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Looking on the bright side, cautiously

07 August 2020

8 minute read

By Alexander Joshi, London UK, Behavioural Finance Specialist

While investors may be easily carried away on a wave of optimism about a stock or sector, maintaining a degree of cautious optimism may be called for during good times.

The start of summer can bring a degree of optimism. This year the mood shift may have been tied to the lifting of quarantining and resumption of many aspects of pre-coronavirus life. Leaving aside the relief of being able to get out and about again, the prudent approach would seem to be to continue exercising caution.

The same applies to businesses. While the resumption of economic activity is welcome, companies should be prepared for the prospect of restrictions being re-imposed. More importantly, however, firms face adapting to what is likely to be a very different world post-pandemic.

Too much of a good thing

Equity markets suffered an unprecedented sell-off, in terms of speed and depth, in the first three months of the year and an equally sharp rebound in the following three months. Large fiscal spending commitments and monetary policy moves, designed to keep money flowing to both businesses and consumers, contributed to setting the ground for the second-quarter recovery.

Historically, it has often paid to have faith in people’s ability to overcome problems with innovative solutions. For this reason alone, our base case assumption is that things will eventually return to as they were previously. This includes our belief that a vaccine will be found for this virus and its variants.

Leaning too far towards an emotion can be dangerous. An overly optimistic lens can help to feed optimism over objective and dispassionate analysis. The confirmation bias might lead to overweighting good news and data points around the easing of lockdowns and paying less attention to the risks associated with further outbreaks until a vaccine is found.

Letting pessimism take hold

The same holds true for pessimism. As the financial markets slid early in the year, pessimism took centre stage in the mainstream and financial media, in turn causing many investors to amplify an undoubtedly severe crisis even further. This led to more defensiveness and risk aversion. It also led many investors to make hasty and costly liquidations or to hesitate in deploying cash into investments. As we have said previously, it is important to be aware of the impact of the news on our decision-making during particularly volatile market periods.

Sentiment swings

Financial markets seem to be largely ignoring risks of a second wave of COVID-19 infections around the world and looking to a quick, V-shaped, recovery. As some markets near their highs, such optimism may be misplaced. While asset values appear elevated, volatility remains high. With consensus expecting next year’s earnings to bounce back to 2019 levels, any developments that indicate a recovery may take longer than is presently expected could hit sentiment.

As November’s US election nears and other event-based-risks like Brexit play out, volatility may also climb. Equities are one area where American election fears could be felt first. Election uncertainty is likely to increasingly influence sentiment and volatility.

Sentiment indicators of individual investors (see chart) illustrate that when market sentiment shifts, it can do so rapidly and markedly, as seen earlier this year.

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Trading data mirrors this change in sentiment. The ratio of put to call options surged in March, before falling sharply, and recently touched a six-year low (see chart).

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In many cases, sentiment tends to overreact to, or even feel disconnected from, fundamentals. In some periods, sentiment may be excessively bullish and in others excessively bearish.

Plan in the calm

In periods of stress, investors’ time horizons can feel shortened, possibly increasing the perceived riskiness of investing. Indeed, loss aversion can lead to decisions which provide short-term comfort, but put at risk the achievement of long-term investment success. This may transpire in, say, cutting risk at the wrong time, or failing to rotate exposures to maintain strategic exposures.

Given markets and sentiment can quickly alter course, investors can get caught out. For this reason, in periods of relative market calm, when being invested can be more emotionally comfortable, it is a good time to plan for the inevitable bumps along the road. While it is impossible to predict short-term market developments with much certainty, the unpredictability of markets is relatively certain.

Prepare for risks, but also opportunities

Planning for different eventualities with a trusted advisor can help to weather uncomfortable periods when they arrive. The best protection, however, is to have a long-term investment strategy designed that can perform well in both rising and falling markets. Such an approach may not need much portfolio maintenance during challenging times.

The investment philosophy of our portfolio managers has remained unchanged during the pandemic. The focus is on investing in high-quality businesses for the long term. It has resulted in resilient portfolios capable of outperforming when markets are slipping or charging higher.

Portfolio diversification can help protect against wealth destruction in turbulent times. However, periods of calm may also provide a chance to capitalise on potential future opportunities when they arise. This might include investment structures aiming to profit from volatile periods without taking directional viewpoints. Examples include market volatility or the dispersion of returns between stocks, noting that the pandemic may have introduced long-lasting differentiation between stocks, which could be further exacerbated by upcoming political events such as the US elections and Brexit.

Periods of calm may also provide a chance to capitalise on potential future opportunities when they arise. This might include investment structures aiming to profit from volatile periods

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Market Perspectives August 2020

Financial markets remain fixated on pandemic risks, and hopes of a COVID-19 vaccine, as spikes in infections occur in regions of leading economies.

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