A Formula for Success through Major Global Events
Investing is a long-term rewarding endeavour. Indeed, people will spend decades pursuing their financial goals. But being an investor can sometimes be complicated, challenging, frustrating, and sometimes frightening.
Ideally we could predict the future. Ideally we could have foreseen the Global Financial Crisis in 2008 and moved to cash just in time to avoid the crash, and then invested at the bottom of the market in March 2009 and reaped the ensuing gains generated by the long bull market that followed.
If you had this special gift it would have been very helpful during the 30-year period from 1963-1993, consisting of 7,802 trading days. Using your skill, you would have been fully invested for the mere 90 days that generated 95% of all market gains during that period [2], and sat in cash on the sidelines for the other days.
Think about that for a moment. Being invested for only about 1.2% of all trading days accounted for almost all the profits the market accrued during that time. as we know, no one has this ability, including “gurus” who claim they do.
So how can we, as investors, maintain discipline through bull markets, bear markets, political strife, economic instability, or whatever crisis du jour threatens progress towards our investment goals?
The answer is to have an enduring investment philosophy, because without one to inform our choices, investors can potentially suffer unnecessary anxiety, leading to poor decisions and outcomes that are damaging to long-term financial well-being.
When they don’t get the results they want, many investors blame things outside their control. They might point the finger at the government, central banks, markets, or the economy. Unfortunately, the majority of investors will not do the things that might be more beneficial— evaluating and reflecting on their own responses to events and taking responsibility for their decisions.
Some people suggest that among the characteristics that separate highly successful people from the rest of us is a focus on influencing outcomes by controlling one’s reactions to events, rather than the events themselves. This relationship can be described in the following formula:
Simply put, this means an outcome—either positive or negative—is the result of how you respond to an event, not just the result of the event itself. Of course, events are important and influence outcomes, but not exclusively. If this were the case, everyone would have the same outcome regardless of their response.
Let’s think about this concept in a hypothetical investment context. Say a major political surprise, such as Brexit, causes a market to fall (event). In a panicked response, potentially fueled by gloomy media speculation of the resulting uncertainty, an investor sells some or all of their investment (response). Lacking a long-term perspective and reacting to the short-term news, our investor misses out on the subsequent market recovery and suffers anxiety about when, or if, to get back in, leading to suboptimal investment returns (outcome).
To see the same hypothetical example from a different perspective, a surprise event causes markets to fall suddenly (e). Based on his or her understanding of the long-term nature of returns and the short-term nature of volatility spikes around news events, an investor is able to control his or her emotions (r) and maintain investment discipline, leading to a higher chance of a successful long‑term outcome (o).
This example reveals why having an investment philosophy is so important. By understanding how markets work and maintaining a long-term perspective on past events, investors can focus on ensuring that their responses to events are consistent with their long-term plan. You can read more about how markets work here: The Journey of Owning Shares
It is worth looking at how markets react around major events as well, to see if remaining disciplined really is rewarded.
The graph below shows the return of a normal, well diversified portfolio[1] for 1, 3 and 5 years after six major events over the past 30 years.
Interestingly in two of the six events (1987 and 1998), the 12 month return after the event was actually above the long term average. After five years, all returns would be considered healthy if not highly impressive.
These results certainly support the decision to stay disciplined with your investment philosophy even after major global events occur.
The Foundation of an Enduring Philosophy
An enduring investment philosophy is built on solid principles backed by decades of empirical academic evidence. Examples of such principles might be:
trusting that prices are set to provide a fair expected return;
recognising the difference between investing and speculating;
relying on the power of diversification to manage risk and increase the reliability of outcomes; and
benchmarking your progress against your own realistic long-term investment goals.
Combined, these principles might help us react better to market events, even when those events are globally significant or when, as some might suggest, a paradigm shift has occurred, leading to claims that “it’s different this time.” Adhering to these principles can also help investors resist the siren calls of new investment fads or worse, outright scams.
Without education and training—sometimes gained from bitter experience—it is hard for non-investment professionals to develop a cogent investment philosophy. And, as we have observed, even the most self-aware find it hard to manage their own responses to events. This is why a financial adviser can be so valuable—by providing the foundation of an investment philosophy and acting as an experienced coach when responding to events.
Stewart Partners has an enduring investment philosophy which is the foundation for how we view the world of investing. We trust in the power of markets to deliver reliable returns over time and focus our efforts on helping clients benefit from as much of the return of the market as possible. You can learn more about our approach here: A Better Investment Experience
We know that investing will always be both alluring and scary at times, but a view of how to approach investing combined with the guidance of a professional adviser can help people stay the course through challenging times. Advisers can provide an objective view and help investors separate emotions from investment decisions. Moreover, great advisers can educate, communicate, set realistic financial goals, and help their clients deal with their responses even to the most extreme market events.
In the spirit of the e+r=o formula, good advice, driven by a sound philosophy, can help increase the probability of having a successful financial outcome.
With thanks to David R. Jones, DFA Australia
[1] Performance of a Normal Balanced Strategy: 60% Stocks, 40% Bonds Cumulative Total Return. In AUD. Balanced Strategy: 30% S&P/ASX 300 Index (total return), 30% MSCI World ex Australia Index (AUD, net div.), 20% Bloomberg AusBond Bank Bill Index and 20% Citigroup World Government Bond Index 1-3 Years; rebalanced semiannual. S&P/ASX data reproduced with the permission of S&P Index Services Australia. MSCI data copyright MSCI 2017, all rights reserved. Data provided by Bloomberg. Citigroup bond indices copyright 2017 by Citigroup. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance. Returns taken one month after specified crisis date.
[2] Stockmarket extremes and portfolio performance 1926-2004, Professor H. Nejat Seyhun, University of Michigan, 2005