:

• Fixed income: One obvious asset you can own is fixed income. This has generally been a one-way bet with no interest risk for a long while now. The last bull market started back in the 1980s! But things are changing, and it's no longer as easy to make money in fixed income as it was over the last 30+ years, not when rates are rising. That's something investors have to really think about, for the first time in a long time.

• Equities: In terms of equities, I’ve already talked about the problems in indices, namely overconcentration and insufficient diversification. There are also governance issues, underrated invisible costs, and too little ability to personalize to meet individual needs. These problems create risk such that, if the market turns the wrong way (or even just a different way), a once-winning strategy could turn into a losing proposition.

• Emerging investments: Then there are new investment vehicles being created. Think about non-fungible tokens (NFTs, which are less than decade old) and cryptocurrencies (only a little over a decade old). Here, successfulinvestors tend to approach these products with a venture capital mindset, where they have money all over the place, so that no single bet will kill them. I don't recommend a completely dismissive approach to new tech or new products – there are some genuinely exciting things happening in these spaces! – but at the same time, it’s not a good idea to jump into it unless you have a level of knowledge and understanding of how these products ultimately create value. Regular investors (those who don’t engage in venture or angel investing) need to be more careful with new, untested, volatile, and sometimes outright questionable investments.

All of these kinds of investments have their place in a diversified portfolio, but it’s a good time to be re-thinking, re-structuring, and re-balancing how to proportion your investments.

If you have X in equities, Y in bonds, and Z in cash (with maybe a little “play” money thrown into more speculative corners), is it time to make some adjustments? There’s a good chance what’s worked over the last 30 years will not work over the next 10 to 15. So, my advice is to take a deeper dive, and unpack what's really driving results right now and what can really produce value for you.

How? I’ll address that in the next post.

-GDS