The Enemy of Failure
Key Takeaways
It has been proven time and time again that we are unable to predict the future. How then can we prepare for the financial impact of unforeseen events? (i.e. GFC, Covid, Rate hikes, etc.) Here are three easy tips:
Know How Much Your Investments Could Lose
Spread Risk Through Diversification
Prepare for Economic Downturns in Advance —
“Health-check” Your Finances.
Reduce Large Liabilities.
Use Extra Savings for Opportunistic Investments
An ounce of prevention is worth a pound of cure.
— Benjamin Franklin
The local news was abuzz recently with reports of the crash of one of the Republic of Singapore Air Force’s (RSAF) F-16 fighter jets. This was likely newsworthy as such an incident rarely occurs — the last RSAF F-16 crash happened 20 years ago in 2004. The rarity of such an event is commendable, given that our air force likely conducts thousands of flights a year. A statement given by the Ministry of Defence highlighted that the RSAF deals with approximately 350 air threats every year.
The amount of training that our armed forces conducts may seem superfluous given that our region is currently peaceful and there is no threat of a war. However, this type of thinking misses an important point and can be tied in to our investing journey. Humans are already extremely bad at predicting the future as we have written many times before;
What more in predicting actual surprises — which actually is being prepared is all the more important. Author Morgan Housel said in his book, Same as Ever: A Guide to What Never Changes that “the biggest risk is always what no one sees coming, because if no one sees it coming, no one’s prepared for it; and if no one’s prepared for it, its damage will be amplified when it arrives.”
Like us, the air force and our armed forces are unable to predict when a conflict will arise, but the continuous training ensures a level of preparedness for that eventual day.
We should approach investing in the same way. Not one economic or market outlook in 2007 predicted the collapse of the US housing market. While an IMF report early in the year noted the turbulence in financial markets, it still reported an expected healthy global growth level for 2008. We eventually had one of the largest recessions in history.
Nobody predicted that lockdowns we experienced in 2020, or the high inflationary environment, and corresponding record speed of rate hikes we would encounter during 2022 and 2023. Nobody expected that banks like Silicon Valley bank and Credit Suisse would again fail — even after new banking laws were enacted after the 2008 crisis.
As such, we want to approach long-term financial planning and portfolio construction with appropriate risk measures and buffers to ensure that should we encounter unforeseen circumstances along the way, your financial life is not derailed by it.
Know How Much Your Investments Could Lose
The financial industry's favourite metric to measure risk for any product is Standard Deviation or Volatility. However, we find that Volatility is not a useful metric as it does not tell an investor how much risk he is taking. Volatility is merely the fluctuation of returns around a mean.
Source: Statistics How To
We find that VaR (Value-at-Risk) is a better metric to be aware of. VaR is a statistical measurement of possible loss in an investment portfolio over a specific time frame. This helps you estimate (statistically) how much your investment portfolio can lose in a normal market cycle and also in an adverse market cycle.
Spread Risk Through Diversification
Many investors suffer from a home bias, where investors feel more comfortable holding stocks in their home country they are familiar with. The issue is our home market comprises a mere 0.4% of all the stocks listed globally. An investor who focuses purely on Singapore stocks would effectively be foregoing the potential returns of 99.6% of stocks from the rest of the world.
On top of that, the local investor would be taking on the full brunt and singular exposure of the Singapore economic cycle. In comparison, a global stock portfolio offers an investor exposure to a wider range of economic cycles and, more importantly, a range of different stock returns from a large number of countries. Global exposure helps to avoid tepid returns should the local economy stall. A diversified portfolio thus makes for a much smoother ride.
Another major benefit of diversification is the reduction of risk. The typical standard deviation, or volatility, of the Singapore stock market is approximately 25%. Global stocks, on the other hand, have a volatility measurement of around 16%.
To measure the amount of return an investor receives for every unit of risk taken, we can apply the Sharpe ratio which calculates risk-adjusted return. By this measure, global stocks have a ratio of 0.44 versus 0.25 for the Singapore stock market (diagram below).
Prepare for Economic Downturns in Advance
Instead of reacting, take action in advance. If and when a recession hits, don’t meddle with your existing investment asset allocation, but instead;
“Health-check” Your Finances.
Whether or not a recession affects you is probably down to whether you still are holding a job. But even if you are still working, there could be a hit in take-home income. As such, a quick check on expenses vs possible reduction in income is important to ensure that you are able to outlast any downturn.
Reduce Large Liabilities.
If you are worried about an upcoming recession, then it is probably not a good time to make any large purchases which involves debt — especially in the current environment where rates have risen to levels not seen in a long time.
Use Extra Savings for Opportunistic Investments
Investors who still have 10 years or more with respect to the end date of their goals have the ability to take more risks if the market comes down further as you have time to ride out the market volatility and have the fantastic opportunity to take advantage of depressed prices. After every decline, the market tends to bounce back, boosting long-term returns over time.
During such a situation, Warren Buffett’s famous quote comes to mind — “Be fearful when others are greedy and greedy when others are fearful.”
These simple points — knowing how much your investments could lose, spreading investment risk, and preparing for a downturn helps you to “train” yourself and your finances for the eventuality that something bad will happen.
If you would like to find out more about how to prepare your investments and finances adequately for risk, come and speak with us.
