The Globe and Mail, Report on Business
Published October 1, 2010

“Maybe you might have, some advice to give, on how to be insensitive.”

The chorus from this great Jann Arden song speaks to where the investment industry has gone over the last 20 years. I’m not referring to touchy-feely, relationship stuff, but rather a hard-core investment issue – valuation.

Today, investors are much more “price insensitive” than we’ve ever been. Many portfolios are set on auto pilot – they’re managed by fixed rules as opposed to being shaped by how attractive stocks and bonds are relative to each other.

In the area of asset allocation, a majority of portfolios are now built around a strategic asset mix. They may shift a little between asset classes, but basically they hold the same proportion of stocks, regardless of whether stocks are cheap or expensive.

As for security selection, the indexing trend has moved us a long way toward being valuation insensitive. The holdings in a traditional index fund are based on company size, not the price tag on the stocks. This showed itself in an extreme way in the late 1990s when Nortel, which was trading at an unprecedented multiple of earnings, accounted for a third of the S&P/TSX composite index based on its market capitalization.

Today, investors are subjected to an array of structured products, many of which are index based or hold a set basket of securities (that is, blue-chip or dividend-paying stocks). These products, including some principal-protected notes and other “guaranteed” products, take insensitivity a step further. They are designed to do “dynamic” hedging, rebalancing or leveraging, which means they actively increase or decrease market exposure at exactly the wrong time – they buy more when prices are up and sell when they’re down. They’re dynamic alright, but in a way that runs counter to common sense investing.

Now, being the new-age sensitive guy that I am, I have mixed feelings about this trend.

On the surface, I don’t get it. Why would anyone buy a security without evaluating its price? We don’t do that in any other aspect of our life.

On another level, I’m excited about it. The more insensitive investors become, the more opportunity there is to pick up bargains. Purchases and sales done for non-economic reasons provide fertile ground for portfolio managers.

For example, when a company splits itself up, or spins off a division, the new entity often doesn’t qualify for the index and isn’t large enough to be held in billion-dollar portfolios. It automatically has to be sold, no matter how attractively priced it is.

Now I’m not saying that insensitivity is always a bad thing. In fact, on the individual investor level, it’s smart to be insensitive, particularly when it comes to asset allocation. Regular rebalancing is the best strategy for all but the most sophisticated investors. It’s a discipline that encourages buying low and selling high. Yes, the weighting for each asset class is set no matter where valuations are, but it means portfolios don’t get loaded up with the most expensive assets at the wrong time.

And even though index funds ignore price, for investors who don’t have the knowledge or confidence in an adviser to pursue active management, they’re an effective way to execute an investment plan.

The question is, can we do better than succumb to this heartless trend?

I think so. At our firm, our preferred approach is to be hypersensitive at the security selection level. Our fund managers spend their days looking for bonds and stocks that are cheaper than the overall market. But when it comes to asset allocation, we dial down the meter to “numb,” in recognition of how difficult it is to time the market or shift between asset classes. We encourage our clients to stay close to their strategic asset mix and make significant shifts only when there are severe dislocations in the market.

The tech bubble and Wall Street’s mortgage meltdown are reminders that the trend toward valuation insensitivity can go too far. At times of extreme valuation, cheap or expensive, investors need to be sensitive to the price they’re paying.