COVID-19 & Investment Markets

The world is watching with concern the spread of the new coronavirus. The uncertainty is being felt around the globe, and it is unsettling on a human level as well as from the perspective of how markets respond. Further complicating an uncertain market are Saudi Arabia and Russia's oil price war, rate-cutting by the Fed (joined by the Reserve Bank) and upcoming US elections.

We are now starting to find ourselves affected by the virus in our day-to-day lives. I have returned early from a trip to Japan due to the closure of tourist activities and new travel restrictions. I am writing this now in my second week of self-isolation, as recommended by NZ health officials. I know many have cancelled upcoming trips. Many more will feel the impact on their careers.

We are always available to discuss recent events and how it affects your plan and your portfolios. We may also be limiting domestic travel, opting instead for conference calls when necessary.

In times like these, even experienced investors can feel uneasy. We want to help you make the best financial decisions while we navigate through the uncertainty.


Recent Market Volatility

As the situation develops globally, investment markets have rapidly priced in new information, expectations and risks. It is clear the efforts to contain the spread of the virus will affect economies worldwide. Economists are still uncertain of the size and duration of this shock.

We believe this uncertainty is already priced into the share market, as investors address both:

  1. decrease in expected future company revenues and;

  2. An increase in rate of return they require from investing (or maintaining investments) in these companies today, due to the added uncertainty.

Both events contribute to a lower share price, and this has been reflected in some sharp downward price movements in recent weeks.

We believe investment markets are very efficient. All information available to investors is incorporated into share prices.

We believe investment markets are very efficient. All information available to investors is incorporated into share prices.

The information available to investors is changing constantly. When bad news is released, we expect prices to adjust, reflecting changes in expected earnings and perceived risk. Likewise, if good news is released, share prices will likely rebound. More specifically, prices will change to reflect the expectations of investors.


Many Investors Follow Their Emotions

It is entirely normal for investors to feel worried during times of volatility. Two behavioral biases, hard-wired into our brains, make downturns particulary difficult:

  1. Loss aversion - People feel pain of losses twice as strongly as pleasure from gains.

  2. Recency bias - More recent information is given more importance in decision-making.

Together with our tendency to expect recent trends to continue, these biases tempt us to make rash decisions. History shows these decisions lead to poor outcomes for investors.

Emotions often drive investors to buy high in elation or sell low in fear.

Emotions often drive investors to buy high in elation or sell low in fear.

We don't yet know if shares will continue to fall in value. We do know current prices reflect all available information along with the uncertainties. We may already be at the "fear" stage of the cycle, soon to reach optimism as new information becomes available.

Emotions are inseparable from investment. Patience, discipline and planning are what deliver long-term returns.


Past Downturns and Recoveries

History shows us how unpredictable share markets can be. Prices often fall, sometimes very quickly. We can also see how quickly they can rebound as new information becomes available.

Since the end of WWII, the US share market has dropped more than 10% in 15 different periods.

Since the end of WWII, the US share market has dropped more than 10% in 15 different periods.

Each downturn in the graph above was precipitated by different factors,as shown by Wikipedia's list of stock market crashes. Many commentators are saying we are now in unprecedented territory, but the same applies to previous crashes.

While much uncertainty remains as to how a pandemic of this scale will affect the global economy, one certainty is the market always recovers. We have no way of knowing when the recovery will begin, so staying invested is essential if we want to benefit during the rally.

There is no pattern in the length or severity of downturns. However, the recoveries are consistently strong and sudden.

There is no pattern in the length or severity of downturns. However, the recoveries are consistently strong and sudden.

Volatility is a key feature of investing in shares, indicative of the risk for which we are compensated for long-term.


Dangers of Market Timing

It may be tempting to sell now and wait for things to "settle down". Doing so now means selling at a discount, selling low and waiting to buy high.

The reason even experienced managers struggle to properly time markets (and why we don't include timing in our strategies) is because you need to be right twice. You must identify when prices have peaked and when they have bottomed out.

Adding to this difficulty is the nature of share markets to deliver returns in short bursts. The best month, week, or sometimes day in a given year often represents a significant part of the returns investors receive. If you sit on the sidelines through these short bursts, you miss the high returns shares can offer. You may even find yourself buying in at a higher price than you sold.

Missing the best days, weeks or months in the market costs investors dearly.

Missing the best days, weeks or months in the market costs investors dearly.

This characteristic is not specific to the NZ market. Across the world, missing out on the best month each year significantly affects investor returns. 

Across all markets, remaining invested benefits long-term investors.

Across all markets, remaining invested benefits long-term investors.

If there was any evidence of a market timing strategy which worked consistently for our clients, we would definitely implement the findings into our strategies. In the absence of such findings, we will continue to use the long-term, disciplined approach which is proven to help investors achieve their goals. This means staying invested through good times and bad.


What Should We Do?

As always, we must focus on what we can control. What has already happened cannot be changed.

Your financial plan is based upon your goals, circumstances and risk tolerance. Your portfolio should reflect your unique needs, balancing expected returns needed for your long-term goals with the stability needed for short-term goals, while also addressing your attitude towards financial risk.

When we make plans, we account for a range of outcomes. Our estimates for future withdrawals and the impact on your portfolio allow for periods of negative returns. While adding capital or reducing withdrawals will mean investors benefit more during the recovery, most can continue on as usual.

If the volatility of your portfolio makes you uneasy, it may be a good time to discuss your risk tolerance. It may be best to exchange long-term returns for a smoother ride. Whatever we decide upon, open discussion can only lead to a better investment experience over time. This may require a difficult decision; whether to change your portfolio while markets are down or wait for markets to recover.

We will continue to monitor withdrawals and deposits. If you are unsure whether you should change your own regular withdrawals or deposits, don't hesitate to ask us how this may affect your long-term goals.


Investment Management and Policy

Changing nothing does not always mean doing nothing. The strategies and policies used in managing portfolios are effective at all stages of market cycles.

Asset allocation, especially the split between growth assets and defensive assets, remains the most important decision investors make. While shares have fallen in value this year, bonds have remained steady, slightly increasing in value.

The importance of bonds is evident when share prices are volatile. They provide a long-term return higher than cash and a relatively steady value in the short-term. Most clients with regular withdrawals could rely on the bonds in their portfolio for more than 7 years of withdrawals. Shares are important for providing income further into the future, not today.

The split between shares and bonds is chosen based on your goals, circumstances and risk tolerance. This defines the target portfolio we believe is suitable for you long-term.

When the prices of assets change quickly, the proportions of each in your overall portfolio become unbalanced compared to the recommended targets. Rebalancing involves buying and selling the investment assets in your portfolio to bring it back to target. This ensures your portfolio remains in line with your needs.

For example, last year saw share prices increase by more than 25%. As shares began to represent more and more of client portfolios, this necessitated the purchase of defensive assets (predominantly bonds) to bring them back to target.

We will continue monitoring portfolios daily and maintain allocations in line with targets.


While the impacts of COVID-19 are concerning, investment strategies based on academic research will continue to deliver positive long-term outcomes.
 

Avoid acting on emotions or making decisions based on headlines. A well-diversified portfolio is made to withstand the ups and downs of the markets. For now, we must wash our hands, keep safe and maintain discipline.