Formulating an investment strategy and more specifically an appropriate ‘strategic asset allocation’ should balance what you are hoping to achieve ultimately against the risk of adverse outcomes along the way. A realistic and humble appreciation is needed of the magnitude and unpredictability of potential short term underperformance of markets, especially the sharemarket, informed by the historical volatility of actual returns. This must then be combined with an honest self-assessment of the investor’s tolerance for such risk.
A mere matter of a few days ago, the US stock market was on a roll, with the major indices finally regaining pre-GFC levels, and then setting new record highs. This helped the Australian market indices to smash through what had previously seemed a ceiling at the 5,000 level (S&P/ASX200) and quickly run up another 3% or so to around 5,150. And this, little more than a year and a half after it had plunged below the 4,000 level and seemed in near freefall, at the height of the ‘Euro-debt crisis’. At the time, some feared that this was the start of ‘GFC Mark II’, until ECB head Mario Draghi stepped in with his celebrated ‘whatever it takes’ commitment to dealing with the problems, prompting sharemarkets to reverse course abruptly and set sail into the aforementioned rally.
But more recently the mood suddenly threatened to turn sour again, with the major US indices dropping back nearly 3% in just a couple of days, while the local index dived back under 5,000. And reportedly, all mostly due to a few softer economic indicators out of the US and especially China, including the report that March quarter GDP growth came in a mere matter of tenths of a percent below expectations and the previous period’s actual.
Losses are more frequent than many expect
Of course, this is only a mild taste of the volatility that sharemarkets are capable of. For example, a recent analysis of S&P/ASX200 index movements since its inception by Morningstar highlights how frequent negative returns are, and how extreme they can be:
- over 20% of 1-year rolling returns were negative
- the largest peak-trough decline in a defined ‘bear market’ was 55% (and perhaps disturbingly, if you assumed that was the 2008-09 GFC, you’d be wrong! Rather, it was the 1973-74, OPEC oil shock/recession episode).
This serves as a reminder of two things (as if we should need reminding of them):
- investment markets are fickle in nature, and shorter term movements are highly unpredictable, often triggered by what might, in isolation and objectively, be seen to be relatively minor pieces of new information, and often come completely ‘out of left field’
- human emotions and behavioural biases play important roles in shorter term fluctuations, as well as conditioning investors’ responses to these same fluctuations.
Of course, one of the keys to successful investing over the longer term is being able to ‘rise above’ these shorter term market fluctuations and the emotional roller-coaster.
Easier said than done! Many years of observing investors, including ‘professionals’, suggests that despite constant reminders of the inherent unpredictability and volatility of financial markets, and routine acknowledgements thereof, investors often seem to be merely paying lip service to the risk. It seems that that the longer the good times roll, the more overconfident many investors become in their ability to predict markets’ future course and in their ability to ‘get out in time’(if their investment approach allows such tactical flexibility). The more they seek to capture the upside, the more they forget how extreme the downside volatility can be. Or maybe, they just don’t want to know.
Investors need to accept reality
Indeed, over many years as a consultant to institutional investors, one of the most common laments heard when they are caught by severe downturns is that they didn’t realise that it could get quite so bad, nor that their particular investment strategy could produce such poor returns in a shorter period. Yet the strategy had often been set in light of analysis of the possible distribution of outcomes over time, including downside risk measures such as the frequency of negative annual returns, or some confidence interval of the range of possible returns.
Which bring us back to the need for realism in formulating an appropriate investment strategy, including:
- Make an honest and sufficiently humble assessment of whether you or your advisor have the forecasting skills, temperament and practical capacity to ‘time’ markets.
In other words, do you really believe you can vary exposure to the various asset classes to take advantage of shorter term deviations in expected performance (aka ‘tactical asset allocation’)? To cut a long story short, since the vast majority of investors aren’t blessed with the supposed insight or information sources of market “gurus”, the honest answer should be NO. That being the case, you are better off choosing a relatively fixed, strategic asset allocation, being the one that is likely to achieve your investment objectives ultimately, and the consequences of which you can live with though all the intervening market ups and downs, and essentially sticking to it.
- Be realistic about the volatility of markets, especially sharemarkets
This means properly allowing for how sharp the downturns can be, and how frequently they can in fact occur. (And without wishing to get sidetracked into technical aspects, these are probably greater than predicted by the normal distributions used in the standard quantitative approaches to optimising investment strategy).
- Be honest with yourself about just how much risk you really can tolerate
How much pain you can truly bear, in the form of poor shorter term investment performance? If you invest in equities, for example, would you lose sleep or would it compromise your retirement plans if the market lost 30% in a month?
This isn’t the place to dive into the debate about whether Australian super funds are more heavily weighted to shares than they should be. Nevertheless, many investors pursue a strategy that exposes them more to sharemarket volatility than they actually need to, and often find themselves lamenting that they did not fully appreciate the risk. These investors might be better off reducing their exposure to the ‘equity risk premium’, and take better advantage of alternative means of enhancing overall returns.
John Stroud is currently Principal of Newport Investment Consulting, after many years in senior roles with major investment consulting firms and fund managers.