Investing

Investment flight plan essential to navigating market storms

  • 11.MAR.2016
  • Jeffrey Johnson,  Vanguard

By Jeffrey Johnson, Vanguard Head of Investment Strategy Group, Asia Pacific

A few pilot friends have  described flying as long stretches of boredom interrupted by panic—and this held true on my first lesson behind the controls.

Unfortunately, the same has been true for investors of late, as the market and economic environment have become more volatile and turbulent.

Like jittery novice pilots, it’s understandable that at least a few investors are feeling nervous as their portfolios are buffeted about in volatile conditions, and wondering whether they should change course.

While there is genuine uncertainty around the future of the Australian economy and international markets, there is also a touch of sensationalism around the recent volatility that has been dominating financial commentary of late. Even the more balanced discussions about the economy can be taken out of context and lead investors to overreact and make short-term decisions with damaging, long-term financial consequences.

In fairness, investing can be a highly emotional activity, and it is understandable that investors are nervous, and nothing seems to provoke emotions like financial losses and market volatility. The market has fallen about 15 per cent from its peak last April and this puts the Australian market in ’correction’ territory.

Other global markets are in worse shape. China has fallen by 45 per cent, Europe and Japan are each off around 25 per cent, and the US has lost 12 per cent.

The upside to the downward trend

No one enjoys it, but this is the 11th correction of the Australian market in the last 30 years. That is, they are an all too frequent part of the investing, occurring about every three years on average. So, by historical standards, this type of market volatility should be expected from time to time.

We’ve known for some time that much of the world and many key economies are decelerating, but this is part of a transition that will ultimately result in a more balanced, less leveraged and healthier equilibrium.

If anything, the correction has made equity valuations more reasonable.

However, there is good news in this outlook, which is that the longer-term return expectations for diversified investors are reasonable. According to our projections, over the next 10 years we see average annual returns in the 5-7 per cent range, depending on your risk tolerance.

Double digit returns are likely out of the question, but with inflation of around two per cent, a return in the 3-5 per cent range is a realistic and not bearish expectation.

Of course, for investors to realise this outlook, they need to ignore the headlines, stick to their long-term strategy and rebalance to their target asset allocation.

This is difficult because humans are hardwired to experience more pain after financial losses than joy after financial gains – the pain of losing $10,000 is far more acute than the joy of winning $10,000. Economists refer to this as loss aversion.

In fact, studies suggest that the emotional impact of losses is twice as strong as those experienced for gains. This phenomenon can prevent us from taking appropriate risks and cause us to make poor investment decisions.

For example, when the market goes through a correction many investors look for safety. Unfortunately, changing asset allocations during times of market volatility—selling equities and going to cash or bonds—can have long-term consequences. This sort of behaviour can derail reaching our investment objectives, or at least delay them by some years.

It is absolutely critical to stay true to a pre-determined asset allocation during these times.

Another good habit to fall back on when markets experience a correction is to rebalance. Unfortunately this is often the last thought entering the mind of the loss-averse investor. Allocating additional funds to an asset class that has recently performed poorly—as is required when rebalancing—can be uncomfortable and seems counter-intuitive.

One way to overcome this reluctance is to develop and commit to a rebalancing plan, in advance. The good news here is that the specifics of the rebalancing strategy matter less than actually committing to the plan.

So, exactly how important is it to stay invested and rebalance?

Rebalancing is critical

A portfolio of 50 per cent stocks and 50 per cent bonds worth $10,000 at the start of the GFC was worth about $8000 at the low-point of the crisis. Many loss-averse investors wanted to ’get out’ at this point. However, by rebalancing and retaining the 50/50 mix, the portfolio would have recovered and been worth around $15,000 today.

Had an investor abandoned their investment strategy and moved to cash, they would have only just recovered their losses recently, and would only be worth $10,400. Had the same investor instead moved to bonds, the investment would be worth around $14,000. That is, even after the recent market volatility, the investor who stuck to their diversified portfolio was better off than those who changed course by scrambling for a ‘safe’ asset allocation.

Vanguard chart of equities vs bonds vs cash

Investing should be simple, but it is rarely easy. Market volatility and economic uncertainty are always present, but unfortunately they can often cause investors to lose focus on their long-term objectives. The best thing an investor can do at times like this is to ignore the headlines, stay invested, and rebalance to their target asset allocation.

Because, like mastering a fear of piloting a small metal flying machine, one of the most important lessons investors can learn is to ignore the urge to panic and stick to their flight plan.

This article first appeared in the Australian Financial Review on Wednesday, 9 March 2016.

Source: Vanguard

 

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