Staying on track whatever the investing weather

15 November 2021

By Alexander Joshi, London UK, Behavioural Finance Specialist

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  • Summary
    • While we expect the global economy to expand further in 2022, there are still likely to be challenges for investors to navigate as we emerge from the pandemic
    • These events can be unsettling when they materialise, but investors should be clear on their goals in order to stay on track – and avoid acting too quickly – during turbulent times
    • Unconscious biases can also lead to investment mistakes – confirmation bias is one of the biggest errors an investor can make
    • With market volatility increasing, having a diversified portfolio can offer the best protection to ride out any turbulence – both financially and emotionally
  • Full article

    The outlook for the global economy is positive, but risks remain. Some, like COVID-19, matter more than most and can derail your financial plans. How can investors prepare for, and react to, risks as they materialise, so as to stay on course to reach their goals, whatever the weather?

    The outlook for the global economy is positive, and we anticipate above-trend global growth of 4.5% in 2022 as the recovery phase plays out. The world is, however, emerging from a difficult period, and there are still likely to be challenges for investors to navigate.

    There is rarely a perfect time to invest, and there will always be risks (upside as well as downside). Risks on the horizon should not, however, deter people from being invested. This article discusses behavioural considerations that may help investors stay on course to reach their goals, even if the journey becomes turbulent.

    Start from your goals

    Are you clear on your investment goals? Our experts have examined the macroeconomic outlook and asset classes in detail, but before acting on it, investors should first be clear on what it is they are trying to achieve.

    With this in mind, investors have a lens through which to consume investment views, and can consider how to capitalise on opportunities, or mitigate risks that may jeopardise their goals.

    Additionally, those that are clear about their goals may be better able to manage volatile periods by having a longer-term perspective. Those chasing performance for performances sake may be more susceptible to behavioural biases due to a more myopic approach1.

    Check your confirmation bias

    It is good practice when consuming financial news to pay attention to, and actively seek out, views which are different from your own, so as to minimise the likelihood and impact of nasty surprises. Humans have a tendency to seek out or pay more attention to information which confirms their prior beliefs – the confirmation bias – which can lead to biased decision-making.

    A recent survey of 300 financial advisors by Cerulli Associates between May and June2, on the biases they observe in investors, revealed that advisors’ believed 50% of their clients are significantly affected by confirmation bias. This was second only to recency bias (58%), a related bias, of being overly influenced by recent events. Both figures were far higher than a year ago (25% and 35% respectively), indicating a marked increase in observed biases in investors navigating financial markets during the pandemic. In difficult markets the risk of biases in decision- making is elevated.

    Challenge your thinking

    An important aspect of robust decision-making is to challenge one’s thinking. Particularly when forming an investment outlook, biased thinking may have repercussions in the form of short-term tactical positioning which drags on returns. In addition, biases can affect asset allocation, which may be more significant for an investor’s return profile over the long term. This may, for example, be an overweighting to an asset class or sector due to a long held view. A view that might have been correct in the past, but is no longer the case, and to which an investor gives insufficient weight.

    A good way to challenge your thinking is to consider what the impact would be if your views were wrong. Where the impact may be material, appropriate hedging may be advisable, as well as diversification, which we discuss later.

    So what if some of these risks discussed in this outlook materialise? What should investors do if and when events occur that have possible implications on their portfolios?

    Think about the impact on your individual portfolio

    Investors should remember the primary risk to be concerned about is not achieving their goals. Look at whether events materially affect your ability to reach these goals, and if so how.

    In Solving the puzzle of the post-pandemic bond world, we discussed the risk that inflation persists and central banks move more quickly in raising rates. If this were to materialise, it is likely to be worse for growth relative to value stocks, because cash flows of the former are further into the future. As such, when the cash flows are discounted at a higher rate, these companies become relatively less valuable.

    But at a portfolio level, the impact is not so clear cut and may not mean that an investor holding growth companies would see the value of their portfolio drastically depressed. Rising inflation will affect different companies in very different ways. It will typically result in higher raw material, wage and debt servicing costs. Companies that can minimise costs, while passing them on to consumers, will do better than companies that do not.

    Thus companies with higher pricing power may be affected less, even if they fall under a style which inflation is typically bad for.

    Avoid acting too quickly without consideration

    Whilst a rotation from growth to value might hurt an investor in the short term, this may reverse. While favouring particular investments in response to an event, such as a rate rise may be beneficial in the short term, these may then fall out of favour.

    On the other hand, a quality company with a strong fundamental business case and strong pricing power, may be expected to continue to grow and provide a good return for an investor over the long term, regardless of the macro environment. A bottom-up stock picker picks companies on the basis of the strength of those businesses, and not macro factors.

