Stressful events such as the current bear market are an unpleasant reality, with many investors trying to wish away negatives results in the hope they become a distant memory, but they also provide incredibly important lessons for investors and financial advisers.
While our present inclination might be to focus on the specifics of the COVID-19, we should instead consider how we can learn the right lessons about both our investments and our behaviour during periods of severe market stress. Because a decision made during such stressful periods can define long-term outcomes. Here are some lessons I think are important.
In the current environment, investors will have a love-hate relationship with cash.
When rates are on the floor, very few people are comfortable holding cash. For most investors, it generates a nominal return post inflation and tax. These trivial returns become even more painful when all other assets are delivering strong performance, and the longer a bull market persists the more unpalatable holding it will become.
In times of market stress, however, cash can become the only asset that investors want to hold. Yet it is incredibly valuable in times of extreme market dislocation. So, what is the answer?
Well, investors could have a sensible long-term view on the role of cash in a portfolio and be content with that. But if an investor wants to own a meaningful level of cash permanently, then they can't complain when their portfolio lags in a bull market.
Downturns are inevitable in long-term investing.
According to the late financial economist Hyman Minsky, market stability itself is destabilising and investing in any form involves downside risk.
An extended period with few slowdowns does not mean that this risk has been eliminated. My sense is that many investors tend to underestimate the potential for downsides in investment portfolios, so it is crucial to be realistic about this from the outset. To generate stable long-term returns and enjoy the benefits of compounding, we need to be willing to bear such risks.
Some alternatives are not that alternative.
Low bond yields amidst COVID-19 outbreak have pushed more investors into alternative asset classes and strategies to enhance portfolio diversification. This is not the first time this has happened.
According to Financial Times, in 2016 when yields on safer government bonds hit rock bottom, alternative assets such as property, infrastructure, private equity and hedge funds were bought up by institutional investors (a company that invests money on behalf of clients or members).
Despite this, historically, market downturns highlighted two crucial aspects around alternative asset classes for investors to consider:
Some strategies appear diversifying until a severe spell of market/economic weakness arrives, and diversification disappears just when you need it. As a famous quote from Warren Buffett reads, "You only learn who has been swimming naked when the tide goes out."
Even if assets are genuinely distinctive from other traditional assets, when there is a rush for cash, everything can get flattened.
We need to have a plan, a plan we can stick to.
Making plans for volatile market conditions is a crucial element of prudent long-term investing. In essence, it is the only thing that will protect us from the news flow, negativity, anxiety and stress, which lures investors toward poor choices.
Investment plans are incredibly important, but also behaviourally challenging to follow. In a bull market it is easy to say: "In the event of market fall, investors should increase their exposure to equities".
The problem is that when investors make such commitments, they neglect to consider how they will actually feel at the time it happens. All sorts of questions and self-doubts come into play: markets are declining for a reason; global news is uniformly terrible! This time it is different; are we sure that our plan was sensible? Hasn't everything changed?
Sticking to our plan will be the last thing we want to do. That is why financial plans and roadmaps need to be clear, specific, realistic and systematic, as far as possible.
We are not epidemiologists. Even if we were, we still wouldn't be able to time markets.
Let's be clear about short-term market noises in this environment. Predicting the future means taking a view on the progression of the virus, the fiscal and economic responses, the economic impact of the reaction, the prospects for businesses and supply-chains, unemployment levels, and, importantly, the behaviour of other investors – all of this on a global scale. That seems like a challenging prediction to make!
Decisions we make in periods of stress will have profound implications for our long-term results.
A virus outbreak, an economic shutdown, negative oil prices – these were not in any forecasts or captured in risk models. As uncertainty increases and markets fall, there will be a certain demand for market activity. Things are happening – what are we doing about it?
For investors, the right thing to do is: discuss or seek help from an adviser or professional, stick to the plan and evaluate whether your plan is still appropriate or may need some slight adjustments.
In summary, despite the unpleasant current reality, there is always an opportunity to learn and refine our assumptions ensuring we are putting ourselves in the best possible position for the long term.
Kia Kaha (Be strong)
Kia Maia (Be steadfast)
Kia Manawanui (Be willing)
The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz
