By Gemma Godfrey
The room’s getting crowded, the party’s been going on a while but more people could still arrive. Just beware fair weather friends and any signs it's time to leave...
For U.S. stocks, 2013 saw the best return in 15 years, as the value of world markets increased by over $6 trillion and the amount of money investors ploughed into equity funds hit record levels. While optimism has bred yet more optimism, these are the questions that all investors should be asking at this point:
How crowded is the party?
In a recent survey of fund managers by Bank of America Merrill Lynch, 54% said they are overweight stocks in their portfolios and 48% have a higher allocation of shares of technology companies than a broad equity index. That's the second-highest percentage for that latter figure in nearly a decade.
However, the risk of owning something many other people own can cause problems when there is a widespread move to sell. When everyone’s rushing for the door, you need a way out or you could be in trouble. This can turn a minor inconvenience into a full-fledged panic.
How long’s the party been going on for?
It has been more than two-and-a-half years since the last "correction," defined as a fall of 10% or more, and in 2013 the market avoided stumbling by even 5%. Whilst similar has happened twice before in the last 25 years, the concern is that both ended in a severe and devastating drop in share prices. The stock market, over the longer term, is not a one-way bet.
And how are the guests feeling?
However, investors seem to be worryingly complacent right now. Expectations for how much the stock market will swing in value are at a near seven-year low. Indeed, stock markets continued to rise in the face of a government shutdown and, at certain points during the year, weaker than expected jobs data. Nevertheless, as government support winds down, investors will be less able to shrug off bad news or continue to look through "beer-goggles" when it comes to their investments.
Any more guests to arrive?
The good news is that not all investors have been complacent and many are still not fully invested in the stock market.Individual investors, operating with their own money rather than a company’s or clients’, still have a large amount of money sitting in "cash-like" funds. This could make its way into the stock market if confidence were to continue to grow.
How committed are they to keeping the party going?
As more cautious investors, however, these are fair weather friends. They are more likely to race to the door at the first sign of trouble and perpetuate rather than offset widespread selling.
Conventional wisdom argues that these investors can be "late to the party." Needing more convincing, they may watch share prices rise for too long before buying. This has been challenged since markets can continue to rally for many years after they invest. However, knowing there to be fewer guests left to arrive can provide valuable caution.
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