Navigating Uncertainty

Joe: We find ourselves living and investing in a bit of a paradox these days. Inflation has come down meaningfully from COVID-era highs, but it remains stubbornly above the Fed's target and now faces renewed pressures. The labor market has remained resilient based on the latest data, yet signs of potential softness are also hard to ignore.

Investor optimism is strong, but consumer confidence, it's in the gutter. Geopolitical risks continue to dominate headlines, yet markets have largely shrugged them off. Stocks sit near all-time highs, but that has generally been the case in recent years. And for many investors, right now feels all too fragile, like sentiment could shift on a dime.

It's no wonder many investors feel like they're caught between a rock and a hard place. Real risks loom, and a desire to protect against downside is understandable. But at the same time, markets continue grinding higher, and nobody wants to miss out on the additional upside. In today's episode, we explore this exact tension and discuss what investors and advisors should be considering when navigating markets shaped by uncertainty and a growing battle between downside fear and FOMO.

Thanks for listening. This is Balanced PM.

Welcome, everyone, to episode two of Balanced PM, an XYPN podcast where we prioritize context over conviction to help you make better portfolio management decisions. We're your hosts, Joe Dunn and Andrew Almeida, coming to you from XYPN Sapphire. Each episode, we'll explore key principles behind investment management and portfolio construction through thoughtful, in-depth conversations.

From timely discussions of current events to the review of evergreen portfolio management concepts, we plan to cover it all. Before we get into it, let's let our chief compliance officer relax a little bit and get that disclaimer out of the way. This podcast is produced by XYPN Sapphire, an SEC-registered investment advisor that is wholly owned by XY Planning Network.

We're part of the same XYPN family, so we may make references to the larger network, and that's okay. This content is intended for educational purposes only and should not be construed as investment advice All right, and with that disclaimer out of the way, I'm excited to welcome everyone to episode two of Balanced PM.

Andrew, how are you feeling after our first debut last month?

Andrew: Yeah, we came out swinging with an episode on stagflation. Um, I'm loving it so far, Joe, and things are feeling good. Summer's here. It's warming up. Let's do episode two

Joe: Yeah, and, uh, on that topic, if anybody is listening to this right now and did not tune into our first episode, we definitely recommend it. Go back for a deep dive on stagflation. I think it was a pretty timely conversation. And we're gonna try to introduce a pretty nice variety of topics across all of our episodes as we continue through the months ahead.

And this is a good example of one that is gonna have a little overlap, because we're gonna discuss the macro side of things to kinda set the stage for the larger portfolio construction related conversation. So, if you've tuned into the first episode and you're here again, thank you. There might be a little overlap on the macro piece, but we promise it's heading in a different direction, and we've also tried to organize it in a little bit of a different way to kinda tell a different story overall.

Uh, but without further ado, let's dive into the topic at hand, and as you heard in the intro, it really comes down to we feel like we're in an environment of very heightened uncertainty right now. And I know myself, as a personal investor, I feel this way sometimes, and I know that a lot of individual investors that aren't as involved in the overall investment industry feel this way.

They're thinking, "It feels like there's a lot of risks looming out there, and I'm concerned about the downside potential in my portfolio." But on the other hand, they're hearing all these awesome stories about the AI revolution and how that's gonna lead to a new economic regime, and they think, "Well, I don't wanna have FOMO.

I don't wanna miss out on more potential upside." And so in this conversation, we're going to kinda break it down and explain, well, why does everything feel so uncertain right now? And then how should investors and their advisors think about such uncertainty in the context of how they manage their portfolio in times of uncertainty like this?

And, uh, to start off, uh, obviously we wanna start with setting the stage, and that begins with, all right, we say it feels uncertain right now, but why does it feel so uncertain right now? And it really comes down to the economic and market indicators that we're looking at. I mean, we have some aspects of the economy and the markets that feel supportive and strong.

We have other aspects that kinda give us a reason for potential concern. And then there are other details that are really hard to get a good read on. I mean, the current data might look strong, but if we kinda zoom out and look at longer term trends, we're thinking, "Well, maybe if that continues, we could see ourselves somewhere in the future where we'd be concerned about this particular detail."

So, there really is a lot of uncertainty out there, and we're hoping to dissect that a little bit for all of our listeners today. There is certainly a lot to discuss in this episode on the macro piece, uh, like inflation, the labor market, consumer strength, economic growth, geopolitics, and of course, markets. And honestly, I got a little bit overwhelmed just listing all of those things off at once. So I know it'd be kind of hard for our listeners to absorb anything if we just kind of rattled off macro insights in that order.

So, uh, we did our best to organize this in a way that is a l- a little bit more thematic, and we kinda narrowed it down to three questions that will encapsulate all of those different macro details that I just ran through. So the first question we're gonna explore is: How do investors think about inflation and the labor market?

Uh, second will be: How should investors think about consumer strength? And the third will be: How should investors think about the impacts of AI? And Andrew's gonna cover what's looking good on all those fronts, AKA the case for why investors might have FOMO, and I'm gonna cover, cover the flip side of that, uh, why we might have some reasons for concern and why investors might be a little bit more focused on the downside risk.

S- uh, does that sound good to you, Andrew?

Andrew: Yeah. Uh, super excited about this one. I have to say the-- this market might be feeling a little bit like the New York Knicks. Uh, you know, can this really keep going? I think that's the FOMO side. Like, is it really good? Are we really there? Is this miracle about to happen? You know, so there's a lot to be excited about on the upside.

I'm happy to get into those parts of the conversation, but overall, we'll get into the portfolio management piece in the later half of this as well to talk about how to position portfolios. Uh, so I'm, I'm really excited for this conversation, Joe.

Joe: Yeah. Well, if nothing else, the NICS and the markets certainly have some strong momentum right now, so it's looking good for your NICS.

All right, so let's start with the first of those three questions on the agenda, and that's how should investors think about inflation and the labor market? And Andrew, I'll tee you up for the first part of that. And so like what's looking supportive and what's the case for FOMO when we're thinking about inflation and employment?

Andrew: Yeah. Well, we have seen historically higher inflation, whether it be the '70s or post-COVID, right? We've, we've come down from the post-COVID highs. That's certainly positive. Um, inflation as it creeps into markets is generally negative on, on asset prices. But, you know, I think the market is digesting this and looking through it holistically, that is that they don't think it's gonna be a long-term concern, market participants. When we look at employment, I'm very positive there. I mean, there's a lot to be concerned about what might happen. Could XYZ happen because of, um, geopolitical or AI dominance, right? Like, you know, I'm not as concerned. We're at 4.3% unemployment historically. That is full employment. It is, it is better than the historical averages over the last 30 years of average unemployment.

We're in a strong employment position, you know, we shouldn't be afraid to say that. Um, underemployment's been trending down. Claims for unemployment insurance are also level, and we've recently finally seen, you know, what was the low hire, low fire environment that persisted for the last year potentially change- changing directions now with the last three months of, uh, non-farm payroll additions, um, being positive or better than expected.

So I'm positive about the employment and inflation situation, and markets are digesting it that way right now.

Joe: And of course, I have to take the other side of the equation, and if we're looking at inflation, if I have any downside fears when it comes to portfolio performance and how inflation impacts it, I mean, I agree, we have made some real serious progress on the inflation front, uh, since the COVID era highs.

But if we look at the long-term trend, it's kind of plateaued since mid-2023, and we've struggled to make any progress since that point in time. Uh, and if anything, it's actually started to go in the other direction because, of course, we're facing renewed pressures from the conflict in Iran, uh, the impact that that has on oil prices.

And if anybody tuned into our first episode, you know very well that oil is a universal input. So it's not just oil prices, it's the prices of everything that it impacts. And I just don't really see an end in sight for this conflict in Iran. I mean, there's been a lot of back and forth, get our hopes up with a tweet, uh, and then our hopes just come crashing back down to earth when the missiles start flying.

