By Tom Claridge, CFA and senior portfolio manager UK, Julius Baer International
Financial markets have a complicated relationship with their underlying economies.
Markets do not react to the good or the bad but instead to circumstances getting better or worse relative to expectations. They react to how things progress versus how investors expected them to progress; therefore, whilst it can be relatively straightforward to predict how an economy will perform over the short term, predicting how financial markets will behave is considerably more difficult.
Keynes compared forecasting markets to a beauty contest, but one where the judges (investors) had to say not who they thought the most beautiful contestant was, but whom most other judges thought it was.
Tom Claridge
Rarely in history have we had a greater illustration of how challenging predicting market behaviour is than the previous two months.
Just as many investors at the end of January thought that coronavirus was insignificant for markets, by late March many could see no hope for the global economy or equity markets.
Moments like this, where markets experience large daily moves and the outlook is historically uncertain, should remind us all to stick to a disciplined investment process that focuses on the long term.
In the short term, one of the most beneficial characteristics of investing in the stock market is the continuous ability to value and to trade that investment.
At times of stress however, having the ability to easily value an investment and having the ability to sell that investment creates an emotional problem for investors. In contrast, people are often unaware of the price volatility of their property investments over similar periods and selling is such an expensive and time-consuming process that most would not consider it.
During times of stress when markets behave unpredictably, the desire among equity investors to sell and reduce risk is extremely tempting. However, tolerating the short term volatility or risks is the price we pay for generating long term returns.
For those currently invested, this all points to a long term, strategic approach. As they say, there is no such thing as a free lunch in investing, but having a long term time horizon and diversification are as close as you can get in public markets.
At its core, a strategic approach requires an asset allocation that takes the maximum amount of risk one can tolerate, making your return a mere residual factor of that risk appetite, knowing that this approach has the best chance of maximising these returns over the long term.
During times of stress, deferring to this asset allocation rather than cash, is the key to generating strong consistent returns.
For those with cash who are looking for an opportunity to invest, we find it best to have a road map laid out which may involve investing over a fixed period of time, say three months.
Ideally, we would suggest investing at regular intervals in equal amounts and into a cross section of your planned portfolio to ensure balance. This should be done during the highs and the lows, removing emotion and deferring to process where possible.
Waiting for it to ‘feel right’ will decrease your investment time horizon, reducing your ability to take risk and lowering your expected returns.
The other crucial point is to be selective. Some of the changes from a seismic shock such as a deadly virus will be short term, whilst others will be more structural and long term. The short term changes create opportunities to buy good companies at decent levels, and identifying the structural changes will allow us to avoid the losers.
Ultimately, whilst we may struggle to predict how financial markets will behave in the short term, the winners will be those who have invested for the long term and employed a disciplined investment approach.
