Why You Need a Financial Fire Drill

No-one can reliably predict when the next bear market will arrive, but given that many of us can recall the downturns of 1974, 1987, 1999 and 2008, we can confidently say that while down markets are always tough, they are even more so for the unprepared.

This means investors and their advisers should be reflecting on whether they have adequately prepared for the next inevitable downturn.

Lessons from history

The looming 10-year anniversary of the collapse of investment bank Lehman Brothers and the unsettling events of October 2008 mean there inevitably will be a flood of stories in the media about the past financial crisis and the possibility of another in the future.

While it’s natural for the media to commemorate such a major negative event, there is unlikely to be much mention of how those investors who kept their nerve and stayed with their plan were rewarded for their discipline. That reward is the payoff for having an investment philosophy and plan investors can stick with through extreme volatility and uncertainty, because over the long term markets reward discipline:

Do the drill before the fire

Firefighters understand that there is no time to develop mastery when faced with an emergency, which is why they regularly carry out drills and rehearse their responses to a major fire. Being operationally prepared with a concrete strategy makes everyone feel more confident.

It’s similar for investors and their advisers. The time for preparing for a crisis is not during a crisis. Instead of trying to predict when a downturn will occur, the focus should be on preparing an agreed strategy and planning what will happen when it does.

In contrast, market timing is hazardous. The graph below shows that an investor who missed just the 25 best days on the Australian market from April 2000 to December 2016 would have been reduced to an annualised return of 1.7% against the market’s 8% return.

A great example of the benefit of staying the course was the conclusion of the 10 year wager between Warren Buffett, chairman of Berkshire Hathaway Inc and Ted Seides, a New York hedge fund consultant. Seides responded to a public challenge issued by Buffett in 2007 regarding the merits of hedge funds relative to low cost passive funds. The two men agreed to US$1 million on the outcome of their respective strategies over the 10-year period ending 31 December 2017. Buffett selected the S&P 500 Index, Seides selected five hedge funds and the stakes were earmarked for the winner’s preferred charity.

The 10-year period included years of dramatic decline for the S&P 500 Index (–37.0% in 2008) as well as above-average gains (+32.4% in 2013), so there was ample opportunity for clever managers to attempt to outperform a buy-and-hold strategy through a successful timing strategy. For fans of hedge funds, however, the results were not encouraging. For the nine-year period from 1 January 2008, through 31 December 2016, the average of the five funds achieved a total return of 22.0% compared to 85.5% for the S&P 500 Index.[1] (Results for 2017 have not yet been reported.)

Having fallen far behind, Seides graciously conceded defeat in mid-2017. But he pointed out in a May 2017 Bloomberg article that in the first 14 months of the bet, the S&P 500 Index declined roughly 50% while his basket of hedge funds declined less than half as much. He suggested that many investors bailed out of their S&P 500‑type strategies in 2008 and never participated in the recovery.

Seides makes a valid point—long run returns don’t matter if the strategy is abandoned along the way. And there is ample evidence that some mutual fund investors sold in late 2008 and missed out on substantial subsequent gains.

Over any time period some managers will outperform index-type strategies, although most research studies find that the number is no greater than we would expect by chance. Advocates of active management often claim that this evidence does not concern them, since superior managers can be identified in advance by conducting a thorough assessment of manager skills. But this 10‑year challenge offers additional evidence that investors will most likely find such efforts fail to improve their investment experience.

Preparing for market volatility

When developing an investment strategy for a client, there are three factors we take into consideration:

1. Risk/Return Required – what annual return does the client require on their assets to realise their lifestyle and financial goals over the long term? This can be established through cashflow modelling.

2. Risk Tolerance – is the degree of variability and volatility in investment returns that an investor is willing to withstand before they lose sleep at night. This can be established through questioning and questionnaires.

3. Risk Capacity – is the ability of an investor to have sufficient cashflow to see them through a downturn without needing to sell assets at distressed prices. This is an area that most investors and advisers fail to focus on, but was the primary reason why our clients made it through the GFC intact.

At a minimum, we want our clients to have at least 5 years of their cashflow requirements invested in accessible liquid assets should significant market volatility occur. So when we develop an investment strategy, we overlay the results of the Risk/Return Required and Risk Tolerance work with the Risk Capacity requirements to ensure they are met. If they are not, we keep working with our client until an overall satisfactory outcome has been achieved.

And you need to be mindful of what an ‘accessible liquid asset’ is. For us, it’s fixed interest trusts that invest in high credit quality bonds. There are many advertisements at present for mortgage trusts that have achieved higher returns in recent times compared to many term deposit and cash offerings. Whilst this is true, they are riskier assets to own and thus should provide high yields, however during the GFC it was these types of assets that were most likely to be frozen – often for years – meaning investors couldn’t readily access their own money. The underlying basket of assets – residential mortgages – is not highly liquid assets, particularly when residential house prices are falling.

2017 was a quite remarkable year for investors. Whilst we had a tumultuous year for a new US president and divisive political trends in many global markets, for the first time since 1897 the total return on the US stock markets was positive in every single month of the year, and out of 254 trading days, the total return of the S&P 500 Index rose or fell over 1% only eight times. By comparison, in a more rambunctious year such as 1999, it did so 92 times[2].

Whilst times like this don’t go on forever, a well considered investment strategy with an adviser who helps ensure discipline is maintained in times of volatility is the best approach an investor can have when the fire alarm goes off. If you would like to understand how your investment strategy prepares you for future market volatility, please contact your adviser team at Stewart Partners.

1. Hedge fund data from Chairman’s Letter, Berkshire Hathaway Inc. 2016 annual report.