And there's so much politics involved in it with not a clear off-ramp for either side that I don't really see an end in sight. Um, so yeah, inflation, there's definitely hope that it could come down if things clear up, but, uh, the, the downside of that is definitely glaring in my opinion. And if we're moving on to the employment front, again, yeah, I agree.

Where we stand right now, not terrible. The unemployment rate has been pretty steady and below historical averages. But if we're looking at trends, mean employment has been gradually trending upwards since 2023, and it's a question of has it stopped or is this just kind of a temporary pit stop, and could we see that trend continue, uh, in the future?

And obviously, that's still to be seen. I mean, we did have the last three non-farm payrolls, to your point, showing strong momentum with an average of about 157,000 jobs added o-over each month. Um, but again, three periods does not make a trend. And if we're looking back a little bit further, we're not that far removed from struggles in the non-farm payroll area.

I mean, since January 2025, we've seen six periods where jobs were actually taken out of the economy, and the most recent one was not long ago at all. It was, uh, February of this year, 2026, where the economy lost 156,000 jobs. So in short order, we went from losing 156,000 jobs to now three periods where it's an average of adding 157.

So I'm just-- I'm not super convinced that we're, we couldn't get back in that scary territory soon. But I do agree that there's reason for hope.

Andrew: Yeah. I mean, that's why we have you digging deep into the data for us, Joe. I mean, you're absolutely right. Th- three, three reports does not make a trend. Um, and can the Hormuz, uh, conflict continue on making inflation, uh, more of a concern the longer it goes? There's a direct correlation there. So, uh, maybe the next episode is tweets and missiles, who knows?

Joe: And I'm curious to get your thoughts on how all this is shaping or forming rate expectations. Uh, if we have any investors or advisors that are paying attention to what expectations are for what the Federal Reserve is gonna do over the rest of the year, they might have a little bit of whiplash at this point in time, because, uh, if y'all recall, when we came into 2026, the market was pricing in expectations for Federal Reserve rate cuts.

But now we're actually looking at implied expectations of more than 50% that the Fed will increase their f- uh, federal funds rate by the December Federal Open Market Committee meeting. So, with such a drastic change in a relatively short period of time, tying that into the, uh, inflation and employment conversation, how should investors be digesting that?

Andrew: Yeah. I like your analogy again on whiplash because, y- you know, when rates are low or if the market anticipates the Fed cutting rates, well, that's your foot on the gas pedal. And now we might be at a base case of no cuts, no rates. Are we about to press on the brake? And if rates go up, we are very much pressing on the brake.

That is, the Fed needs to increase interest rates to combat inflation. So the longer inflation goes on, the harder we need to press on the brakes, the worse the whiplash might be

Joe: I think it's also really important to remember that the actual expectations aren't necessarily the story. It's what's driving those changes in expectations. And looking back at recent changes, uh, we have a few different drivers that tell different stories. So I mean, the first big bump in terms of people moving from, all right, we expect Fed cuts to now we expect Fed rate increases, the big first bump came from inflation fears and people thinking, all right, the Strait of Hormuz situation is going to increase inflation.

The Fed's gonna have to stay higher for longer, or even, like you said, step on the brakes even harder to curb those rising prices. But if we look more recently, the timeframe for expected rate increases actually got moved up a little closer in time, and that came from the other side of the spectrum after we got a surprisingly strong employment report, which you'd think is a good thing.

But that sent rate expectations higher because I assume, uh, market participants were like, "Well, now the Fed has more flexibility to only address the inflation side of things with higher rates without as much of a fear that higher rates will have a negative impact on the employment side of the picture."

Andrew: Yeah. It's, it remains to be seen what the Fed will do, but like we said, the harder they press on that brake, the, the worse the whiplash may be. And, you know, hopefully real growth and investment continues on, and that could lead the Fed to delay longer and give them m- you know, sort of a buffer before they increase rates.

But expectations are key as well, like you said. If an, if a hike is unexpected but happens, that's when you'll see more of a negative market reversal in terms of just pricing, um, when an unexpected event, especially when it comes to rate expectations and hikes, um, are recognized, so

Joe: New Fed Chair Warsh has his job cut out for him in terms of, uh, setting expectations and really communicating efficiently. So yeah, we'll see how that plays out. All right, but let's move on to the second question on this macro part of the agenda, and that's how should investors be thinking about consumer strength?

And again, Andrew, I'll let you take it away with what's going well for the consumer and what's supporting the case for potential FOMO?

Andrew: Well, you know, if, if investors and advisors haven't heard it by now on the number of calls they get on, I mean, we're all aware consumer is the largest part of, of GDP. It's the largest part our, of our economy, right? So it is important to pay attention to how the consumer feels, how they act. It may not always be correlated with market pricing, but if we're just gonna look at the consumer and their health, I think we're in a good position.

I, uh, you know, I s- I said how positive I am about where we are in the labor market. Any bleeding seems to be slow and not rash, you know, changes in employment like we saw in COVID or in recessions. So there is, uh, a positive undertone in the labor market still, despite what might be in the headlines.

Personal income and spending have shown mostly positive growth. And if we're gonna look at the other side of the coin, because there is another side to spending, and that's saving. So if we're not confident in the spending numbers or we're wary, where can we look into deeper data? We could look to the personal savings rate.

Consumers are consuming. And how are we seeing that? Well, personal savings rates are going down. Now traditionally, not always, but if we see personal savings rate go up, it's more likely assumed that that's because investors or consumers, excuse me, are pulling back on spending, and that's-- it's a real sign of fear showing and reflecting the pocketbook and how they decide to use money.

So overall, trending down in personal, uh, savings is also, I wou- I would think, positive in terms of spending, which is positive for growth

Joe: Yeah. Saying they d- they don't feel the need to have a significant cash buffer. So I could see that. But again, I'm taking the other side of the coin here, and, uh, I think this is a fun one to actually have the, the case for downside fear on the consumer front because, uh, there's a, a few notable instances of, uh, reasons to be concerned.

And first, I know, yeah, we talked about the labor side of things. I'm not gonna rehash that. Uh, again, labor market uncertainty. If anything, we don't know which direction it's gonna go in, so regardless of which way you think it's gonna go, there is a lot of uncertainty, and that's not super great from a consumer lens because, uh, the, those employees are also the people that are consuming, and if they have uncertainty about the labor market, then that could shift aggregate consumer, uh, sentiment and consumer activity.

So we'll see if that plays out, but at least recently and anecdotally, uh, people seem to be a little pessimistic on the consumer front. Um, I'm glad you mentioned the personal income piece, um, because yeah, y- I mean, you can't argue with the hard nominal numbers that personal income has grown in recent periods, but that's the important piece, is that the personal income growth has only been on a nominal basis in recent periods, meaning we're not yet taking the impact of inflation into consideration.

If we're looking at real personal income growth, we actually just crossed over into a pretty important territory. Uh, and it's been trending down since June 2023, but we just recently crossed into slightly negative territory in the last two months. So that's saying that even though on a nominal level, uh, consumers, their personal income is going up, once you adjust for the heightened level of inflation, uh, which impacts their purchasing power, then their real personal income is, is actually going down.

So, that could be a concerning trend if it continues. Obviously, that could bump right back up into positive territory if the inflation piece comes under better control. But as of right now, that's not the case, so it's a concerning trend in my eyes. And also really glad that we're talking about the personal savings rate, 'cause that's one of those things that it's not really telling you a clear story just based on the number alone.

You have to know what's driving it. And what we've seen historically is that in times of higher inflation and higher living costs, people are having to spend more on the things that they need. A lower personal savings rate can actually point to financial distress, and that makes sense. Like, yeah, it, it's, it's one thing to say, "Oh, someone is saving less because they're spending more and they feel good about the economy."