    So a knee-jerk reaction to sell those companies in response to a rate hike may not be the best decision in the long term. In the short term it could temper possible underperformance, but when taking a broader view an investor may have sold very good businesses that are still expected to perform well in the long term – remember a business doesn’t necessarily stop being a good business just because of higher interest rates.

    The lesson here is that not all news has to be binary good or bad, and a portfolio move up or down based on the impact of said news. An investor’s individual portfolio is not the market. A tried and tested way to minimise the impact of any one event on an investor’s portfolio is to have a portfolio which is well diversified.

    Diversification is the best protection

    A diversified portfolio remains the best way to protect and grow your wealth across market conditions, due to imperfect correlations between assets, which can reduce risk and smooth returns.

    Diversification involves owning a range of securities within each asset class, which is unlikely to respond to market developments in the same way. It can be used to hedge for specific risks; as we discuss in How to diversify portfolios and hedge inflation risk: from commodities to bitcoin, we believe that multi-asset class diversification across commodities, inflation-linked bonds, defensive equities and shorter duration bonds can provide a good inflation hedge.

    When we consider the risks to a portfolio, we cannot discount unknown unknowns – risks that we don’t know that we don’t know. A pandemic, for example, is an event that most investors didn’t consider as a risk factor.

    Given the unexpected nature and consequences of such events, one way to reduce the possible impact is to hold a variety of asset classes (see asset class returns table). On any given year, it is also difficult to predict the ranking of returns across asset classes, and so holding a range of assets may be a good approach. By diversifying, top-performing investments may help compensate for underperformers.

    An emotional buffer

    Diversification can also provide the benefit of an emotional buffer. A key insight from behavioural finance is that losses and the prospect of them can have an outsized (adverse) impact on our decision-making. In addition, our natural aversion to losses can induce us to make decisions to stem losses in the short term which may not be in our long-term interest.

    An example of this is selling at the bottom of a downturn or cutting risk exposure, despite being a long-term investor and having sufficient liquidity to see it through. 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 long-term investment success.

    This makes volatile periods particularly challenging for investors, where the risk of biased decision-making is high.

    Particularly as volatility is the norm in investing

    By offering a layer of protection against volatility, diversification can protect from the emotions that volatility in a portfolio can induce. The benefit is that while others may have their decision-making impaired during a market crisis, holding a diversified portfolio can create the conditions for you to think clearly. Having a clear head is important to make decisions effectively, and capitalise on opportunities that may arise while navigating additional risk events.

    Volatility is a normal part of investing (see figure 1), therefore investors need a plan to ride these periods out instead of just reacting to them, so as to reap the benefits of staying invested.

    Active management is key too

    While diversification offers important benefits, diversification in itself is not an investment approach. Just holding a variety of assets and doing nothing more may not maximise an investor’s returns for the level of risk they are taking.

    Active management of an investment portfolio, with a robust investment process designed to produce investor value over the long term, may be able to generate additional returns for the same or a lower level of risk. An active manager might be able to outperform a benchmark due to factors such as asset class allocation, security selection or a style bias.

    As we have outlined, while rate normalisation may come earlier than previously projected, we expect a low-rate environment to persist for some time, with rates settling below neutral levels and to remain some way beneath their historical averages. In addition, lower returns than has been seen in recent years, for a given level of risk, are expected in 2022. These challenges mean that a passive approach to investing may see many clients’ portfolios disappoint. As such, being active seems as important as ever.

    Is now a good time to invest?

    Given the investment opportunities and risks, and that volatility is the norm, investors will ask – is now a good time to invest in the financial markets?

    While having a plan and strategies to deal with turbulence is helpful, we understand that investing and staying invested at a time where there are possible risks on the horizon, can be unsettling for some.

    Volatility on the journey does not necessarily prevent you reaching the destination. As figure 1 shows, the S&P 500 has posted positive annual returns in 31 of the past 41 years, averaging 10.3%, despite average intra-year falls of 14.2%. This far exceeds the returns that an investor would make from holding cash. As we discussed in Our five-year forecast and scenarios: strap up for a two-speed recovery article, we expect the average real cash return of close to -1% over the next five years.

    History shows us that getting and staying invested for the long term provides an investor with the foundation to protect and grow their wealth.

Outlook 2022

Our investment experts look at why active management looks key for equity investors, what elevated inflation and promised rate hikes mean for bonds, our five-year capital market assumptions and the potential opportunities created by climate change that investors need to consider.

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