Lessons from lockdown
This year's bipolar market swings have been exceeded only by the wild price action during the Great Financial Crisis in 2008 and the beginning of Great Depression in 1929. Stock markets around the globe tumbled dramatically in late February and March on fears over the novel coronavirus, but then rebounded sharply in April and May on the back of massive government stimulus and economic recovery hopes.
The US alone has so far ploughed over $3 trillion into the system in an effort to offset artificially constrained consumption of goods and services as many businesses were made to shut down just as even healthy people were forced into quarantine.
Investors who survived the recent vicissitudes can take away a few important lessons. First of all, long term investors need to have an appropriate asset allocation policy suitable to their individual risk profile. Secondly, diversification should be a part of everyone's personal investment mandate. And finally, investors should try not to panic when the news headlines appear most grim. Those with more aggressive allocations should have the mindset to live with worst-case drawdowns on occasion.
Asset allocation and diversification as concepts actually well work together. A personal investment policy statement should include some combination of fixed income, equities, cash and possibly exposure to real assets such as commodities and real estate.
Having positions in lower risk investments like high grade bonds and money market funds will likely reduce portfolio total return over the long run, but should also help minimise volatility in the short and intermediate term, particularly during volatile periods such as this one.
We know from history that equities provide greater returns over time, but at the cost of increased near-term fluctuations. However, an allocation to so-called “risk-off” assets can have an overall positive impact as some security types typically move in different directions over short periods of time. For example, government bonds and gold tend to zig when the stock market zags.
During the first quarter of this year, when the S&P 500 declined by 19.6 per cent and the MSCI World Stock Index fell by 20.94 per cent, the Barclays Aggregate bond index increased by 3.15 per cent and gold increased in value by 4.89 per cent.
Using a disciplined allocation approach and rebalancing on a regular basis may help investors achieve superior risk-adjusted returns over time. For example, an investor with a 50 per cent stock/50 per cent bond ratio would have found themselves at a ratio of approximately just 40 per cent equities at the end of first quarter when the stock market tumbled.
Rebalancing the portfolio back to 50 per cent equities at the end of March entailed buying more stocks at lower prices while simultaneously selling more expensive bonds at higher prices. This investor would then have benefited from the recent surge in stock prices since the end of last quarter.
Unfortunately, some individuals find it difficult to buy when markets are at their lows. Typically, the news headlines are the worst during these times and human tendency may lean towards inaction or even panic.
This spring, the major news sources would have you believing the world might be coming to an end. I wrote about this pattern here in an earlier article, “Navigating the pandemic of fear”, on March 19 where I mentioned that buying when fear was the highest has historically been a good strategy. Indeed, the S&P 500 has increased in price by 27.3 per cent since then.
We keep an eye on the Chicago Board of Options Volatility Index, which often spikes to new highs when the market is hitting new lows. We saw this in late March when the Vix hit 82, its highest level ever. Even now, the Vix stands at an historically elevated level of approximately 36, more than double its five-year average as of this writing which suggests fear remains a pervasive force.
If investors cannot bring themselves to rebalance their asset allocation when world events reach major inflection points, they should at least avoid selling into the panic. Keeping a calm head or working with a professional investment adviser is particularly important during times of crisis.
Asset allocation should be a dynamic process. As an investor's time horizon for needing to spend funds becomes shorter, they should consider reducing their risk profile to include more cash and short-term bonds. However, longer-term investors with a stomach for volatility, may continue to reap the benefits of a more diversified approach.
• Bryan Dooley, CFA is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.