It's another thing to say, "People are saving less because they have less to save because they have to spend more on the things that they're buying for themselves and their families, and they have less to save after the fact." So, I mean, we'll have to wait for more periods of data to really figure out what is driving that change in personal savings rate.

But I could certainly see the case for it being a negative trend, especially when you tie in the fact that credit card delinquencies are part of the equation, and those r- numbers have been steadily increasing since 2023. And credit card delinquencies, the rate just hit the highest level in 15 years, and that's since the immediate aftermath of the 2008 global financial crisis.

So, people are having a harder time paying off their credit cards. And then tie that into, all right, if we see rates stay higher for longer, that's certainly not gonna help that picture. If, uh, credit card rates are staying higher and people are able to save less, then what is that off-ramp for, uh, credit card delinquencies to start trending down?

So, uh, all that together, I think I'd tie it into, uh, consumer sentiment. I think that all those pieces are impacting consumer sentiment, and I know that's one of the measures that we kinda have to take with a grain of salt 'cause it's survey-based and it's also been relatively depressed just in the overall post-COVID era.

So take that as you will, but consumer sentiment is not looking super strong these days.

Andrew: Yeah. A lot to consider on the other side of the equation there, Joe. I mean, you did bring up credit card delinquencies. They are at higher rates. Uh, you know, I do look at, uh, total debt to personal, uh, average household income as well. Uh, and debt as a percent of household income is still relatively total debt around long-term historical averages, right around 11 and a half percent or so.

But, uh, the point you made about wages and inflation, you know, inflation eating away at wage growth is, is, uh, a statistic that re- that did just change. That is inflation now, the rate of inflation or CPI, let's use, is higher, you know, roughly around 3.8, 3.9% higher than wage growth. When wage growth is outpacing inflation, you know, whatever those numbers are nom- nominally are, are less relevant because you're still...

People are still earning at higher rates and their incomes are growing faster than inflation is growing. But now inflation is growing faster than income, and that's when you start falling behind. So it will be important to see how long this trend persists.

Joe: Yeah. And again, a l- I think a lot of it comes down to more of the inflation side of that equation than the income side, and we're not expecting a huge uptick in personal income on a nominal basis. So hopefully the inflation piece will come under control, and we can at least get that real personal income growth. Let's move on to the third question in this macro section, and that's how should investors be thinking about AI? And I know, Andrew, uh, you probably got a lot going on in your head in the AI space. I know you do. You could probably do five hours straight on AI. But again, we wanna bring this back to the investor and, and not what's going on in the back of your mind 'cause we wanna keep this a little short.

So take us through, uh, how investors should be thinking about AI, and also let's use this section to open it up a little broader too and just think about the actual market piece of the equation.

Andrew: Yeah, a lot is going on in my head about AI for sure, but how is the market digesting it? I mean, there... Like we said earlier, market's looking through in- inflation. Well, a lot of that has to do with the confidence the market has in the productivity gains of AI and the long-term disinflationary effects. I think the market is signaling confidence in how it is being perceived.

Um, overall, the AI story is one, in my eyes, of real growth because of real spending. When people and investors see market prices accelerating, there's a lot of why that goes behind that, and that will be differ by company, but by and large, it's not simply that our investors are paying more for the same level of earnings.

Investors are paying more for growing earnings, for growing industry, for an entirely new growing innovation that is just beginning. So there's a lot of growth out on the horizon, and I think there's a lot to be excited about in terms of AI. The market has obviously been driven by that narrative to, you know, where we're starting to hear new pieces of jargon, n- not just FOMO, but FEMO, right?

The fabulous earnings momentum that is out there and that is driven by AI. Companies are earning real money. I think if we looked at the Mag 7 versus the 493, earnings growth in the Mag 7 is double in terms of how quickly it's growing, roughly 32%, 33% versus 15, 16% of the remaining S&P 500. So these companies are growing at twice the rate.

Um, and then if we look across the board, uh, just for the first quarter, overall earnings growth, as, you know, uh, framed by the S&P 500 this quarter, first quarter 2026 versus last year, 85%, uh, of S&P companies reported positive EPS upside surprises with 28% earnings growth compared to last year.

Joe: Woo

Andrew: the numbers are outstanding and supportive of a bullish market.

Uh, I mean, I, I'm excited about that. I know there's a lot of reasons why people might be fearful. I know, I know you're gonna get into that side, but even just looking at the valuations, I mean, on a forward basis, we're at a 21 PE. That's, you know, not terribly high considering the growth rates that we just quoted.

But please, you know, let me know what, what people are thinking and feeling on the other side.

Joe: Yeah, and this, this topic is honestly one where I find myself most on the fence because from a fundamental story, I agree fully that, uh, AI in terms of productivity gains and what we're seeing with earnings growth is super supportive. And yet, even though I like, I believe in the long-term story of AI, I can't shake this feeling that something could go wrong in, in the mean-- in the like intermediate term, I guess you could say.

And so yeah, there's definitely some case for downside fear in this regard, and I will, I'll get into AI a bit more in a second. Um, but since we're kind of broadening this out to a general market conversation, I want to start with the, the non-AI pieces of the equation. And obviously the big one is Iran and geopolitics.

There are so many geopolitical conflicts floating around out there, um, whether they're on your radar still like the story in Iran or they've fallen off your radar because Iran has dominated the airwaves. Um, there's so much uncertainty out there. There's so many areas where we could see tail risk that I think that's, that's such a big area of concern in terms of general market performance in the future, and something could hit the fan and, uh, and turn around really quickly And the other piece that's not necessarily AI related is just the sustainability of the earnings growth.

You know, you saw that even outside of AI, other companies and industries and sectors are doing really well with their earnings growth as well. Um, but I'm curious to know what's gonna happen if we start to see that earnings growth decelerate. So I'm not necessarily concerned about earnings declining by any means, but where we've seen such a strong period of earnings growth, I think people's expectations are really high.

The bar is really high. So even if we see what would historically be considered a really good period for earnings growth, what if it doesn't meet the high bar expectations that have been set by recent periods? And how are investors gonna respond to a deceleration, uh, in, in any earnings growth? So that's, uh, another area where I have potential concern.

But let's open it to the, the AI piece of the conversation, and I think that's where a lot of people's downside fears are also coming from, because it's not just will AI pan out or will it not? It's look at the high level of concentration in the markets right now due to how well AI related stocks are doing right now.

Again, if we're using, uh, S&P 500 as like a, a general framework of the stock market, then we're looking at the top 10 constituents of the S&P 500 making up roughly 40% of the index. 40%. And all 10 of those top 10 constituents, they have some exposure to AI, but nine out of 10 of them have deep exposure to AI.

So you could read that as not, uh, that more than 40% of the S&P 500 is concentrated in 10 names. It's also more than 40% of the S&P 500 is concentrated in AI. So I, like-- people like to think of the S&P 500 as a diversified way to enjoy the stock market, but now you could see it as a, a pretty strong AI play.

And if I kind of broaden out beyond the S&P 500, just to give everybody a little snapshot of what else is happening in the market, year to date, 2026, just under 50% of all new investment grade corporate bond issuance is directly tied to AI. go down the credit spectrum and we're looking at junk bond issuance, just under 40% of junk bond issuance year to date is directly connected to AI.

And then if we get a little even more specific and we're looking at the venture capital space, uh, nearly 90% of new venture capital funding is directly ta- tied to AI. And that one makes a little bit more sense because I know VC is all about the what's new and what's, what's the future. So AI is obviously the dominant theme right now, so I'm not super concerned about that.

