market views

Don't Gamble When Investing—Diversify

Chris Gaffney | May 1, 2017 3 MIN READ

I’m a hockey fan so this is absolutely my favorite time of year. My St. Louis Blues are a big underdog going into the playoffs. Most of the smart money is riding on the Washington Capitals who had the best record in the regular season. They seemingly deserve the title of being the odds on favorite to win the Stanley Cup this year. You’d certainly have to think there are those out there who’ll be betting on them.

Whether you’re betting on a game, spending time in Vegas or whatnot, gambling comes in all shapes and sizes. Investing is even sometimes referred to as gambling, and for speculators, that is certainly a proper description. But most investors would probably shun the label of gambler. And when you look at the returns generated by the S&P 500 in the chart below, it doesn’t look like much of a gamble at all.

View a larger image here

Data Source: Bloomberg


But just like in hockey, you certainly can’t predict the future. A goalie can go cold, stars can get hurt, and sometimes the puck just doesn’t slide your way. Investors, just like the folks who set the gambling odds, have to consider the uncertainty of the future in valuing today’s investments. This is done by discounting the present value of future earnings for companies. But what discount rate should be used? And can you fully price the probability of black swan events, those which nobody can really predict?

WILL PRICING FOR PERFECTION PAN OUT?

A popular way to try and compare the valuation of different equity markets is to look at the trailing twelve months price earnings ratio or TTM P/E. According to this popular measure, the S&P 500 is very near the highest level in the past five years. TTM P/E for the S&P 500 has averaged 17.6 over the past five years, and the 22.0 high was reached in March of this year. The March 31 level of 21.6 is very near this high point, and would indicate that we’re reaching the top end of valuations. With the TTM P/E still near the high point, investors seem to be convinced that the U.S. equity markets are the odds-on favorite to continue to produce the best risk-adjusted returns over the next 12 months.

View a larger image here

Data Source: Bloomberg


But here's something to consider. These valuations show that investors have priced these markets for perfection. Valuations reflect the best-case scenario of sustained earnings growth, continued stimulus, and lower interest rates. Remember though, there’s a lot going on nationally and on the global scene. Enough so that some could start to re-consider these optimistic outlooks.

DIVERSIFICATION IS KEY

I don’t mean to suggest that the equity markets can’t continue to climb higher, especially if the global economic recovery gathers steam contributing to higher growth and earnings for companies. The point is we just don’t know what will happen. But assuming the best-case scenario has already been priced in, I think the greater risk is on the downside. What can investors do to protect their portfolios? I believe that the simple answer is diversification—spreading the overall risk by allocating investments across multiple asset classes and even into non-U.S. markets.

And while investors should certainly look at markets that are most favored, spreading a little money around can sometimes be the safest bet in the long run. Just like in the NHL, even the professional handicappers get it wrong sometimes. In the case of my St. Louis Blues, I’m sure hoping this is one of those times.

Chris Gaffney
Chris Gaffney
President, EverBank World Markets
Chuck Butler
Chris Gaffney
President, EverBank World Markets
With over 30 years of experience in the financial services and global markets industries, Chris is often called upon by the national media for insights and commentary on the news and trends shaping our world economies and opportunities.

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