30 Jun What to do in the next crash
“Doubt is not a pleasant condition, but certainty is an absurd one.“
As world equity markets continue to hit new record highs, so the mutterings of ‘experts’ forecasting the next crash grow louder and louder.
Of course, at some point, equity markets will suffer a fall – history tells us that markets are falling roughly one third of the time.
An oft quoted reason for market volatility is that ‘the markets don’t like uncertainty’, but just how logical is it to say that? There are many different aspects to uncertainty, some of which can be measured and some which cannot. Uncertainty is an unchangeable condition of existence. As individuals, we can feel more or less uncertain but that is a distinctly human phenomenon.
“The longing for certainty… is in every human mind. But certainty is generally illusion.”
– Oliver Wendell Holmes
Rather than ebbing and flowing with investor sentiment, uncertainty is an inherent and ever-present part of investing in markets. Any investment that has an expected return above the prevailing ‘risk-free rate’ (UK Government treasury bills for example, although no asset is truly risk-free) involves trading off certainty for a potentially increased return.
Consider this concept through the lens of equity vs. bond investments. Equities have higher expected returns than bonds largely because there is more uncertainty about the future state of the world for equity investors than for bond investors.
Bonds, for the most part, have fixed coupon payments and a maturity date at which the principal originally invested is expected to be repaid. Stocks have neither. Bonds also sit higher in a company’s capital structure, so in the event that a firm goes bust, bondholders – at least in theory – get paid before stockholders.
So do investors avoid stocks in favour of bonds as a result of this increased uncertainty? Quite the contrary; many investors end up allocating capital to stocks due to their higher expected return. In the end, many investors are often willing to make the trade-off of bearing some increased uncertainty in exchange for potentially higher returns.
“Look at market fluctuations as your friend rather than your enemy;
profit from folly rather than participate in it.”
– Warren Buffett
While the statement “the market hates uncertainty” may not be logical, it doesn’t mean it lacks educational value. Thinking about what the statement is expressing allows us to gain insight into the mindsets of individuals. The statement attempts to personify the market by ascribing the very real nervousness and fear felt by some investors when volatility increases.
It is recognition of the fact that when markets go up and down, you may struggle to separate your emotions from your investments. It ultimately tells us that for many an investor, regardless of whether markets are reaching new highs or declining, changes in market prices can be a source of anxiety.
During these periods, it may not feel like a good time to invest. Only with the benefit of hindsight will you feel as if you know whether any time period was a good one to be invested. Unfortunately, while the past may be prologue, the future will forever remain uncertain.
STAYING IN YOUR SEAT
In a recent interview, David Booth of Dimensional Fund Advisors was asked about what it means to be a long-term investor:
“People often ask the question, ‘How long do I have to wait for an investment strategy to pay off? How long do I have to wait so I’m confident that stocks will have a higher return than money market funds, or have a positive return?’ And my answer is it’s at least one year longer than you’re willing to give. There is no magic number. Risk is always there.”
“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”
– Mark Twain
Part of being able to stay unemotional during periods when it feels as though uncertainty has increased is having an appropriate asset allocation that is in line with your willingness and ability to bear risk. It also helps to remember that, during what feel like good times and bad, you wouldn’t expect to earn a higher return without taking on some form of risk. While a decline in markets may not feel good, having a portfolio with which you are comfortable, understanding that uncertainty is part of investing and sticking to a plan that is agreed upon in advance and reviewed on a regular basis can help keep you from reacting emotionally. Ultimately, your ability to do this is what will give you the best chance of having a successful investment experience.
“I can live with doubt and uncertainty and not knowing. I think it is much more interesting to live not knowing than to have answers that might be wrong.”
– Richard Feynman