Um, but it's just kind of-- I think it's helpful to lay out these statistics to show concentration risk goes beyond what's in the S&P 500, and there's concentration risk in other areas of the market that people are less familiar with. But that doesn't mean that it can't have some sort of contagion effect if something goes wrong in one of those corners of the market.

And the last thing I'll say, uh, because there's a lot of risk on the concentration front, but other than just like the AI concentration, I think it's not just the number of constituents and the portion of the index, but it also comes down to the concentration in fundamentals, earnings growth concentration.

Yeah, you said that, uh-- you pointed out that earnings growth is quite favorable across the board, which I certainly agree. But the Mag Seven stocks, those grew at more than 60%. So if we're looking at the aggregate number, uh, S&P 500 saw roughly 28% earnings growth. And if the Mag Seven was over 60% for their earnings growth, uh, average across those seven stocks, that leaves us to believe, all right, what about the S&P 493, the rest of the index?

And that only grew earnings around 17%. And again, that's great. Any other year, people would be like, "17% earnings growth for the S&P 493? Not gonna bat an eye at that." But on a relative sense, and if people are quoting that 28% earnings growth and not realizing what the breakdown is of how concentrate that-- how concentrated that earnings growth is, I think that's a really important part of the story

Andrew: Yeah. I mean, concentration is top of mind for everyone on the side of managing downside risk because portfolios have naturally become more concentrated. And you point out very well, like holistically even now across sectors, they're ti- it's tied to AI. But I do want to create and take a step back just to talk about the word FOMO a bit in context because it's not a technical term, right?

We are using a term which is thrown out over the airwaves a lot and fear of missing out, you know, could just, you know, could be driven by a number of things. Is it justified? Is it not? Are markets reacting in a FOMO type of way? And just for some context, I mean, you had post-COVID, $4 trillion cash injection from the Fed, surplus cash on, uh, a- across the market, you know, more stimulus checks in people's houses.

They didn't know where to spend that money or put that money to work, and you had money being deployed everywhere. You know, uh, every software, you know, Zoom, every software company, uh, crypto, everything, right? And prices were going up based on FOMO, based on fear of missing out. Simply more buying was driving up prices.

The market is different today, and if you have a fear of missing out and concerns about the downside and, uh, concerns about AI, that's one thing. But these companies, which are over a trillion dollars in, in value, are unloading hundreds of billion dollars off of their balance sheet because of their confidence in how to grow their companies, and they are growing.

So there is a demand-driven aspect here versus a simply pay higher prices for stocks. It's a little bit different is what, is what I would say compared to then as a, when we think about FOMO

Joe: Yeah, I think that's a, a good distinction to draw because people might see, say, like the post-COVID environment and what we're seeing today and draw the connection saying like, "Well, people were grappling with we're entering a new economic environment that we haven't seen before. I see where the money is going, and I don't wanna miss out on that."

But in the post-COVID instance, it was going to companies like Zoom, Netflix, like already existing companies, and it was more so like these companies aren't really gonna be doing anything different. They're not injecting a ton of hundreds of billions of dollars into building out their platform. It was more so these companies are already well-positioned for maybe a, a more fully remote, uh, dispersed environment.

Whereas now, that is not the case. Like these companies are changing where they're putting that money. They're changing their business models to a large degree and, and that's a completely different angle that it's being approached from. So I would, uh, I'd be in agreeance with you on that front.

Andrew: Yeah, for sure.

Joe: So we just went through why everything does feel uncertain, but now let's get to the actual meat of the conversation and how does that uncertainty translate into portfolio construction decisions? How does investor uncertainty specifically impact what the investor wants to do with their portfolio?

And, and how should investors think about balancing their FOMO or their fear of missing out on more potential upside with the other side of things, which is their fear of downside and the impact that that could have on their portfolio. And we're gonna try to approach this, uh, by looking at both ends of the spectrum of investor reactions.

On one end, if somebody's experiencing heightened FOMO, uh, then they might find themselves over-invested. They wanna put more money to work or, uh, take on more risk than maybe they should. And on the other side of the spectrum, uh, we have under-invested. If somebody's a little too scared of the downside, uh, part of the equation, then they might take too much risk off the table.

Uh, so we're gonna look at both of those pieces, uh, talk about what might contribute to that thought process and what the risks are, 'cause Andrew, you and I both know that there are risks to both of those decisions. Um, so let's start with the under-invested side. I think that's where a lot of investors start when they're approaching the topic of uncertainty.

They're just getting scared, so their reaction is to, uh, to be less exposed to the market. So what is it that leads to investors being under-invested, and what are the risks that come with that?

Andrew: Yeah. Great, great topic and question because it's important to frame this, uh, at a high level, but also with the recognition that this is situational for every client. Uh, so we could speak about it in generalities, but I think one of the more common things that an advisor would see here is they have a client, maybe they've had them for some time.

They've-- the client's been investing for a long period of time regularly to their 401or to their investment accounts, and now they get a cash windfall, and they're back in control of a large sum of money, and they need to decide what to do with it. And in, and in this market, you know, it's happening a lot with, uh, you know, companies IPO-ing and, and, and, uh, investors getting new sums of money that they are questioning whether they should put to work.

If they're feeling wary about that, well, what are they missing out on? If they decide to keep that cash on the sideline and say, "Hey, you know, maybe right now is not the best. I'm gonna wait. I'm gonna wait things out a week. I'm gonna wait things out a month." Well, you're losing to inflation every day, right?

The opportunity cost of keeping that money not invested, you're losing the compounded return that you and your advisor probably started off with a sound plan about how to get to some goal, right? So you are actively making a choice probably to step away from that if you're keeping cash on the sideline.

You're losing to inflation, probably losing to taxes, um

Joe: if your money market's spitting out 3.4%, headline inflation is above that right now. So yeah, it's not, not keeping up

Andrew: Yeah. And the, truth is, so many stu- so many studies, we've all seen them. I know there's one from J.P Morgan that shows that over a 20-year period, if you miss just 10 of the best trading days, your return would've been cut in half, right? So let me just say that again. Missing 10 days within a 20-year period, if you miss those days specifically or decided to sell on the wrong days or not put...

You got a cash inflow on one of those days, didn't put the money to work, you missed out on serious returns, So there is a lot to the school of when you get the money in hand, put it to work

Joe: And those days happen to be around the times when there's a lot of uncertainty.

Andrew: Yeah. I mean, you see the biggest market reversals and some of the biggest upside days like we did last year. I think we had a 9% day, in late April post, the Liberation Day tariffs when the market digested it and said, "You know what? Not an issue." And then boom. So you don't wanna miss that

Joe: And can you speak a little bit to, like, what are some of the thought processes that might be going through an investor's head that make them kind of forget about their long-term goals and what their planning expectations were before the uncertainty came? Like, what changes?

Andrew: Well, one thing that's gonna change for the investor is their time horizon, right? You have this time horizon compression. Now, that'll be different for everyone, but young guy like yourself, Joe, you get a cash windfall, you still have a long-term time horizon, right? You, you can still live at... Your expectations of to retirement or life expectancy would be that you're gonna live through more than one more market cycle or two more market cycles.

So your time horizon is still long-term. So don't get too focused on, yeah, don't get too focused on the near term and what's happening around you today when you still have a long-term time horizon. Of course, that might be different for someone who's closer to retirement. You also have a prospect theory of, you know, is why people would refrain from actually putting that money to work, is people fear loss greater than they feel rewarded by gains.

And, you know, that is a cognitive bias, um, again, something that you would want to have talked through with your advisor when you initially start a relationship about times like this.

Joe: Yeah. Prospect theory says that the pain from loss hurts roughly twice the joy that you get from gain. So I guess it does kind of make sense why people would want to avoid that, that two times pain. Um, but how about the other side of the coin? If we're, we just talked about what the risks are and what leads to somebody potentially being under-invested, how about somebody being over-invested and potentially maybe getting ahead of their skis?

