Although it feels like painful events such as bear markets are an unpleasant reality best quickly forgotten, they are incredibly important for investors. Our decision making during such difficult periods can easily define our long-term outcomes. Whilst our present inclination might be to focus on the specifics of the coronavirus we should instead consider how we can learn the right lessons about both our investments and our own behaviour during periods of severe market stress. We can then be better prepared for the next bear market, whenever it may arrive.
Here are some lessons I think are important.
In a low interest rate environment we will have a love / hate relationship with cash: When rates are on the floor, very few people are comfortable holding cash. For most investors it generates a low nominal return and often a negative real return, plus a fee is levied for the pleasure of owning it. These paltry or negative returns become even more painful when all other assets are delivering strong performance. In times of true market stress however, cash can become the only asset that investors want to hold. This will make us start to question why we and others weren’t holding more of it.
This presents something of a conundrum. In a low rate world, cash is likely to prove a material drag on returns, and the longer a bull market persists the more unpalatable holding it will become. Yet it is incredibly valuable in times of extreme market dislocation. So what is the answer? Well, we could just hold low cash when the market is rising and then increase our exposure before the market falls (this is a joke). The only option is to have a sensible long-term view on its role in a portfolio (given its risk profile) and be content with that. If we want to own a meaningful level of cash permanently, then we can’t complain when our portfolio lags in a bull market. Conversely, if we believe it will be of long-term detriment to own exposure to an asset that may produce a negative real return then that is likely to leave our investments more vulnerable in markets like those we have seen for spells of 2020.
Investment returns are not normally distributed, and prolonged periods of subdued volatility do not mean it is a good idea to increase your exposure to risk assets: These seem like obvious points to make but they are often ignored during a bull market. Investment results come with more periods of sharply negative observations than one would assume from a normally distributed set of returns. Irrespective of how low realised volatility has been there will always be wretched bouts of performance, which render any ‘information’ gleaned from periods of below average volatility meaningless.
The related issue regarding volatility (I have written about its use as a measure of risk here) is that during sustained spells of depressed realised volatility, there is often an overwhelming temptation to hold more risky assets. Whilst a low volatility backdrop persists this can be an effective means of increasing returns and also looks fine when run through a backward-looking risk model; but can suddenly become incredibly problematic when volatility erupts.
Drawdowns are an inevitable feature of long-term investing: Investing in any form of risky asset (above cash) involves drawdown risk. An extended period with few material drawdowns does not mean that this risk has been extinguished. As a rule of thumb, I would say that for a diversified portfolio of liquid traditional assets the absolute minimum expected drawdown over a market cycle should be 2x the expected long-term volatility. This is a base level because, as mentioned earlier, returns are not normally distributed – there is a negative skew – 3x volatility is probably a more reasonable expectation, depending on the assets / strategies involved. My sense is that we tend to underestimate the potential for drawdowns in our portfolios so it is crucial to be realistic about this from the outset. To generate strong long-term returns and enjoy the benefits of compounding we need to be financially and behaviourally disposed to bearing such risks.
Illiquidity is not diversification: Just because something doesn’t price, does not mean it is providing diversification to a portfolio. As I (and others) have mentioned before, the major advantage of illiquid assets is that the inability to trade limits our propensity to make bad short-term decisions. This is a behavioural premium created by structurally compelling us to be long-term investors (obviously with the caveat that a bad investment is still a bad investment). Ignore anyone saying that their private equity holdings have ‘held up well’ during a market sell-off.
Some alternatives are not that alternative: Low bond yields have pushed more investors into ‘alternative’ asset classes and strategies in order to ‘enhance’ portfolio diversification. The market downturn has highlighted three crucial aspects around this for investors to consider: i) Some apparent diversification is just a different pricing methodology. ii) Some strategies appear diversifying until a severe bout of market / economic weakness arrives and diversification disappears just when you need it. iii) Even if assets are genuinely distinctive from other traditional assets, when there is a stampede for cash, everything can get trampled.
We need to have a plan: Making plans for torrid market conditions is a crucial element of prudent long-term investing. It is probably the only thing that will protect us from the confluence of newsflow, negativity, anxiety and stress, which lures us toward poor choices. Of course, we cannot prepare for specific eventualities – here is what I will do in a global pandemic – but we do know that severe declines in asset prices will occur at some unpredictable juncture. Even acknowledging this (and writing it down) can help.
We need to have a plan we can stick to: Investment plans are incredibly important, but also fiendishly difficult to follow. In a bull market it is easy to say: “when valuations become more attractive (markets fall) I will increase my exposure to equities”. The problem is that when we make such commitments we neglect to consider how it will actually feel at the time it happens. Markets will be declining for a reason. News will be uniformly terrible. Are we sure that our plan was sensible? Hasn’t everything changed? Sticking to our plan will be the last thing we want to do. Plans need to be clear, specific, realistic and, as far as possible, systematic. Make the decision before it happens.
