Staying anchored in an uncertain market
An edited version of this article was published in the 2 September 2017 issue of TODAY.
The Financial Times article "The perils of calling the peak of the equities bull run" (17 Aug 2017) discussed strategies to deal with apparent over-valued markets and why things may now be different. Although we previously dealt with the topic of market highs, it remains a frequently-voiced concern of many investors.
In our experience with investors, we have observed the following: when a market meltdown happens, many who claim to be long-term investors are not really long-term, and investors who claim to have a high-risk tolerance actually just have a high tolerance for making money!
This change in behaviour becomes apparent when the market corrects and an investor's definition of long-term suddenly shortens to days or weeks. Almost everyone is happy to be invested when markets are rising, but how do we guard against our own instincts telling us to run when markets fall and news headlines scream that the end of the world is nigh?
One possible way is to devise, well before any market crisis occurs, some penalty to dissuade us from cutting and running. This is similar to how certain investment managers impose "gates" or lock-in periods which force investors to stay invested over a minimum period of time. Investors can create their own unique set of rules to do the same.
Let's assume that the value of your investments suddenly plummet and you feel like selling everything. A simple rule you could follow would be to allow yourself a maximum initial liquidation of between 20 and 50% of your holdings. Taking this simple step partially satisfies your need to get out of the market, but at the same time ensures that you do not sell everything at the bottom of the market, and gives you some skin in the game to participate in any sudden rally.
Another method is to follow institutional investment committees and fiduciary advisors in the US and Australia. At the inception of your portfolio, work with your adviser to draw up an investment policy statement, which is a written description of the philosophy, strategy, asset allocation, and implementation of what you want to achieve with your investments. Once written, put it up in a prominent location as a reminder of why you started on this investment journey in the first place, and the agreed strategies for reaching your goal.
A critical part of this exercise is for your adviser to tell you about their action plan in the event of a market crisis, and what you can expect to happen to your portfolio. Going through such a mental rehearsal of a hypothetical market meltdown long before an actual one occurs (and writing it down) would prepare you to ride out such an event with much better investment outcomes. There is surely much wisdom in the age-old Scout's motto, 'Be Prepared!'
One other strategy is goals-based investing, which requires that you allocate your different financial goals into different 'buckets' that are then funded and invested independently. Even a goal like retirement can be broken down into different buckets, like essential expenses and discretionary spending. As different financial goals have different capital requirements, each goal can have its own unique time horizon, asset allocation and risk tolerance.
Most investors typically invest fully into a single portfolio based on a singular personal risk profile, to fund all their financial goals. But, if you think about it, different goals like saving for your children's education, retirement, going on sabbatical, holidays, buying a new home, etc. have varying degrees of importance.
For example, if your investment plan for a big overseas trip does not work out well, you might be disappointed, but you could always go another year. The same cannot be said if your retirement plan fails and you have to work many more years in a job that is taking a toll on your health while waiting for the plan to yield the expected return.
In the wake of the global financial crisis, many investors had a hard time coming to terms with the level of losses suffered and consequently abandoned their plans at the worst possible time. Goals-based investing helps to break up your investing goals into smaller chunks with different plans and risk, thus allowing you to experience different investment outcomes as compared to an investor with only one plan and, consequently, one outcome.
Planning for different goals, with corresponding investment plans, helps you mark out different finishing timelines and provides you with something to look forward to over time. It gives context to your investments and keeps you on track whenever you might panic in a crisis or get discouraged about the performance of a plan. You no longer invest just because "everyone is doing it" or you "need a high return". Instead, you have a plan and purpose, and know why you are actually investing!
In our conversations, investors typically want an investment with a high rate of return. However, when we share with them the corresponding value at risk to achieve those returns, most recoil in horror. Interestingly, we later find that some of them have already close to what they need for retirement or another financial goal. What is needed to close the gap and beat long term inflation requires a much lower rate of return and, correspondingly, a much lower risk.
Thus, with proper planning and advice, investors only need to take the risk appropriate to their needs.
At the end of the day, just saying you made 7% per year from your investments doesn't mean much. But if you had invested systematically, stayed calm in crises, retired well, bought your dream house and sent your children to the schools they wanted, then the return you got – whether 3% or 7% – was just a means to those ends.
That is when you would be able to say that you had invested well.
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(This is part of a series of articles that we have been writing for Singaporean investors.)
