It’s now been a little over one year since the COVID-19 outbreak sent global markets into freefall. After a sharp downturn, global markets have rebounded strongly. 2020 was an important behavioural stress test for investors and there were a number of important lessons to learn:
As analysts continue to roll out their investment market predictions for 2021, it would be prudent to consider what their expectations were for 2020 and how those played out. Markets, economies and people are far too complex to foresee with any level of confidence or accuracy. Making predictions about financial markets is one of those activities that we perform in an indefatigable fashion in the face of overwhelming evidence that it is a hopeless endeavour; perhaps because it is in none of our interests to state that we just don’t know. We should never make our investment outcomes reliant on heroic forecasts.
It is not simply that we did not predict a global pandemic that evidences our limited abilities in the art of divination; it is that even if we had known about coronavirus in advance, there is a very good chance we would have made some very poor and costly investment decisions.
Imagine if – at the close of 2019 – we were told that there would be a global pandemic in 2020 with an impact so severe most of the charts we use to track economic data would fall so precipitously that we wouldn’t be able to use them meaningfully in the future. Would we have gone long global equities? Financial markets are complex, adaptive systems; even knowing certain pieces of information does not mean we can predict related outcomes.
Although we cannot anticipate their shape or form, we should treat recessions and bear markets as an inevitable feature of investing. Rather than worrying about when they will happen; we need to make sure we are appropriately prepared for when they do.
Our capacity to withstand drawdowns and financial loss is often framed in purely financial terms – what is our ability to bear such risks? Although this is crucial, equally important is our behavioural tolerance; are we able to withstand difficult periods without making poor decisions? We need to understand how we will feel and how we might react.
Bear markets are a test of temperament, not intelligence. Success through torrid periods is about having the disposition or processes that enable us to make clear-headed and rational decisions in the face of huge emotional stimulus. If we don’t prepare then the chances are that we will be overwhelmed.
The problem with investment intentions is that it is impossible to appreciate in the present how we will feel in the future when we actually have to implement the decision. Saying that we will buy equities when they are 30% lower is easy to say and hard to do. When they are 30% lower it will be for a reason, and there will inevitably be a host of negative narratives as to why they have fallen. In the midst of that that noise, sticking to a plan is anything but straightforward. We should not make a decision about the future in a cold state and then try to carry it out in a hot one.
The best option is to make such choices systematic. This is why rebalancing is so effective – it systematises sensible decisions that we probably would not make consistently if left to our own capricious devices.
A host of behavioural factors – such as recency and availability – make us worry about yesterday’s crisis. There will be misfortunes and turmoil in the future, but the causes will probably be different to the ones we are currently experiencing. We should not let 2020 entirely define how we think about markets and future risks for the next decade.
The severity and speed of market movements in the first half of 2020 was a perfect example of the challenges and dangers of attempting to time short-term volatility. One wrong call during this period could have resulted in an arduous road back.
The most crucial discipline for the majority of investors is the adoption of a long-term approach when making decisions. The central problem of periods of crisis is that our time horizons contract dramatically. Our attention and concern are inexorably drawn to what is happening in the current moment. This risk of making reactive, emotion-laden judgements that make us feel better (and safer) in the present is never greater.
Events such as the pandemic feel profound for investors and it is hard to accept that they will probably appear to be an insignificance over the long-term (from a returns perspective). Most things matter far less than investors think they will when we are living through them.
The case for investors doing less has again been bolstered through a tumultuous 2020. The impulse and encouragement to act during a period of such high volatility and extreme change was incredibly powerful. The hardest thing to do is the thing that nobody wants us to do. Sit on our hands, follow our processes.
The political will to take such dramatic action to stem the spread of the virus provided a wonderful contrast with the trudging (in)action and apathy around the climate crisis. The consequences of climate change for humanity are likely to be far more devastating, so why the indifference? Coronavirus is present and salient; climate change is a future risk that feels removed and abstract. The risk is stark that we don’t take enough action on the climate until its most severe implications are as close as the pandemics. Too late.
In all our investment decisions we tend to focus on the issues specific to the particular case (the inside view) rather than general lessons or similar incidents (outside view). When high yield spreads went to 1000 over in 2020, it was far easier to think about the disastrous consequences of the pandemic on default rates; than to focus on the historic attractions of investing at such widespread levels. The outside view is even more important during tempestuous spells in financial markets.
As investors we worry a great deal about drawdowns and losses. The potential damage wrought by bear markets and severe market losses always looms on the horizon, but we think about this risk in the wrong way. If we are appropriately diversified and have a long-term approach; it is not the short-term declines in markets that matter, but what we do in those periods. The consequences of rash behaviour and injudicious decisions made in difficult periods will likely have far greater long-run consequences than the near-term losses themselves.
It is difficult to think of a more challenging year to navigate for investors. The list of unprecedented events is long and distinguished. The potential to make classic behavioural mistakes driven by emotion, short-termism, and skewed risk perceptions never greater. Yet the year is also testament to the benefits of being aware of our most damaging behavioural tendencies. 2020 was a behavioural stress test for investors. It is important to check how we fared.
To find out more about how any of these measures may be of assistance in your individual circumstances, please contact Gordon Thoms or David Conte at Calibre Private Wealth Advisers on ph. (03) 9824 2777 or email us here.
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