Andrew: Yeah. Also a good one. You see this happen a lot, especially when markets are doing very well. Joe Dunn gets his cash windfall. He sees all his friends making money, uh, in Anthropic and, uh, in this coin or that coin and, and they worked at companies that their shares are IPO-ing, and now you have a fear of missing out like everyone else.

One danger that comes from that is putting money into risk, into higher risk assets that are outside of the norm of your portfolio plan, let's say. You have more money, you're feeling more confident, now you're gonna put it into more risky assets. Certainly warrants a conversation with your advisor, but to just willy-nilly buy hi- the highest risk assets because you feel like you've missed out on the return that others have gotten, right now I think that's most evident probably with everyone wants in on the, you know, SpaceX or the Anthropic IPO.

Um, are you buying at a top? I mean, from an insider's perspective, they're certainly bringing these to market so they can liquidate and sell their shares at favorable b- favorable valuations that they like. So always consider that on the other side of the equation. Um, you know, there's real biases, again, cognitive biases that come with this, the recency bias of, of returns, the keeping up with the Joneses or comparing yourself to your neighbor.

So it's not as easy to always say, "Yeah, get the money to work right away." Well, don't just put it anywhere

Joe: Yeah. I think the recency bias, I would expect that that would be one of the more dominant impacts on somebody deciding to be overinvested. Again, like, yeah, you, we keep coming back to the example of someone, uh, in my age group who's on the younger side. And if we're thinking about recency bias, that's all right, what are the market environments that they've experienced?

And we have been privileged to enjoy such a, a long period of incredible returns. And a lot of people who are investing in the stock market these days, that might be all that they know. So it, it might be not on the front and center of their mind that, hey, maybe it's not always like this. And especially when you tie in, there's definitely a real piece of, like, narrative addiction, and people are really tied into financial media and what they're saying.

And, uh, for better or worse, the financial media tends to be a little bit more biased to the upside, um, 'cause it's kinda like talking your book in a way. Like, people, you, you want it to do well, and so, uh, unless there's any really glaring reasons to say that things aren't going well, then p- then what people are paying attention to is often on the bullish side of things, and that can really influence how they view the market as a whole Um, but through all of this, whether you're deciding to be over-invested or under-invested, uh, people are constantly doing a tug of war in a period of uncertainty like this.

They're afraid of overreacting, they're afraid of underreacting, and a lot of times that can lead to a bit of decision paralysis where just nothing happens. And honestly, I think that that can be the best outcome potentially, but there's a real big caveat with that, that inaction or decision paralysis, it could be the best outcome if you have a strong stategi- strategic foundation that drives your portfolio construction.

So let's get into strategic portfolio construction and what a, a strong foundation would look like to help you navigate a, a period of uncertainty like that. And in my head, it starts with consistency and process, process, process. And I think that that is most well documented and communicated through a clearly defined IPS or investment policy statement.

So that's the document that takes all the investor's, uh, goals, their return objectives, their risk tolerance and whatnot, it packages it into one document that says, "This is how we're going to manage your portfolio." And I like to think of an IPS as a bit of a, like a woosah moment where, uh, so like if you're experiencing-- and that comes from like, it's actually a quote from "Bad Boys," but, um, it comes from the meditation space where if you're experiencing a personal period of difficulty or uncertainty, use the word woosah as a reminder that like to come back to center and like refocus on like what's really important and like the core of our existence or whatever.

And the IPS can be that woosah moment, 'cause when things are hectic, you can look back and remember, "All right, I have this document that me and my financial advisor put together at a point in time when things weren't uncertain. I wasn't this scared, and there was a reason we built it in this way. So I just have to remember, come back to that IPS and say, 'I trust it.'"

Andrew: Yeah. The investment policy statement is your core centerpiece of the portfolio management process. You know, for advisors that are using an investment policy statement, and if you're not, I would certainly suggest that you do, but this is the living document. This is the living document that you and your client agree on is the investment plan.

And you talked about the strategic foundation of the portfolio. It is rooted in the investment policy statement. It is, and at the most high level, is strategic to provide what? Your strategic allocation for this investment adventure that you're on. Whatever your goal might be for that particular portfolio, whether it's a bank portfolio, an individual retirement portfolio, your portfolio to get you to, uh, your vacation, whatever it might be, the strategic allocation is the mix of stocks and bonds that you and the advisor have agreed on is the right mix to get you to that end point.

And during times of turbulence, you may say and go to your advisor, uh, and say, "Um, should we do this or should we change that?" Well, you know, your advisor pulls out his investment policy statement and says, "We agreed we would do this." So we don't have to debate it. We have the living document to reference.

Now, does that say that an investment policy statement can't change or does not need updating? Yeah. It's a living document, right? That's where we started. But what should dictate that change? That change should be dictated by a change in the investor, in their life, not necessarily changes in the market.

Now, if over a, you know, timeframe their willingness to take risk is, is totally or impacted by how markets have changed, well, yes, then something has changed with the investor and we can get into those components of risk. But more importantly, it is a change to that personal profile or the portfolio profile versus what's happening in the market that would dictate why you change the plan

Joe: Right. Yeah, and it's important to note that, like, we do stress discipline when it comes to following the IPS, but discipline does not equal rigidity. Like you said, it's a living document, and as personal circumstances change, yeah, IPS should change. But as market circumstances change, unless that coincides with personal changes, stick to your guns and know that the IPS is there for a reason and it aligns with your long-term goals. Let's move on to the actual contents of the IPA, and this kind of ties in some nice timeless portfolio management principles that I think should be addressed in every IPS. And those are the things that should not be just thrown to the side when uncertainty arises. Um, but Andrew, you and I both know that the answers to a lot of the questions that are in-- that lie within an IPS, uh, those questions are very personal to each individual investor.

And we'll leave that piece, uh, to the financial advisors to really directly have those emotional conversations with clients and figure out what their IPS should look like. But luckily, we can kind of approach it from more of a, a general sense and look at what are some of the major components of an IPS and how do we think about them in terms of uncertainty.

And I think that one of the biggest pieces of an IPS is risk tolerance. So Andrew, take us through kind of how we think about risk tolerance in terms of IPS construction and tie it into the topic of uncertainty.

Andrew: Yeah. Um, this is really most important for me. It's forefront, you know, assessing risk being the top of mind and, and, uh, and really at the leading, um, the construction of an investment policy statement. And why is that? Um, you cannot determine how you position the assets without understanding two things about your client.

That is their ability to take risk and their willingness to take risk. Now, if you're a new financial advisor, you know, you may be getting a lot of contacts from all these service providers, and they have all these tools, and they all do something different. Y- you have to shape what's right for your practice, but you do need to assess two things to get a proper risk assessment of a client, no matter what tool you're using, right?

So on the ability side, that is how much can the client take risk from more of a mathematical perspective, right? We think about how much liquidity they need, how much cash they need on a monthly, annual basis, um, what their time horizon is for that particular goal or for that portfolio, how long can the money stay invested, right?

And then their overall financial wherewithal. What is their income? What are their expenses? What are their assets? How many children do they have? What do they wanna do with those assets, uh, at the end of life or end of retirement, or when they reach their goal? So all the collective happenings around their financial wherewithal and what their ability is to take risk is what, is what you're considering on the ability side.

And, you know, in-- It doesn't necessarily also mean the more money you have, the more risk you can take. Someone with a lot of money might be living with, you know, expenses right up to that level as well, and they don't have a high ability to take risk. So ability is very important for an advisor to dissect from a quantitative standpoint

Joe: And I think this is a good point to mention that like when we're talking about risk tolerance, the ability piece, that's probably a portion that I would think wouldn't change based on what the stock market's doing.

