Don't just do something, stand there!
Can you think of one person you know who has renovated their house and there was not a single change to the original plan? No matter how good the architect or builder, or how determined the owner is to have no variations the contract, it always happens. Some of the changes are driven by the owner, some changes are driven by the unexpected.
Your financial plan is the same. When we create a plan for a client, we know it will evolve over time. We expect periodic volatility in financial markets. Life is unpredictable. Investment markets are unpredictable.
In March 2023, Silicon Valley Bank (SVB) collapsed. Technically the bank had sufficient assets to cover its liabilities but given the unexpectedly high interest rate rises of 2022, many of the bonds held by the bank had fallen in value (we can discuss how their Treasury operations functioned another time…), so once a run on the bank started, it was doomed.
The media loved the opportunity SVB provided to ask questions like is this another GFC, or what other banks may soon fail? This inevitably creates stress and anxiety for many investors.
How do we react during stressful periods like this, and what does it tell us about how we deal with investment risk?
Joe Wiggins wrote an excellent article[i] listing 10 behaviours we commonly exhibit when unexpected events like the SVB collapse occur. His article was so good we hardly changed a word of his list:
1. Our time horizons contract
The key danger for investors during periods of market stress like the SVB collapse is the contraction of our time horizons. Even if we have a long-term orientation, we quickly start to worry about the immediate future. All our carefully considered behavioural plans can be torn asunder, as we seek to remove the anxiety we are feeling right now.
2. We focus on one thing
It is not just that our time horizons contract, but our focus narrows. The attention of many investors turns to one thing — in March it was SVB and the risk of more banks going under — typically at the expense of issues far more important to our long-term fortunes, like asset protection and our personal expenditure.
3. We feel like we must act
Never is the most damaging investor urge of ‘something is happening in markets; we must do something to our portfolio’ more powerful than during a concerning and unexpected market event. It feels like everything is changing, so our investments must also change. We never let our failure to predict what has just happened stop us predicting what will happen next.
Morningstar has just released a report showing if 34 tactical U.S asset managers - being funds which adjust asset-allocation exposures depending on their market forecasts - had made no changes to their portfolio over the past 10 years, rather than transact on their projections, their investors would have ended with twice as much money. Double! Over the 10 year period 22 of the funds died, and of the 12 that still exist, not one generated a higher return that the market portfolio.
4. We are all ‘after-the-fact’ experts
When a significant market event that nobody predicted occurs, hindsight bias runs amok. Back in March, many commentators could cogently explain the risk inherent in the SVB model - not many did so in the days or weeks before it failed. While everyone is busy discussing what transpired, it is worth reflecting on why nobody expected it.
5. Uncertainty hasn’t increased
During stressful periods in markets, it is common to hear people comment that markets are now “more uncertain”. This makes no sense. Markets are always uncertain. If we felt more confident in the future before the surprising occurrence with SVB then it turns out that we were wrong. We simply don’t know what is going to happen tomorrow.
6. Market / economic predictions are tough
I don’t recall reading many 2023 market forecasts which mentioned the failure of SVB - or Credit Suisse being forcibly taken over by UBS nine days later. The problem with complex, adaptive systems is that things change / events happen and that alters everything. Let’s stop making short-term market predictions.
7. The most meaningful risks are the things we don’t see coming
Both how we think about and model risk is conditioned by what we have seen and experienced. The most profound and material risks are the ones that we do not anticipate.
8. Risks are either understated or overstated
We are prone to treat risks in a binary fashion. Either completely ignoring them or hugely overstating them. We tend not to buy flood risk insurance until our house is under water.
9. We focus on risks that are available and salient
The risks we focus on are those that are available (in recent memory) and salient (provoking emotion). It is easy to be complacent about risks that have not come to pass in a long time (perhaps in our living memory).
10. This risk is now available and salient
Now the type of risk encountered by SVB has become available and salient it will be at the forefront of investor thinking and decision making, we will see it everywhere. Unfortunately, the next major risk event is likely to be something completely different.
Unexpected market events like the SVB collapse in March are anxiety inducing and provoke some of our most damaging behaviours. It will be in most investors interest to focus less on the current issue and more on our response to it. Sensible investing principles — such as taking a long-term perspective, systematic rebalancing and being appropriately diversified — are designed to deal with situations like these. Let’s not forget them.
Author: Rick Walker
[i] 11 things the SVB collapse tells us about investor behaviour | TEBI (evidenceinvestor.com)