Staying safe in turbulent times
Marcus Stafford of Scotiabank shares some simple and straightforward investment concepts to help keep your money safe during times of extreme market volatility caused by uncertainty and panic.
“Maintaining discipline is vital to the success of your long-term goals.”
Marcus Stafford, Scotiabank
The COVID-19 pandemic caused the greatest economic slump since the 1930s. Record-breaking unemployment, lockdowns, businesses going bust and no sight of a solution. The S&P crashed down 34 percent and the Dow Jones was even worse, slumping to 37 percent creating a panic for investors worldwide. Despite this collapse the markets bounced back with the S&P at the time of writing up 15 percent year to date and up 6 percent for the Dow.
Economic data appears to show that the market bottomed out in April and bounced strongly in May and June. Data since then has been less strong. The expectation is that the economy will now slowly grind upwards held back by COVID-19 caseload setbacks, high unemployment and depressed customer demand.
With all the bad news why have the markets re-bounded so well? The answer is because of the record-breaking scale of money that has been injected into the world economies by global governments—more than $10 trillion and counting. Most of this money went into the purchase of financial assets.
Records show that there is a link between excess liquidity, or money in the hands of market participants, and company valuations reflected in the strength of the S&P/Dow Jones. This is considered technical assistance to stabilise the markets and has worked very well. Figure 1 shows the stimulus injection and Figure 2 shows the relationship between excess liquidity and changes in valuations.
“The longer you hold an investment, the more likely you are to achieve lower portfolio volatility.”
This first phase is critical to stabilising the markets but is unsustainable in the long term. Governments need to get the economy working again and this means an end to lockdown of the economy and businesses. An effective vaccine is the answer and once this is in place the economy can open again, businesses get back to work and unemployment reduce.
Corporate profit outlook should then recover in a sustainable fashion without having to continue to rely upon government support.
The good news is that there are 11 vaccines in large-scale efficacy testing and the breakthrough of the Pfizer vaccine is being seen as a game-changer. Corporate valuations are currently high due to the government stimulus but with the news of the vaccine these valuations can now be supported by very low interest rates and continued government stimulus. This means that in phase two corporate outlook should recover in a sustainable fashion based upon the economy versus stimulus.
The question then becomes what strategies can we employ to keep our capital safe during these unprecedented times. First, maintaining discipline is vital to the success of your long-term goals. Market volatility is here to stay but how you react to it will impact your long-term success.
As volatility increases investors have a natural tendency to move towards safer investments hoping to avoid further losses. This can result in locking in losses on investments which over time are likely to recover. The key is to not time the market: selling at the wrong time and missing just a few days of market recovery can have a significant impact on your portfolio as Figure 3 and Figure 4 highlight.
History has shown that missing just the best 10 days in the market over a 10-year period reduces your return significantly—returns of only 1 percent versus an invested return of 9 percent. Maintaining discipline and a long-term perspective during extreme volatility rewards patient investors when markets return to their inevitable upward trend.
This year many investors liquidated their portfolios at the market low in March. If they had stayed invested, by the end of June an investment in the S&P would have been down just 1.6 percent. If they liquidated and subsequently bought the investment back but missed the best five days they would be down 22.5 percent. If they missed the best 10 days they would be down 36.6 percent (Figure 3).
“Not paying attention to asset mix drift can result in exposure to unexpected risks and missed opportunities.”
Most studies find that attempts to time the market usually add to the portfolio’s performance variability without a commensurate increase in return.
The next strategy is to have a diversified portfolio. You will have heard this many times before from your investment professionals but it is worthwhile mentioning it again because it is a golden rule of investing and key to reducing risk in your portfolio. This means combining in your portfolio investments across different asset classes including cash, fixed income and equities; industry sectors; geographic areas; and investment styles.
Asset classes can be negatively correlated, which means they do not move together but they perform differently in any given year. At any time one asset class will be leading the market while the others lag. Diversification reduces the impact of volatility on your overall portfolio by combining assets that react differently to changing market conditions. It is difficult to predict which market class will lead or underperform the market each year so by including a mix of assets the risk can be minimised over time.
It’s worth mentioning time and using it to your advantage. Volatility has less impact over longer time horizons. Years of strong equity markets can outweigh unsettled periods of decline resulting in long-term returns that consistently outperform other asset classes.
Returns can have a very wide range over the short term with an average one-year rolling return for a diversified portfolio ranging from a high of 58 percent to a low of minus 27 percent between 1980 and 2012.
However if an investor held the same portfolio for a longer period of time the range of potential returns decreases: the 30-year average rolling return as high as 11 percent and a low of 9 percent—a difference of only 2 percent. This means that the longer you hold an investment, the more likely you are to achieve lower portfolio volatility and a rate of return similar to its long-term average.
Your captive insurance company should have an investment professional to help your financial team in creating a diversified portfolio, with a disciplined long-term approach that will keep your capital safe, ready for when you need it. That said, we cannot overlook performance and returns. To this end your investment manager will need flexibility in the investment policy statement to rebalance the portfolio regularly because this is one of the most effective ways to stay on track and reach your investment return objectives.
Asset mix drift is caused by market fluctuations that cause a shift in how your assets are divided in the portfolio. This will cause a change to your asset allocation mix and potentially not meeting your return expectations. Rebalancing creates the opportunity to lock in gains from one asset class and invest them in other asset classes that have become relatively inexpensive. Not paying attention to asset mix drift can result in exposure to unexpected risks and missed opportunities.
The strategies I’ve outlined above can help you feel confident and focused with a clear idea of how you can keep your capital safe and look for consistent long-term returns. As ever, talk to your investment professional about these strategies or any concerns you might have in these unprecedented challenging times.