“The hardest work in investing is not intellectual, it’s emotional. Being rational in an emotional environment is not easy. The hardest work is not figuring out the optimal investment policy; it’s sustaining a long-term focus at market highs or market lows and staying committed to a sound investment policy. Holding on to sound investment policy at market highs and market lows in notoriously hard and important work, particularly when Mr Market always tries to trick you into making changes.” Charles D. Ellis
As the American baseball coach Yogi Berra, renowned for his comical quotes, once said ‘It’s deja vue all over again!’; that is very much how this recent market sell-off feels.
Experienced investors will be familiar with the scenario that has been playing out over the past couple of weeks in the markets and familiar, too, with the feelings of uncertainty, disappointment and measured concern that accompany such times. Specific events – in this case a falling Chinese equity market, coupled with a broader reassessment of the prospects for the Chinese economy – often act as a trigger for a major movement in global equity markets. That is how equity markets work; the current value of the markets reflects the aggregate of the estimated current value of firms within it, based on the market’s view of their future earnings.
Markets move when new information becomes available; if this news is bad for company earnings, markets will fall; if it is positive they will rise. In this case, the Chinese government’s ham-fisted, desperate attempts to shore up the Chinese equity market, combined with its recent devaluation of the Yuan, was taken by the market as a sign that the Chinese economy – which represents around 15% of global GDP – was perhaps slowing at a faster rate than was previously thought.
Bursting of the Chinese equity market bubble
As an aside, the Chinese equity market rose dramatically by over 70% (MSCI China Index) over the 12 months to May this year, fuelled by rampant speculation; in the last week of May alone, 4.4 million online retail brokerage accounts were opened! Chinese investors had borrowed a record US$232 billion to invest in the market. The subsequent fall that we have seen has simply given back the previous rampant and unrealistic returns. Even Eugene Fama would struggle to claim that there was no Chinese market bubble!
For those less familiar with investing, the temptation is to panic in the face of uncertainty and the fear that accompanies headline-grabbing BBC news reports (Robert Peston loves the drama of any market turmoil) and worrying about what is happening to their hard-earned assets.
Keeping events in perspective
There are some important things to remember at times like these:
- These market gyrations are an inevitable consequence of owning equity assets; markets go up, down and sideways from time to time. Two steps forward and one step back is a reasonable way to think about owning equities. Experienced investors will realise that it is the very uncertainty of short-term market returns that delivers the longer-term incremental returns that equities offer, above owning bonds or cash.
- In investing, you do not make a financial loss unless you sell out of a position e.g. selling equities when they are down. As a long-term investor you have the luxury of being able to hold your assets until the storm passes.
- The allocation to equities in your portfolio is linked to your emotional tolerance for risk, your financial capacity to suffer losses and your need to take risk in the first place. Most investors own a balance between bonds and equities. Remember that your portfolio is unlikely to have suffered anything like the headline falls of the Chinese market!
- You own a well-diversified portfolio made up predominantly of developed market equities and high quality bonds and your direct exposure to the Chinese market will be very small, probably less than 2% depending on the structure of your portfolio.
- The high quality bonds that you own will be undertaking their defensive duties at this time. For example, since the start of August short-dated gilts (FTSE Actuaries Conventional Gilts up to 5 Years Index) have risen by around 0.5%, whilst the developed equity markets (MSCI World Index) have fallen a little over 10%, as has the UK market (FTSE All Share Index). In contrast to your high quality bonds, global high yield bonds, i.e. those with higher credit risk, which you do not own in your portfolio, have fallen by over 2.5% over this period (Barclays Global High Yield Index).
- The UK market was last at its current level as recently as mid-December 2014, but few were alarmed at that time as the market was gradually rising. In fact even with recent falls, the UK market is up around 45% over the past 5 years and the global developed markets are up around 60% over the same time frame. We need to keep these short-term events in perspective.
- The US and UK economies are growing strongly – it is not all doom and gloom.
- Depending on how far your portfolio’s allocation has changed, it may be necessary to think about rebalancing your portfolio by selling some of your high quality bonds and actually buying more equities to return the portfolio back to its original structure. We will, of course, contact you if we decide that such a move is appropriate.
Remember that investing is a long-term game that requires both patience and discipline. Once you realise that you can’t control the markets – and that nobody can – and that knee-jerk decisions almost always result in the wealth destruction strategy of buying high, selling low, then all you have left is structure, patience and discipline. Time heals most investment wounds.
Perhaps reflect a while on these wise words written by Charles D. Ellis in his excellent book, Winning the Loser’s Game (Ellis, 2002):
“The hardest work in investing is not intellectual, it’s emotional. Being rational in an emotional environment is not easy. The hardest work is not figuring out the optimal investment policy; it’s sustaining a long-term focus at market highs or market lows and staying committed to a sound investment policy. Holding on to sound investment policy at market highs and market lows in notoriously hard and important work, particularly when Mr Market always tries to trick you into making changes.”
He shares more wisdom with us:
“Don’t trust your emotions. When you feel euphoric you’re probably in for a bruising. When you feel down, remember that it’s darkest just before dawn and take no action. Activity in investing is almost always in surplus.”
As ever, we will remain vigilant on your behalf and keep you posted, but for the meantime keep calm and stick with the programme. Please do call us if you have any specific concerns.