Andrew: No, not at all. And that's, and that's goes right back to what we said about when you change an IPS or what warrants the change for that. On the other side of the risk equation is willingness, more qualitative. How much investment knowledge does the investor have? What is their personal experience with investing?

How do they feel about loss aversion? Do, are, you know, do they hold to those prospect theory numbers that they feel twice as bad about a loss as they do about the benefits of a gain? So, and, and then volatility aversion. I call that the can you sleep at night? You know, if your portfolio moves down by 10%, can you still sleep at night?

And, and, you know, you want to consider the client's willingness along with their ability come up with an overall risk profile that helps you set up the asset mix to meet the objective, and that's the return side, but we can touch on that also

Joe: Yeah, and back to just kind of how an IPS is a, a living, breathing document on the willingness side, like you said, since that is so connected to investment knowledge and personal experience, if we're talking about this in the context of a period of heightened uncertainty, this might be the first time they're experiencing that.

So that might genuinely change their overall risk tolerance, even if their ability to take risk hasn't changed. So it could be a good, good time to consider reassessing the risk tolerance of clients when we find ourselves in a new environment like this.

Andrew: Yeah, and so much more has come out around behavioral finance theory where, you know, traditional finance theory were so built into just the numbers and the economics and the data and the, and the ability side. But more and more tools have come to life and about for advisors to use to assess the behavioral willingness side as well, and it goes to the whole behavioral finance studies.

Joe: And another big piece that we find in every IPS, or at least we should, um, is some diversification parameters. And I kind of want to start our conversation on that front by talking about classic asset class diversification. You kind of alluded to this before. Uh, we're talking mostly stocks and bonds and cash if we're thinking about just the, the classic asset class diversification.

Um, so I'm kind of wondering how you think about that in the current day. I know we've seen some periods where bonds have not done what we wanted them to do. They didn't really provide that ballast in a time of uncertainty. Uh, so how should investors be thinking about classic asset class diversification in periods of uncertainty like this?

Andrew: Yeah. After you and your advisor assess your risk profile, you know, uh, c- and the, and your return need, that is how much on average annual return would you need to meet this goal of yours? Let's just say it's X amount of dollars at retirement. Okay, so we know we need to get there. I know how much risk my client is willing to take and how much return they would need to get there.

How can I shape the portfolio, a mix of stocks and bonds, where I think I could reasonably get or compound at a rate of return to get me to that goal, and are they in line? Now, that asset mix, if y- you know, generally longer term time horizons, m- higher abilities to take risk further away from that goal in terms of nominal dollar amount, you have higher equity portfolios geared towards growth to get you there.

As you're getting closer to retirement, you're dialing down to more fixed income s- so that you're increasing your safety and shoring up the portfolio. That is, it will be less volatile, or in many ways, what you're also hoping to plan for is you're limiting the exposure of volatility in your portfolio in any one given year, because as you get closer to that goal, that Black Swan year could really affect you, and you mentioned it.

Sometimes one of these isn't going up. That is, equities aren't, uh... If equities are down, it might not, you, you may also have bonds down, right? It's not always that the strategic allocation is providing an environment where when one asset class is doing well, the other asset class is doing poorly, or one's doing poorly and one's doing well.

You're hoping for that balance so that you're getting, you know, some level of return in the middle. But there have been many market environments where both correlations go to, to one, and both assets are suffering in down markets. So it's, it's, it's more of an art than it is a science, and that's why reviewing your IPS, your asset allocation with your advisor annually, you know, always makes sense.

Joe: And I think one of the important pieces is really expectation setting around diversification because, yeah, if, uh, I think someone who's not super involved in the investment space, they might think that, oh, yeah, as, as stocks go down, bonds go up. That's just kind of the traditional story that people hear at some point in their life.

But it's really important to temper those expectations and realize that diversification doesn't prevent losses, it doesn't outperform in every environment, and it doesn't provide protection in every environment. But even though it's not maximizing your returns and it's not eliminating risk, it definitely reduces the severity of outcomes in different environments, and it, it smooths out the risk-adjusted returns over the long term.

And even though if we're looking at the hard numbers, if you had a less diversified portfolio that does better over a long period of time, yeah, sure, that's c- cool if the numbers say that. But if we drill down into what the actual investor experience is and what it's like to construct a portfolio that an investor can stick with, I think that trying to smooth out those, those ups and downs over the long term, that makes it more sustainable, and that's, I think, really one of the main benets- benefits of a diversification.

Um, but we were talking about just asset class diversification in that case, and we know that in today's day and age, that diversification goes well beyond the asset classes. I mean, you can drill down into sectors, factors, do thematic diversification. You can diversify by market cap, small, mid, large companies, diversify by geography, diversify by, uh, rate sensitivity.

And so it really, even though people think stocks, bonds when they think of diversification, I think we're in an era these days where it's really not your grandfather's diversification anymore.

Andrew: Well, you know, it's an interesting point, Joe, because-- and I do want to go into this just a bit because portfolio construction and portfolio theory has different approaches. You know, the grandfather's approach, let's call it, or the market cap weighted approach was very easy to understand, um, and you weight your portfolio similar to the market and, you know, you're benchmarking yourself to these market weightings and you're staying as close as you can to them.

And it's very easy to understand that from the top down, things get more risky. That is, a small cap is more risky than large cap. Whereas other frameworks, like a factor-based framework, does a lot to explain where returns are driven from, but it's not as easy to assess, oh, how is the risk of growth compared to the risk of value compared to the risk of momentum?

There's less of an underlying risk framework there. So then you're kind of reverting to s- to use different risk frameworks of, on the portfolio level. S- so how you choose to position assets and what approach you take may very well impact, and is going to impact the return side of, of how you position the assets after you make this client assessment.

So you're right, there's, there's a lot that goes into this, uh, beyond the asset classes, but it's important to be transparent and holistic in your investment policy statement to explain k- the framework that you're following when you set up an allocation for a client.

Joe: Right. And again, just to wrap up this diversification piece, I think the real thing to hammer home is that diversification is kind of a double-edged sword that you're guaranteed to regret at certain times because there's times where concentration-- concentrated plays actually pan out. But again, it comes down to the long-term experience and smoothing out that experience from an investor's perspective, and that's where diversification shines.

But let's move on to the next, uh, strategic consideration, uh, when it comes to managing a portfolio and, and dive into managing cash deployment. And, and you kind of referenced this. I mean, people have the debate of do I deploy cash? Do I hold onto it in cash or, or somewhere in the middle? But what's, what's a real like strategic foundation that we can think about in terms of cash deployment that will help mitigate some of those decisions in times of uncertainty?

Andrew: Yeah, I stick to this core tenet, and I learned this young in my career. It's time in the market, not timing the market that leads to success. Okay? How, you know, contributing regularly and being invested for longer periods of times are what will contribute to the greatest components of your return because you can compound returns for longer periods of times, and nothing in this world is stronger than the force of compounding interest, right?

The longer you can invest and the longer you can compound interest, the more you increase your probability of reaching any outcome from an investing standpoint, no matter how you're invested, and that's something investors have control over. How we shape the portfolio to manage risk to something we don't have control over, what the market does, is the portfolio management piece.

But investors should really pay attention to what they do have control over, and that's how they contribute and for how long.

Joe: Yeah, and I think when we're thinking about the IPS and maybe a way to manage an imbalance between, uh, you, you might again have an IPS where a-- the goal is to get money invested as soon as it's available, but then you're gonna have an investor who in this uncertain time is trying to pump the brakes and trying to think about, "Do I wanna do this?"

So it's an advisor's job to partially, uh, maybe find a middle ground that allows them to sleep at night and not push them beyond their risk tolerance from a willingness standpoint, while also trying to keep them a little bit closer to their risk tolerance from an ability standpoint. And dollar-cost averaging, that is a, a potential tool in an advisor's tool belt that they can use to kind of walk that middle ground.