Base rates are ignored even more than usual in periods of stress: During the recent market turbulence high yield spreads moved to 1000 over. Historically, this has been a good time to own lower quality credit for the long-term, and on a five year view has typically led to strong returns. We can call this the base rate or our outside view. Despite the importance of this information we are prone to ignore it, particularly in times of stress. Rather than consider the relationship between starting valuations and future long-term returns; we focus on specific, salient issues (the inside view) – the virus, the default rate, the energy sector travails. It is not that this information is irrelevant, but that we weigh it too heavily in our long-term considerations.
We should always start with the base rate / outside view (spreads being wide is good for long-term returns) and make any adjustments we feel are prudent based on the prevailing backdrop. Instead, we start with the inside view – the particulars of the current scenario – and the salience and availability of that tends to overwhelm any consideration of base rates, or the things that are likely to matter more over the long-term.
It is hard to make good long-term decisions: Our obsession with the present makes it close to impossible to implement sensible long-term decisions. Time horizons contract dramatically and savagely during market declines. The quality of the choices that we make will be judged over the next week or month (rather than the usual quarter).
People will want action! As uncertainty increases and markets fall there will be an inevitable clamour for activity. Things are happening – what are we doing about it? Whether or not what we are doing is likely to be beneficial in the long-term or is even part of our investment process is likely to fade into insignificance.
For the vast majority of investors sitting on our hands, or making very modest adjustments based on pre-existing plans is the right thing to do. The problem is nobody else thinks it is, and it might see you out of a job.
Some people will look stupid, some will look smart: Most of it is luck and randomness. When recessions and bear markets arrive there are always heroes and villains. Some will be lauded for their foresight (and perhaps have books and movies produced about them) others will be castigated for their folly. Outcome bias grips us hard. There will always be a few skilful exceptions, but even then we don’t know if the individuals involved will repeat such feats (history would suggest not). If you work on the assumption that most investor results during such periods are the result of luck and sheer chance, you will have the odds on your side.
Recessions will happen, and for reasons we have not predicted: There are plenty of things that people ‘know’ are a waste of time in the investment industry but keep on doing anyway – one is speculating about recessions. Experts cannot predict when they will develop or what the cause will be. We shouldn’t waste our time trying to forecast the next one. (I am assuming that nobody leaving their homes for months means that we are in one now, but I am no economist).
It is difficult to tell whether changing market structure, or the nature of the pandemic caused the pace and severity of the asset price decline: The speed and severity of decline in risky assets was likely in part due to changes in market structure, but not all arguments are equally valid. A reduced willingness for investment banks to warehouse risk seems likely to be a contributory factor; the growth in low cost index investing wasn’t.
Whilst the structural arguments have some merit, the nature of the market drop was also due to an unprecedented economic stop and huge uncertainty around a global pandemic. There were (are) some deeply negative economic consequences from the coronavirus outbreak and nobody had (has) any confidence about what probability to ascribe to them. Does the recent decline provide information about how market bear markets may occur in the future? Yes. Will they all look like this one? No.
We are not epidemiologists. Even if we were, we still wouldn’t be able to time markets: Let’s be clear about short-term market calls in this environment. It means taking a view on the progression of the virus, the fiscal / monetary response, the economic impact of that response, the prospects for businesses, the reaction of individuals, and, crucially, the behaviour of other investors. Good luck.
The virus and its consequences will be used to support everyone’s pre-existing beliefs: The virus will change the beliefs and behaviours of very few people. When I say ‘very few’, I really mean nobody. Growth investors will tell you that societal changes following the virus will bolster the prospects of tech companies. Value investors will say the fiscal response means that inflation and rate rises are inevitable providing a catalyst for the long awaited resurgence. MMT advocates will say their ideas have been validated, naysayers will forecast the coming inflationary reckoning. Active investors will say dispersion is high and the time is right; passive investors will say they held up just fine in a bear market. Everyone has an angle and everyone will use the same information to bolster their own contradictory views.
Decisions we make in periods of stress will have profound implications for our long-term results: If an investment decision makes you feel good immediately, it will probably make you feel bad in the long-term. In periods of market weakness, the temptation to do what will make you feel better now can be overwhelming.
Things will happen that we had never seriously considered: An economic shutdown / negative oil prices. These weren’t in forecasts or captured in risk models.
Depending on the progression of the virus and its market / economic impact, there may or may not be a part 2 of this post (hopefully not).