Investing is a tricky business. At any given time there are just as many compelling reasons to invest as not to invest in an asset. When an investor’s stocks are sailing with the wind and share prices are rising, they may have reason to fear that stocks are getting too expensive and wonder how long until the wind dissipates. When bonds seem like a relatively safe place to hide, they may fear interest rate hikes could soon sink their bond prices.

All types of assets get caught in the cycle. Small cap stocks, emerging market stocks, commodities, junk bonds, and treasury-inflation protected bonds, to name a few, all ride the frothy wave at times. After a time on the wave people start to figure out that the crest is pretty high and can’t last. But the ride is so exhilarating and so liberating that it is easy to lose a sense of caution.

Quantitative models that forecast when and for how long a particular asset will hold its momentum rarely succeed. Human behavior becomes predictable en masse but unpredictable at the turn, that is, at the point of change.

So, what in heaven’s name is an investor to do? A disciplined and experienced investor may manage to mitigate losses by abiding by two golden rules:
1. Keep it simple. Stocks and bonds generally are usually not positively correlated to each other, which means that when one of them gets highly inflated, the other settles down. Money flows back and forth between stocks and bonds so it is wise to not try to market time the asset groups and best to maintain a long-term allocation between the two groups in proportions that will provide a maximum return for that blended risk. One should also diversify in sub-sectors within the general category of stocks and bonds, such as international and small cap stocks, and corporate and treasury bonds.

To determine what the blended risk may be, you need to have an understanding of what the historical volatility of return is for each asset class. For example, over the last 80 years the average annual return of large capitalization stocks has been +10%. But most of the actual returns varied around the average return by plus or minus 20%; that is, most of the actual returns ranged from +30% to -10%. That’s a lot of volatility. Everything is relative and though large cap stock returns have higher volatility than bond returns, they happen to have lower volatility than other groups of stocks such as small cap or international stocks. Your investment professional can help educate you about historical returns and the volatility of these returns for many asset classes.

2. Shut out the masses. There is a constant mass hysteria that vacillates between exhilaration and fear for various assets and asset groups in short-term time frames. Ignore it. Be skeptical. Be more rational and be a contrarian. That means when the crests get too high you should be selling when others are buying, and when the troughs get too low you should be buying when others are selling.

Investing is never easy. But you can manage your risk if you maintain a disciplined approach and stay on top of the fundamentals and invest for the long term.

Currently, the stock market has a lot of positive momentum. In fact, the first quarter earnings reports have been quite strong. Companies are increasing guidance and analysts are raising earnings estimates. Stock prices are not yet in bubble territory but they aren’t cheap either. Now may be the time to be on alert for trimming stock positions that are reaching unsustainable price to earnings levels. Yet human behavior does just the opposite, it wants to chase the heck out of this rise while assuming that the wave will only get higher.

Of course, I can’t say for sure when the wave will peak out. We haven’t even reached the October 2007 market heights yet. But I can tell you that every single market time period is unique and unpredictable. Save yourself some heartache and stay diversified and balanced in your asset risk!