And that's saying, "All right, we're not going to invest all this cash at once, but we do recognize that we have to get it deployed, and we wanna do this in a, a systematic way that helps us be consistent." And dollar-cost averaging says, "All right, let's, uh, take this cash amount, split it up into however many equal or s- mostly, usually equal pieces, and let's, uh, invest this cash over a regular scheduled period of time, um, so we can kinda walk that middle ground, get you invested without dumping it in all at once and making it harder for you to sleep tonight."

Andrew: Yeah. When you get that cash windfall, if you're a middle career person, you know, and, and you know what do with that, that, that amount of money right away, DCA is a way to meet in the middle and, and start getting that money to work.

Joe: And now we're kind of moving away from components of an IPS, but still thinking from like a foundational, uh, strategic point of minds. And I think one of the big things that advisors can help investors do or investors can do for themselves in a time of uncertainty, it comes back to recenter on your long-term goals.

During periods of uncertainty, those long-term goals can be- come a little harder to see, 'cause you got so much noise blocking you in the meantime. Uh, but really, like I, I know we kind of said this again or said this originally at the beginning when we were introducing the IPS, but that's such a big piece is, don't throw your long-term goals out the window just because of some short-term noise.

Um, and I think that a piece of that equation is a lot of investors tend to get trapped into this way of thinking, uh, it's benchmark rel- uh, benchmark relative investing. And people might look at the S&P 500 and, uh, and even though they're a little bit worried about what might be lying under the hood and, and they wanna take risk off the table, they're also afraid of underperforming.

But I mean, that underperforming versus the benchmark, I feel like from an actual investor standpoint, yeah, psychologically it might be a huge impact, but in terms of long-term portfolio management, the benchmark is your financial goals. What is it gonna take for you to live your best life and reach your financial objectives?

What the S&P does is irrelevant. If the, uh, S&P has a 28% year and you diversified a bit more and got 18%, like that's still in isolation a very good year. So just focus on what does this do to get me closer or further away from my actual financial goals?

Andrew: Yeah. Joe, if there's one takeaway that advisors could walk away with from this conversation, I think this is the biggest one. In some respects, especially when it comes to fear of missing out. You know, so often we compare ourselves to the benchmark versus the S&P versus the MSCI, but the reality is the only benchmark that is important is the, is the client benchmark.

Benchmarks are great for asset managers to compare returns amongst each other or for an advisor to say, "Hey, what asset manager did well versus the other one on an annual basis?" What they're not good for is, is drawing the same comparison for a client because if the client has a return profile where they can com- compound at 8%, let's just say, or 10% to get them to retirement, uh, dollar amount or, or nest egg is the word I'm looking for, you know, in 40 years, then that's, you know, that's the number you should be benchmarking to, how well you do at compounding returns to get them towards their goal.

Not worried about, oh, well, you know, emerging markets did 25% last year and I think the dollar's gonna do XYZ, so if I really wanna get my client there, I need to shift there to look better compared to the benchmark, and that is not, that's not the right approach. The, the, the right approach is a client-centric approach.

And, um, I think it's important and, and why you review performance on an annual basis, not to compare yourself to the benchmark to, but to compare yourself to the goal you're trying to get to. Benchmarks should be internal

Joe: Yeah, and I definitely see why you could see that as being maybe one of the more important takeaways from this whole thing. But I'm gonna move on to the next point, which I think is actually the most important takeaway in that I think one of the biggest things that you can do in these times of uncertainty is really assess the investor's relationship with uncertainty.

And that comes down to realizing that uncertainty, it, it's what drives the risk premium. It's what drives, uh, outperformance of risk assets over the long term and the varying levels of risk and varying levels of uncertainty. That's what creates this, like, big menu of potential investments where an investor can, can pick, uh, what their goals are, what level of risk or uncertainty they are comfortable with, and then choose an investment that aligns with their goals throughout that whole menu.

I think that relationship with risk is people have a tendency to be like, I just don't want to deal with risk or don't want to deal with uncertainty at all." But it's really just part of the game, and it's not something to be avoided

Andrew: You said this, best when we were doing our, pre-review of this, so I'm going to credit your language here before I steal your words, but uncertainty is the price of admission. that's what's at stake. And you said risk premiums. I'll just translate that into a more everyday word for, our clients and advisors.

You're rewarded for returns in stocks better than you are in bonds for taking risk. Risk equals uncertainty.

Uncertainty

is the price of admission.

Joe: it's, a feature.

Andrew: Exactly.

Joe: Perfect. Well, I think that's a pretty good way to wrap up the strategic piece of portfolio construction, but as we know, in today's modern age, it goes beyond strategic foundations, and we also have to be cognizant of investors might want to deviate away from their strategic foundation, and that's where some tactical considerations might come into play.

And of course, there's a, a lot of angles we could approach this from, and we really don't want to be prescriptive by any means. And that's-- it would be hard to avoid being prescriptive if we really started recommending ways to use, uh, tactical portfolio adjustments. But we just want to make everyone aware of maybe some of the options that are available out there in case they become helpful in navigating a client's relationship with risk in these uncertain times.

Um, and if we're looking at various ways of doing that tactically, there's a bunch of products out there that we could look at, and one of the ones I want to start with is just the varying methods of index weighting, uh, that are available out there, and using those as a way to maybe reduce some of that concentration risk if that's something an investor is afraid of.

And one of the big ones that comes to mind is using equal weighted index versus market cap weighted index. We know S&P 500 is a market cap weighted index, so those largest companies that are seeing the strongest performance and they're getting bigger and bigger, as they do better and get bigger, they represent more of the index and that increases the concentration risk.

But we can also do an equal weighted version of the S&P index where we have 500 companies and they are each allotted 1/500 of the weight of that portfolio. And that's kind of a way to still maintain some exposure to those names that are more concentrated while reducing the actual impact of that excessive concentration.

Andrew: Yeah, I'm, I'm gonna comment on this one a little bit, Joe, because just a moment ago I said, "Hey, don't necessarily compare your performances to the benchmarks," but we're saying it's a tactical option to take, um, especially when we consider all the concentration risk in portfolios. So I'm just gonna say, say it this way.

It-- the risk is not that of underperforming the benchmark when you use equal weight. The risk is not being invested in the largest companies maybe as much as you should have. These largest companies are the largest because they're the winners. They're the largest for a reason. You're actively choosing not to bet on the best companies in the world.

So, you know, how you wanna diversify that can be managed, but in today's market, they do make up such a, a big weighting that diversifying against them in an equal weighted S&P would be highly deviated from where the market is. I will also say this. You know, for anyone who hasn't been in this long enough, benchmarks and indexes change over time.

I wouldn't be surprised if we go back to using something like a Dow 30, and maybe not the Dow 30 itself, but, you know, there was a time where that was the most heavily quoted and followed benchmark and what people tried to imitate. As that lost effectiveness, as our-- we moved away from an industrial economy, we looked at, and more people compared themselves to the S&P 500.

More and more people are now looking at a global all cap world index, but how do we know the pivot isn't back to, you know, some AI index of 30 companies? So be careful with that.

Joe: Yeah. Who d- who's to say that in 20 years we have, like, an index of 10 pure AI plays, but tho- those are the blue chips. Those are the, the ones that have consistent cash flow and, uh, they're, they're not the innovators anymore.

Andrew: And the, and the index is meant to be, you know, it grabs like a social consensus that the market participants start saying, "This is the best thing to follow that really imitates the market and our economy and how our, our economy is shaped." And more and more that is AI, so

Joe: Right. And, uh, beyond the weighting schemes that we can look at in terms of reducing concentration risk or modifying concentration risk, uh, there's also the area of defined outcome products and derivatives, which I think are really important to at least know about, um, even if you don't use them, just to know that they're there.

So let's start with some option strategies, and again, we're not being prescriptive or recommending any of this. We just want to make people aware of what's out there. So say someone has a, a larger fear of the downside. They're fully invested in the S&P 500, and they're nervous that things are going to go south sometime soon.

Uh, obviously there's a lot of considerations like capital gains taxes if they were to sell, so you don't necessarily want to sell. Um, or it's just a matter of, I mean, you don't want to miss out on all the participation with the upside of the S&P 500, but you want to protect some of your downside. Well, you could use put options to protect yourg- self against some downside, and obviously there's a cost that comes with that because you have to pay for those options, so it could end up not panning out well.

But it, it's a way to take some risk off the table and, and minimize your downside risk. Uh, on the other side, you have call options. Uh, maybe you don't want to actually be directly invested in these, in these Mag Seven companies, but you also want to have some exposure to potential upside if they really take off.

Call options might be a way to do that, where you don't have to buy the securities directly, but if they perform strongly in the future, you're paying a premium to enter that options contract. But if things go well, then your options will do well, and if things go poorly, I mean, the most risk that you're putting out there in terms of the options trade would be just losing the premium that you paid to buy that option.

And then there's option strategies that allow you to kind of look in both directions. So I think this is a, a g- good one for right now because we're talking about uncertainty. People see the reasons that things could keep going up, up, up, but they also see reasons why things could come crashing down quickly.

Uh, maybe they want to entertain an option straddle, so that's a combination of a call and a put. So it costs a little bit more because you have to buy two options. But if there's a big move in either direction, then you're able to participate in that. So there's a wide range of option strategies, and these are relatively complex investments that are hard for a lot of retail investors to wrap their heads around, so it's important that there's an educational component of this as an advisor if you decide to use these with your clients.

Uh, but it's certainly a tool that you can include in your tool belt.

Andrew: Yeah. I think the big place this is coming up today is that there are a lot of advisors dealing with clients with concentrated positions. They're looking for solutions. Options is one of them to help manage the risk around a concentrated position. It's certainly not for play, right? I don't look at options as something to say, uh, necessarily I just say, "Eh, maybe I'll participate a little bit."

I look at it more of as a tool to help manage risk. Again, you know, putting risk at the forefront of everything. You know, be cautious and, uh, work with a professional, uh, who understands how these thi- these instruments work.

Joe: And that's why it's definitely under the tactical, uh, side. I don't think I'd recommend ever seeing option strategies in, in most of the, like, foundational aspects of an IPS for most retail investors, but something that you can use if the situation fits. Uh, and kind of tying into that, there's another area of the market where it's, uh, defined outcome products, structured notes, buffered ETFs.

I mean, I won't dive into it too much because it really comes back to it's still using derivatives. It's, it's put options, it's call options, the derivative contracts that these investment companies just package together, and they do it in a way that creates an easy story to tell. You can tell your, uh-- the investor can be told, "All right, if, if, uh, say, S&P 500 performs one way versus another way, this is how your product will perform."

There's way to build in some customization, so you can have different levels of upside participation and downside protection. Uh, and again, these are sophisticated products. I remember, uh, my previous role, I was a structured product analyst, and one of the big things I did was just read through the prospectus of a structured note and try to translate it into wor- terms that the investor and the advisor could understand.

And it's, it's more complicated than you'd expect. So if you don't understand it, that's a good sign that you probably shouldn't be invested in it because you don't know if you know how it's gonna pan out. Uh, but again, just want to put it out there because it is out there in the product landscape, and it could be useful in some advisor situation or some investor situations.

And I just kind of want to wrap all that up, um, by highlighting that with everything that we just went through from a tactical standpoint, it's not a free lunch. There are costs involved with it. Um, whether it's options, you're paying premiums to enter into those options contracts, and they may or may not pan out, and especially with structured notes or buffered ETFs.

I mean, it's all about a trade-off between if you want to protect some of your downside, oftentimes you're going to have to give up some potential upside. So you might enter a buffered ETF that, uh, that protects you from a 20% decline in the S&P 500, but if the S&P 500 does really well, then the structured product or buffered ETF might not perform as well as the actual index did.

So there's always, always another side to the story, and that's really important to take into consideration with these tactical moves.

Andrew: Yeah. We see more and more advisors using, uh, different products on the sapphire side, uh, when they want to, um, maybe provide a little enhancement on either the return or risk mitigation side. It's not, uh, incredibly common, but I think it's only gonna be more common with market concentration, but always be careful with different products.

Joe: And for any of our XYPN advisors that are listening, if this does interest you and you're not familiar with it, don't just dive right in, but we're happy to have conversations with you and, and take more of an educational, uh, angle when we're having this conversation. Uh, but I want to wrap up this tactical part of the conversation and, and move beyond products and just think about some, some short-term process improvements or considerations that we might be able to take into consideration during times of uncertainty.

So one of those things is rebalancing opportunities. So how do you think about rebalancing opportunities in such uncertain times?

Andrew: Yeah. Well, if there's more volatility, um, you can take that in your rebalancing strategy one way or another. That is more frequently rebalance to your targets or let them drift and participate in that upside if you think the volatility is, is hap- going to happen to the upside. You know, in a well-crafted IPS, this is generally defined in advance, so advisors take different approaches, whether it be quarterly, uh, annually.

Um, that really is up to the advisor. But with that volatility, there's also other opportunities to, you know, make adjustments of the portfolio, especially when it comes to things like tax loss harvesting. Um, you know, volatility in the portfolio might mean the opportunity to take and harvest, recognize a loss, bank that loss against future gains, uh, to avoid future taxes, and you could always replace that position which you sold at a loss with a similar position that might perf- you would expect to perform similarly.

This has been great in the world of ETFs when you can swap, you know, Vanguard S&P 500 fund for the iShares S&P 500 fund and recognize the tax loss harvest. You know, if you're an individual security investor, that might mean swapping Coke for Pepsi, uh, you know, but most of our investors are invested in ETFs.

Joe: Yeah. But it's just a matter, like we kinda said something similar at the end of episode one, it's you gotta look for the silver linings if you find yourselves in an environment of turbulence. And if you have securities that, uh, perform poorly, then hey, harvest those losses and take the tax benefit. It's the least you can do, uh, if, if you're not happy with the actual performance.

But I think that is a great place to wrap it up, Andrew. And so I just want to kinda sum up everything that we went through and give our listeners something cleanly packaged that they can walk away with In many episodes, we're gonna strive to provide actionable takeaways relevant to the topics discussed.

But in this case, with a topic centered around uncertainty, the takeaway is a little bit more philosophical than actionable. In the current environment of heightened uncertainty, many investors ask themselves, "How do we solve for all of this uncertainty?" But uncertainty isn't something that can be solved, or it's not something that should be solved.

It's the price of admission, and it's the reason that risk assets have historically outperformed in the first place. The real key is getting in touch with our own personal relationships with risk, and that makes financial advisors even more important during this time of uncertainty. Whether an investor is more afraid of the downside scenario or FOMO and missing out on potential upside, that's gonna come down to a combination of factors from where they are in their life and their investing life cycle, to how much pain they can emotionally stomach, what market environments they've experienced already in their life, or what their outlook is on the age of technology and the future of humanity.

Investors' relationships with risk can be as unique as their fingerprints, and it comes down to building a portfolio that they can stick with. Maybe diversify and trim your downside risk if you can't sleep at night, or lean into the concentration if that excites you and you can tolerate a pullback. We could do multiple full episodes on the many different components of risk, and maybe we will.

But for now, the message is, don't try to immunize yourself from risk. Don't try to immunize yourself from uncertainty. Accept it. Thanks for listening to episode two of Balanced PM.