January 2, 2021
One of the notable features in the markets over the last year has been the return of volatility. After almost three years of unusually volatility-free growth in equity markets, the end of 2018 saw a big correction, followed by a sharp recovery in 2019, with more turbulence along the way.
This has been against a backdrop of political drama, as Brexit continues its twists and turns, and POTUS wages Twitter wars with either China or the Federal Reserve, depending on which Fox & Friends op-ed he’s streamed at 3AM while chugging choco shakes in his DJT bathrobe.
Many investors have had questions and concerns about what all this volatility and underlying political upheaval means for their investment strategy.
The first and biggest question is whether it fundamentally changes the arguments for investing in the first place. History suggests not.
Going all the way back to why we hold different asset types in a portfolio, and what their roles are, 'Risk assets', such as stocks and shares, are by their nature volatile. The reward for taking on this risk has, over time, come in the form of a 'risk premium'. This is the name for the slice of returns over and above what you could get from a ‘risk-free’ asset (say, short term treasuries). If there was no risk premium, investors would - rationally - hold only the more stable assets. The risk premium varies across markets and time periods but, since the mid-1970s, is generally considered to have been between 3.5% and 5.5% (source: investopedia.com, January 2020). The important point to bear in mind is that this long-term average masks the fact that there have been many shorter periods when the risk premium was strongly negative. This raises another question which comes up regularly in the minds of investors – 'is this time different?' This is a subject tackled by Carmen Reinhart and Kenneth Rogoff in their excellent Book This Time Is Different: Eight Centuries of Financial Folly. They make the point that, throughout history, people have been crashing and recovering their way through many and varied financial crises, but that holding risk assets across cycles has still delivered for investors.
Each time, there has been table-thumping and shouting from experts that the old rules of valuation no longer apply, that the new situation bears little similarity to all the past disasters. But, in reality, every new crisis has a precedent in history. The technology bubble at the turn of the millennium pales in comparison with ‘Tulip Mania’. In the 1630s, the going rate for a single Semper Augustus bulb was reportedly 12 acres of land. They should have hung on for 15% off in Homebase.
Despite all this, so far throughout history the fundamental trends have persisted, including the reward investors have received for holding risk assets.
Of course, knowing this is great but it doesn't solve everything. Even the most sophisticated investors are still, to an extent, at the mercy of behavioural finance biases which reduce their ability to behave rationally. Some of the most common of these are:
Risk aversion is normal, and entirely rational. But one of its quirks is that people tend to feel the pain of losses more keenly than the joy of gains of the same magnitude. Portfolio losses can therefore stick in the mind more, making it hard to assess past performance in a balanced way.
People are often drawn to information or ideas that validate existing beliefs and opinions. This can make it hard to interpret financial news in an even-handed manner.
People tend to overestimate their ability to control and influence events, which is challenged by the inherent unpredictability of markets. Investors can sometimes express a preference for investments which they see as more tangible, and therefore easier to understand and control, such as residential property or gold. But in reality, such investments still carry risk, and investors are similarly unable to control the forces which drive their prices.
The tendency to over-extrapolate recent trends, which often lurks behind both speculative bubbles ('buy high') and the disposal of holdings at a loss ('sell low').
People are social animals and as useful as this is in many areas of life it can be a hindrance in investing, where a tendency to follow the latest trend and not miss out can move people away from their carefully designed long term strategy.
We've had some excellent reminders of this in recent years. As Donald Trump's surprise election win began to materialise, US futures markets implied large losses for equities. But this was quickly reversed and headlines on finance websites like ‘FTSE 100 sees £37bn wiped off value as Trump win sparks market turmoil’ were hastily taken down as markets recovered, then rallied to register record breaking highs in early 2017.
Before that, the Brexit vote had already shown the dangers of giving up a long-term strategy to chase short term trends and market noise. Again, the initial correction, after the 23 June 2016, was quickly reversed and gave way smoothly to talk of a ‘Brexit bounce’, as though that was always a 'thing'. This can be a problem. Despite the truth of William Goldman’s famous line 'nobody knows anything', that won’t stop people claiming to have simple answers that can be condensed down to newspaper headlines which sell copy. People will extrapolate and assert and express views and predictions that will sound convincing now but completely ridiculous in a year.
So what the heck should a concerned investor do, accepting that risk and volatility are an essential part of investing, and that their ability to make decisions about risks are fatally impaired by behavioural biases?
It’s wise to remember two broad principles.
First, invest with a plan. If you know, following proper consideration, why you are investing, what return you are seeking and what degree of risk you are prepared to tolerate (as opposed to simply chasing maximum returns without considering the 'why') then you should be better equipped to make sensible judgments about whether your strategy remains appropriate over time. If you have a long-term plan and your portfolio is structured strategically to achieve this, accounting for the inevitable ups and downs in the markets, then you can resist the urge to respond to market noise and take rash decisions.
Second, for most investors, it is appropriate to diversify sources of returns to manage risk, rather than chasing the 'best' asset class or individual holding, with all the risk that entails.
If you have a portfolio that is diversified across different asset classes, regions, sectors, and if that diversification has been maintained through regular reviews and rebalancing, then you’re ahead of the game. Given a wide range of outcomes it’s important not to be dependent on a small number of them, which is where investing strays into speculation. As the markets' reaction to Brexit and Trump proved, even when the initial response seems to tell a particular story, the cause and effect become less predictable the further you project into the future.
At times of uncertainty, there is often a flight to haven assets, such as gold and historically stable currencies. Such a move can seem appealing but is actually speculative in itself, in that these assets themselves fluctuate aggressively, and moving in and out of risk assets in an attempt to benefit from short term movements introduces timing risk on top of the risk present in the underlying assets themselves. The fact is, most investors get timing decisions wrong and the cost of that can be massive.
Unfortunately, too many advisers and investment managers fail to properly prepare clients for the way markets naturally work when they set up a portfolio. They present attractive cashflow projections, using straight line returns which, without the proper context, are insanely misleading. If we know one thing about market returns, it’s that there will probably never be a year where we nail the long-term average.
At Eleven.2 we always make sure clients, and we as their advisers, are very clear about the ‘why’ before we give any investment advice. Our plans are constructed, and regularly reviewed, with reference to a bespoke lifetime cashflow plan. That way, we know what return is needed, and how much risk is acceptable in pursuit of that return. And plans are stress tested against a range of projected outcomes, so that the natural ups and downs are accounted for in the plan before they happen.
We also respect human fallibility. The right amount of risk is not just about the maths. We aim to educate clients about the different (and competing) types of risk and the trade-offs between them. But we don’t twist arms and we respect that fact that risk tolerance can have deep roots, which it’s our job to understand and respect. A portfolio with huge return expectations, but a volatility range that gives you night terrors, is not a good outcome.
So, in conclusion, if you have a robust long term strategy and a properly thought out and diversified portfolio (based on long term evidence of risk premiums and the relationships between asset types), then you can relax and feel smug when stories about financial Armageddon make it onto the front pages of newspapers. You’ll be safe in the knowledge that the need to make knee jerk decisions has been removed.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
The information contained within this website is subject to the UK regulatory regime and therefore restricted to consumers based in the UK. The Financial Ombudsman Service is available to sort out individual complaints that clients and financial services business aren’t able to resolve themselves. To contact the Financial Ombudsman Service, please visit www.financial-ombudsman.org.uk.
