Global equity, fixed income and currency markets have traded with increased volatility over the past two months. Global economic growth is slowing and concerns about inflation levels are increasing, even as numerous governments struggle to implement sound long-term fiscal policies. Even emerging markets (including China) are not immune to these issues, leaving investors wondering where to go.
In this environment and after a decade of disappointment in conventional investment markets, it’s tempting to think that the combination of factors facing investors today implies that traditional guidelines of successful investing – patience, focusing on the long term and staying diversified – no longer apply.
With this kind of thinking, it’s easy to see why some investors are casting about for answers, cures and protection. Maintaining perspective poses a real challenge when so much of the discussion in the financial press centres on such flawed concepts as ‘risk on, risk off’. The noise of trading, rather than investment issues, dominates the media coverage.
Markets have struggled before and they no doubt will again. Times were also tough in 1980-82 when oil reached $35-40pb, inflation rose to double digits and investors considered equities dead. Likewise, 1973-74 saw wars in the Middle East and Southeast Asia, Watergate and the collapse of the US ‘nifty fifty’ stocks. These events dragged down market indices worldwide. Does this all sound at least a bit familiar? We can’t help but notice how asset classes across the globe recovered from each of these difficult periods.
Mark Twain once said, “History doesn’t repeat itself – at best it sometimes rhymes”, and that would seem to be the case now. This period of uncertainty is different to those that have gone before, but it does seem familiar nonetheless – in other words, it rhymes.
When will it end?
The historical ability of markets, economies, companies and countries to heal themselves is well documented. Finding ways to survive, adapt, improvise and then thrive after difficult periods has been the norm throughout history, not the exception. However, no one knows when it will end and that is exactly the point. No one knows. Let reason, not emotion, be your guide.
These are exactly the kinds of times in which to consider the lessons implied by behavioural financial theory. Researchers in the field have identified a number of human decision-making traits that can lead to poor investment outcomes.
In particular, behavioural finance identified that people are more sensitive to financial losses than they are happy about financial gains. We can also be driven to herd-like behaviour, such as panic selling on the way down and panic buying on the way up. Simply stated, making big portfolio changes based on emotions is a bad bet. Avoiding risk can also be costly. Historically, 78% of a market’s first-year rebound has generally come within six months of a market bottom. Given the near impossibility of calling a bottom, the opportunity cost of being out of the market at the wrong time could be significant.
Vanguard’s research has clearly shown the tendency for “excessively rosy forecasts because of overconfidence and excessive extrapolation”, as well as “the resetting of those forecasts to an excessively cautious level in the subsequent market crash”.[1]
While it’s now fashionable to talk about new investment paradigms and the need for ‘absolute return’ portfolios, both institutional and individual investors should tread cautiously. The data and theory supporting a long-term equity risk premium are robust, while there is limited basis to support assertions that ‘absolute return’ portfolios will deliver as promised.
Stick to the plan
Cagey investors structure their portfolios based on a carefully considered asset allocation plan that reflects their willingness, ability and need to take risk. Rebalancing to ensure the portfolio stays true their risk profile requires discipline to take away the problem of emotional decision-making. A disciplined rebalancing approach can seem counterintuitive when it suggests selling ‘winners’ and buying the laggards. Successful investing requires patience, perspective and the discipline to keep emotions at bay.
