We are living through extraordinary times. All facets of life as we know it have changed in some way. The impact of the coronavirus on individuals, families, businesses and countries has been immense and will continue to be so for the foreseeable future.
As the number of infections continues to rise rapidly around the globe, entire countries are in lockdown, with economic activity virtually coming to a halt. Many people are being retrenched globally while businesses face uncertain futures, and global health systems are under strain. Governments have rushed to respond with various economic rescue packages, the success of which remains to be seen.
Equity markets have responded to the crisis by falling in excess of 30%, while bond and credit markets have also been volatile.
There has been no place to hide, with even “safe haven” assets like gold falling. During times of crisis like this, many articles will be written about the importance of investor behaviour and how important it is to be aware and control emotion when making investment decisions. The common refrains repeated include:
- Don’t panic!
- Trust the process.
- Don’t liquidate and sell risk assets after they have fallen.
- Equity markets have always recovered their losses following a crash.
- Significant market falls mean there are buying opportunities
It is not different this time!
This is always a lot easier said than done but in the vast majority of cases, the advice is sound.
The reality is that there is very little that can be done to manage the assets in the middle of the crisis – the opportunity to make changes and restructure portfolios is before and after the crisis.
The best opportunity to deal with a crisis is before it happens
A market crash always highlights the importance of proper financial advice and ensuring that individuals are invested with appropriate levels of risk appetite and importantly appropriate time horizons.
If an individual goes into a crisis appropriately invested and diversified given their specific circumstances, then the risk of poor investor behaviour is significantly mitigated. For example, an investor with a long-term time horizon sitting in high levels of risk assets should be able to follow the advice above and ride out the storm. The problem comes when an investor has taken too much risk given their circumstances by chasing extra return and needs to access their assets over a short-term time horizon. This often results in being a forced seller at the worst time.
“…the opportunity to make changes and restructure portfolios is before and after the crisis.”
The same rings true when building investment portfolios. Appropriate risk management and portfolio construction over time should allow a portfolio to ride out extreme volatility.
The challenge arises when undue risk has been taken chasing extra return. In our opinion, the massive flows into “search for yield” investments over the past few years is an example of this. Many portfolios have added high-yield corporate credit indiscriminately, chasing the higher yield and excess returns given without properly assessing the associated risks.
Disinvesting from a particular asset held in a portfolio in a falling market is at best difficult and at worst not possible due to liquidity drying up. Funds are then having to deal with redemption requests from clients and, as a result of illiquidity in certain of the assets they hold, are forced sellers of their more liquid assets. This increases the proportion of the fund held in the illiquid asset, exacerbating the problem. There is usually no opportunity to deal with the problem assets in the middle of the crisis.
Portfolios end up having to close to redemptions and investors’ capital is locked up at a time when they can often not afford for that to happen.
Calling “the bottom”
One of the most difficult investor behaviour challenges to deal with is buying assets after a significant market fall. When everyone is selling amidst mass panic and peak pessimism, it is very difficult to be contrarian and buy risk assets. People talk about waiting for “the bottom” of the market so they can buy.
It is impossible to call the bottom.
In his latest newsletter, Howard Marks from Oaktree Capital states, “The bottom is the day before the recovery begins. Thus it’s absolutely impossible to know when the bottom has been reached… ever. Oaktree explicitly rejects the notion of waiting for the bottom; we buy when we can access value cheap.”
That echoes our thoughts exactly. It is impossible to call the bottom. Marks goes on to write, “Given the price drops and selling we’ve seen so far, I believe this is a good time to invest, although of course it may prove not have been the best time.” And that is key – it is not about buying at the cheapest point, it is about buying at a point when the future returns from an asset compensate the investor for the risk been taken. It seems obvious but is a very difficult thing to do in the middle of a crisis.
We expect volatility to continue as the reality of the impacts of the coronavirus are revealed. Now is certainly not a time to panic.