Ben Kumar, Investment Manager, Seven Investment Management
Someone once told me that on average, we won’t remember 10% of what we read, 20% of what we see and 30% of what we hear. There is no way that’s true. I think we forget a lot more than that. Why else do I have to pause Game of Thrones every three minutes to google who a character is? And I’m paying attention in Game of Thrones! Memory gets even more challenging depending on where we were when we were trying to retain the information, what else was going on (in the room and in our lives) and how long ago it was.
However, memories are really important with regard to investing. They affect us positively when we remember how well a particular investment has done and negatively when we suffer at the hand of market movements. These experiences bring in behavioural biases that change our decision making process and it’s amazing how quickly the past is replaced by the even more recent past.
Throughout 2017 and into January 2018, markets were incredibly unruffled by what was happening in the world. Whatever the news, markets kept calm and carried on steadily increasing over the course of the year. An excellent example of this composure was the S&P 500. Throughout 2017 i.e. out of some 252 trading days, we saw just eight days when the market moved more than 1%.
However, shortly before the end of January, markets moved and volatility made a comeback. In the two and a bit months of this year, the S&P 500’s moved by more than 1% over ten times (as at the time of writing).
What many people seem to have forgotten about this current bout of movement is that it is actually quite a normal state of affairs. The overreaction from investors has been akin to having a couple of hot weeks in September, and deciding that you will never need central heating again. Even just going back to 2016 shows that what is currently happening was reasonably ‘normal’ as markets moved by that 1% mark or higher nearly 50 times over the year i.e. around once a week; around the long term average each year for the main US stock market. We’ve simply been lulled into a false sense of security by very recent history and completely forgotten that this is how markets usually behave.
This raises two issues. The first is for cautious investors who have been tempted into investing in equities in far greater volumes than they would traditionally have ever been comfortable with. The second is that it has started the debate as to whether this is the beginning of the end of the bull run in equity markets.
The first matter has been a concern of 7IM for some time. We are multi asset investors and believe that each type of investment plays a different role in the portfolio. So, for example, equities have traditionally held the role of delivering higher returns than many other investments, but they always came with the recognition that those returns were recompense for the higher levels of risk that they typically carry. Meanwhile, the conventional role of bonds has been to deliver a steady stream of interest income and to dampen the volatility of the equity part of a portfolio.
Both of these views have been challenged by recent history. Record low volatility has led some to believe that the allocation to equities can be increased without increasing risk, whilst there have been multiple periods when equities have fallen in value at the same time as bonds. Here therefore, there should be some thought about what people can use to diversify portfolios, and how much risk they are taking.
The second concern is a more difficult debate. We know that markets may start to trend downwards some six to 12 months before any poor economic growth data is released. This is the third longest bull run since World War II. The second longest was the run in the late 1990s which ended with the dotcom bubble and comparisons with this period are already being circulated. However, bull markets do not simply run out of steam – they need a catalyst. The global economic situation – even including our own confused scenario here in the UK due to Brexit – looks set to continue for the foreseeable future. Given memories may just have been jolted about the fact that markets do go down as well as up, this is something to be aware of. Again though, look out for that recency bias! Just because markets fell in the last few weeks, doesn’t mean they will go on falling. Always try to put things in perspective.
Given I’m writing this article, it should come as no surprise that we have thought about these things. So we have slightly lower than average equity holdings (markets look expensive, but can certainly continue growing), decent cash allocations (to pick up any opportunities), and have invested in some other defensive measures. These should help mitigate any pain and, more importantly, could provide chances to invest cash into attractive assets at much more appealing prices than the last few months have afforded.