The sharp falls we have seen in equity prices in recent weeks remind us how swiftly investor sentiment can change.
While lower prices are beneficial for investors with a long-time horizon and periods of volatility create opportunities for excess returns in the future, abrupt changes in market conditions, which are usually accompanied by macroeconomic and geopolitical concerns, tend to be treacherous for investors as they encourage poor decisions that can prevent investors from reaching their goals.
So how should investors approach the conditions in which we find ourselves? Rather than address each of the specific concerns that are driving current price movements, it is more useful to create a framework to help us avoid mistakes in any market environment.
Set the objectives
First, we need a clear objective for our investment and deploy capital accordingly. While this may appear obvious, objectives are typically personal to the end investor, while professional money-managers tend to have broader objectives, such as maximizing returns for a given level of risk, replicating a benchmark or beating a peer group. Objectives that are of limited relevance to the end investor. Consequently, typical measures of success used by professional investors are of similarly limited value. The most important measure of success for an investor is whether they are getting closer to their goals and at what pace. While the recent falls in asset prices may be disconcerting, veteran investors are likely to still be ahead of their planned path towards their goals. This forward-looking approach helps prevent errors that arise when investors focus on the past.
Manage the expectations
Second, we need to take the uncertainty of the future seriously. Human beings dislike uncertainty, which, following Prof. Frank Knight, we can describe as a situation in which both the outcome and distribution of possible outcomes is unknown. When faced with the uncertainty of the future, we typically try to simplify it by imposing a defined distribution upon it or, more naturally, substitute uncertainty for certainty by applying a narrative to current events that make the future appear obvious. Both of these approaches are inherently appealing but dangerous to investors as they promote the overconfidence that is at the heart of the most serious investing errors.
The irreducible complexity of the future demands a combination of humility and boldness from investors. The former, to accept what we do not know and the latter to seek returns when offered favourable prices.
Investors with these characteristics are unlikely to be at the top of the short-term performance charts in any particular environment, as that honour will go to the confident investor that structured their portfolio as if the future was known. Over the long term, these confident investors tend to fall by the wayside, as the period to which their portfolio was perfectly suited is outweighed by those periods where it was spectacularly unsuited.
Focus on valuations and fundamental research
Third, to cope with uncertainty, we must build portfolios that are robust to a range of potential market and economic scenarios. The focus of such a portfolio is to access the benefits of a compounding return.
The long-term impact of the continuous compounding of returns is the key to helping end investors reach their goals but is frequently underestimated in the pursuit of short-term returns. Permanent loss of capital, that can occur when one becomes too enamored with one vision of the future, is the enemy of compounding. Such losses typically occur when one pays too high a price for an asset that is vulnerable to the future. Typical examples would be companies with significant debt, poor governance/risk management or subject to technological obsolescence.
Equally, overly aggressive growth assumptions can lead to valuations that can never be justified, leading eventually to a decline in price to more realistic levels. This latter characteristic has been clearly demonstrated by the price movements in the most aggressively priced technology stocks over the last few months. A robust portfolio must therefore be grounded in a sound understanding of valuation and informed by fundamental research.
Keep the rule of diversification
Fourth, to be robust, a portfolio must employ effective diversification. We typically think of diversification as holding a variety of different assets in a portfolio, but Howard Marks describes it more correctly as holding assets that ‘respond differently to the same factors’. This variability in response not only benefits the portfolio, but also the investor.
By ensuring that the portfolio is less vulnerable to a single economic or market outcome, an effectively diversified portfolio should also deliver fewer surprises for investors. These surprises can cause stress; exacerbating the behavioural biases we are trying to avoid.
While we don’t know what the future holds, we do know that having a sound framework for investing can help investors avoid mistakes during turbulent market conditions. This, in turn, can provide access to the benefits of compound returns. To help people reach their goals we therefore need to focus less on maximizing returns today and more on building robust portfolios for tomorrow.
Dan Kemp, global CIO, Morningstar Investment Management
Neil is the Deputy Editor of the wealth titles, including ifa and InvestorDaily.
Neil is also the host of the ifa show podcast.
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