There has been a lot of talk recently about whether there is a bubble in certain parts of the market, but this might be the wrong question. Perhaps we should instead be asking what we would do about it if there was one. Imagine if you – and only you – knew for certain that there was a bubble in US equities. What action would you take?

Let’s define some terms. You are managing a traditional multi-asset portfolio holding a globally diversified mix of assets for long-term growth. Through an unexpected dose of divinity, you know without any doubt that US equities are in the midst of an investment bubble – that is, valuations are unsustainably high relative to underlying fundamentals and will aggressively revert at some point.*

There is a catch, however. Your ability to see the future does not extend to timing. So, while you know a bubble exists, you have no idea when it will pop.

You know something will happen, but you don’t know when.

How would you adjust your asset allocation?**

For your personal portfolio the answer is probably straightforward: you remove most, if not all, of your US equity exposure and are comfortable being patient (perhaps you simply invest in non-US equity markets).

If, however, you manage money professionally for others, the answer is likely to be very different.

When a professional investor assesses an investment opportunity and decides how to size it, they think primarily about four things (or at least they should):

• The potential payoffs – the future returns in different scenarios.
  
• The probability of each payoff – how likely each return outcome is.
  
• The cost of being wrong – the impact if the assumed payoffs and probabilities prove incorrect.
  
• The need to survive – how much underperformance we can bear.

The final element – survival – is about understanding that being right isn’t always enough. It is about our ability to withstand the path to validation. It asks:

How can I size a position so that I don’t lose most of my assets, or my job, if it temporarily goes against me?

Drawdowns, whether in absolute terms or relative to a benchmark, are incredibly challenging. And it is not just their depth that matters, but their duration.

If you don’t scale your position for survival through time, then whether you are correct can become an irrelevance. That is why, for professional investors, even the enormous advantage of knowing without any doubt that US equities are in a dangerous bubble would not make allocation decisions easy — unless you also knew the timing.

Imagine you take the bold choice to reduce your exposure to US equities by three-quarters because of your bubble prescience. What if the US market outperforms for the next four years? You will appear completely wrong and probably lose a lot of clients, even though you possess an exceptionally valuable piece of foresight.

When managing a portfolio, sizing is all about survival or gauging your ‘portfolio pain threshold’ – for how long and by how much could you bear a decision appearing wrong, even if it is ultimately right?

This reality of professional investing can lead to behaviours that seem irrational — such as holding an asset you know is in a bubble — but are in fact ultra-rational within the context of surviving the unpredictable nature of markets.

This dynamic makes it essential that professional investors ensure their clients have clear expectations about the approach being adopting and the performance realities that come with it.

Unfortunately, no investor has advance warning of what will happen in the future. We must contend not only with the pain of short-term underperformance when we are right, but also with the uncomfortable truth that we could be completely wrong.

It doesn’t matter how confident we are in our investment thesis: if we don’t consider survival and understand our tolerance for portfolio pain, we might not be around to benefit even if we are ultimately vindicated.

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*This is not a view, just an example for the sake of the post.

** No options or instruments with convex pay-offs are allowed, as that spoils the game. The question is – how would you adjust your allocations in a simple fashion?

This is an excellent piece from alpha architect on why seeing the future wouldn’t stop an active manager getting fired.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.