Lessons from COVID-19 for Investors

“How long will this last?” “Have we seen the bottom yet?” “What will it mean for the economy?” The volatility we’ve been seeing in global financial markets reflects uncertainty around the possible answers to those questions.

Of course, you can attempt some guesses, but the fact is no-one really knows what will happen. In fact, the future is always uncertain, we just “feel” that uncertainty more in times like this. Although it feels like painful events such as bear markets are an unpleasant reality best quickly forgotten, they always provide valuable lessons for investors. Below we’ve listed the most important lessons people should remember from COVID.

Lesson 1 - In a low-interest rate environment we will have a love-hate relationship with cash

When interest rates and bond yields are at historically low levels, few people are comfortable holding cash. For most investors it generates a low nominal return, which can feel like a material drag on returns, particularly when stockmarket returns are strong. Yet a capital stable component of your portfolio is incredibly valuable in times of extreme market volatility. It is important to have a sensible long-term view on the role of cash and bonds in a portfolio and be content with that. The role of bonds is not to generate high returns, but rather be a source of liquidity and cashflow when the equity portfolio experiences inevitable volatility (16 falls of 20% of more since world War 2).

Lesson 2 - Investment returns are not normally distributed

Investment results come with more periods of sharply negative observations than one would assume from a normally distributed set of returns. The graph below shows the actual calendar year return of the Australian stockmarket since January 2000 and the intra year lows experienced:

Every single year has experienced an intra-year decline. In 2009, as the stockmarket emerged from the GFC, the market experienced a 15% fall despite ending the year up 38%. In 2012 and 2013 when the market was up 20% in each year, there were still intra year falls of 10% and 11% respectively.

Volatility when investing in stocks is absolutely normal.

Lesson 3 - Some alternatives are not that alternative

Low bond yields have pushed more investors into ‘alternative’ asset classes and strategies in order to ‘enhance’ portfolio diversification. For example, many Australians favour the inclusion of “hybrid” securities in their portfolio as an alternative to bonds and term deposits. As we have said repeatedly, hybrids should not be considered as an alternative to bonds as their characteristics are completely different.

The graph below shows the relative price performance of the CBA PERLS XII hybrid versus a Sustainable Bond Trust we use for clients. Between 3 February and 23 March 2020 the hybrid’s price declined by 27% relative to the bond fund. Clearly the hybrid did not provide the level of capital stability investors require in volatile periods.

Lesson 4 - You need to have a plan

Making plans for torrid market conditions is a crucial element of prudent long-term investing. It is probably the only thing that will protect investors from the confluence of news flow, negativity, anxiety, stress and uncertainty, which lures us towards making poor choices. Of course, we cannot prepare for specific eventualities — here is what I will do in a global pandemic — but we do know that severe declines in asset prices will occur at some unpredictable juncture. Even acknowledging this (and writing it down) can help.

Lesson 5 - We need to have a plan we can stick to

Our obsession with the present makes it close to impossible to implement sensible long-term decisions. Time horizons contract dramatically and savagely during market declines.

Investment plans are incredibly important, but also fiendishly difficult to follow. In a bull market it is easy to say: “when valuations become more attractive (markets fall) I will increase my exposure to equities”. The problem is that when we make such commitments we neglect to consider how it will actually feel at the time it happens. Markets will be declining for a reason. News will be uniformly terrible. Are we sure that our plan was sensible? Hasn’t everything changed? Sticking to our plan will be the last thing we want to do. Plans need to be clear, specific, realistic and, as far as possible, systematic. Make the decision before it happens.

Always remember markets are forward looking, and today’s price reflects known information and future uncertainty.

Lesson 6 - Many people will want action!

As uncertainty increases and markets fall there will be an inevitable clamour for activity. Things are happening — what are we doing about it? Whether or not what we are doing is likely to be beneficial in the long-term, or is even part of our investment process, is likely to fade into insignificance.

For the vast majority of investors sitting on our hands, or making very modest adjustments based on pre-existing plans, is the right thing to do. The problem is this can be hard to do when the media is constantly trying to find new angles to focus on, frequently resulting in heightened anxiety.

Let’s be clear about short-term market calls in this environment. It means taking a view on the progression of the virus, the fiscal/ monetary response, the economic impact of that response, the prospects for businesses, the reaction of individuals, and, crucially, the behaviour of other investors. Good luck.

We’ve previously confirmed our clients deserve an A+ for the discipline they’ve exhibited in recent months in sticking with their plans. If an investment decision makes you feel good immediately, it will probably make you feel bad in the long-term. In periods of market weakness, the temptation to do what will make you feel better now can be overwhelming. This discipline will help ensure the probability of well-considered plans being realised remains high.

Lesson 7 - Recessions will happen, and for reasons we have not predicted

There are plenty of things that people ‘know’ are a waste of time in the investment industry but keep on doing anyway — one is speculating about recessions. Experts cannot predict when they will develop or what the cause will be. An economic shutdown and negative oil prices – who would have predicted that! We shouldn’t waste our time or energy trying to forecast the next one.

Lesson 8 – Evidence based investing using academic science remains appropriate

Nothing which has eventuated in recent times has caused us to fundamentally question the investment approach we use to develop client portfolios.

The value premium we target in equity portfolios has also not been evident over the past decade. In the US, the annualised compound return has been 12.9% for value stocks, which contrasts with 16.3% annualised compound return for growth stocks, or those with a high relative price.

Looking at returns for the US value and growth indices separately in the graph below, we see that growth’s annualised compound return of 16.3% over the 10-year period ending June 2019 was much higher than its return since July 1926, at 9.7%. On the other hand, value performance over the past decade has been in line with its historical average: 12.9% vs. 12.7%.

We can see value has performed similarly to how it has historically behaved. It is growth stocks that have had very good recent returns relative to the long-term history. The strong performance of growth stocks has been driven by companies like the FANGs, being Facebook, Amazon, Netflix and Google.

Investors maintaining an emphasis on growth stocks may be hoping this departure from the trend will endure, despite the historical long-term averages.

While stock returns are unpredictable, there is precedent for the value premium turning around quickly after periods of sustained underperformance. The research also shows there are periods – often quite prolonged – when equity premiums are not evident.

Looking at the U.S, the graph below shows the likelihood of a premium being negative over 1, 5- and 10-year periods since June 1927 (the longest stockmarket data set available in the world). For example, the size premium (that is, small stocks outperforming large stocks) was not evident 28% of the time over a 10-year period. Please note the “Market” example is stocks outperforming bonds – you can see bonds outperformed stocks 15% of the time over 10-year periods. There will always be periods when investors are not rewarded for the risks they are taking.

The question for investors is if you’ve just experienced a 10 year period when premiums were not evident, should you abandon the strategy and revert to another strategy?

The next graph shows the subsequent performance of premiums over 10 years after a negative 10-year premium. For example, when no Size premium is evident for 10 years, over the subsequent 10 years it has historically returned an average annual premium of 4.5% over large cap stocks. Note 4.5% is not the absolute return, it is the annualised average premium. For value stocks the average annualised premium versus growth stocks has been even higher at 8.3%.

Using this evidence rather than “gut feel” or past performance leads us to conclude that staying the course over the long-term with our investment approach is in the best interests of investors and our clients.

Author: Rick Walker

With thanks to Joe Wiggins’ article “17 lessons for investors from the COVID crisis” posted on 25 April 2020