Knowledge after the fact

David Crozier

Share prices have been falling and there is an innate human desire to know why, to seek an explanation.

You are not alone; everybody wants to know.

Going on about market fluctuations, or “A Random Walk Down Wall Street”*, simply isn’t enough. We want something more definite, some tangible cause that is giving rise to the effect.

There are any number of possible explanations for the recent sell-off: Brexit, inflation fears, a slowdown in China, trade wars and tariffs. Take your pick from that lot, and a range of other potential issues.

For those that are simply passive consumers of news, any of these reasons, whether right or wrong, will serve to explain the “why” and are more or less harmless. (Whether the explanation is actually true is another matter.)

For investors, however, such reasonings can lead to actual harm. Humans – you, me, all of us – are emotional beings. Our impulsive response to bad news is to panic and sell after the fact. We respond to good news and higher prices in a similar fashion, by panic buying after the fact, for fear of missing out.

It does not take a genius to work out that this is not an effective long-term investment strategy.

The S&P 500, the main indicator of US stocks, is only down 9.8% from its recent all-time high, which is just above the average of the 22 prior corrections since March 2009 (-9.3%). The UK equivalent, the FTSE All Share, is down a similar amount at 9.93%†.

I am indebted to Pension Partners for the following table, showing that all of these corrections had fear-inducing explanations associated with them that seemed like the end of the world at the time.

All, without exception, were soon followed by new stock market highs

That may, or may not, be the case this time also. It could be another run-of-the-mill market correction, or it could be the start of something bigger. We will only know in hindsight. Regardless of what happens next, panic selling (or buying) is not the answer.

Bear in mind that your portfolio is structured so that you should not suffer the full effects of a fall in equities. You will have some fixed interest, which acts as a buffer. It’s not that fixed interest securities can’t go down in value – they absolutely can – but they tend not to happen at the same time as falls in shares, and the magnitude of the falls is nowhere near as large.

The reward for being a long-term equity investor does not come without a large dollop of risk – frequent bouts of it, three or four corrections of at least 5% per year, on average. During the most peaceful US market in history (2017), many investors forgot this lesson. The S&P 500 advanced every single month last year without a drop greater than 3%. Investors having been getting a reminder of equity risk in 2018, but it still pales in comparison to what we saw from 2000-03 (48% FTSE All-Share decline≠) and 2007-09 (46% FTSE All-Share decline±).

Is there ever a reason to sell? Yes, of course; but it should be unemotional, in response to a clearly defined strategy or a change in circumstances, whether that be objectives, risk budget or time horizon, and always within the context of your long term financial plan. If you sell today, when do you buy back in and what is the catalyst for doing so? If you can’t answer that question with a repeatable process, better to stick to your written Investment Policy Statement, based on your Risk Budget (yes, every investor should have these).

While it may be a basic human urge to explain every twist and turn in the market, post hoc explanations do not give investors any advantage. Knowing the reason for market movements is only helpful if that reason is forward looking, but of course, and sadly, it never is. It cannot be, unless your name is Nostradamus.

Daily financial news is primarily a form of entertainment, which should play no role in how you manage your portfolio. It is their job to entertain to gain viewers; it is your job – and ours – to ignore it, and to remain invested for the long run.

As ever, if you have any queries about the issues raised in this article, or if you need to discuss any aspect of your financial planning with us, please do get in touch. We are here to help.

Kind regards

David Crozier CFP
Chartered Financial Planning

Important: the value of real investments can fall as well as rise, and you may get back less than you invested. Past performance may not be a guide to the future.

*Malkiel, B G. 1973. A Random Walk Down Wall Street

†Source: Financial Express 09/08/2018 to 26/10/2018
≠Source: Financial Express 04/09/2000 to 12/03/2003
±Source: Financial Express 11/10/2007 to 03/03/2009