There are some important lessons from the last two weeks of market action. All the more so as the typically murky Autumn lies just ahead. And lastly I will look at the (positive) outlook, at least in the short term.
Do you remember the crash in Japan last week? The apocalyptic headlines? The certainty of the US recession? This week the headline was “Global stocks surge”. “US not heading into recession”.
Two weeks ago US recession was a certainty. This week no recession is a certainty.
I’m sure you have already figured this out but it is worth repeating. One of the key features of this new environment is volatility. As we said on 5th July, “volatility will mark out the new investment cycle for years ahead”.
Understanding this is crucial to your investing success. Volatility creates uncertainty and fear, which is the father of a multitude of poor investment decisions. For example, the scale of selling on the day of the flash crash (see definitions last week) meant a number of investment platforms failed (again), unable to cope with the rush to sell.
Were those retail investors selling because this was the disciplined application of a stop-loss? No, not in the vast majority of cases. 99% of the selling was a behavioural response to (mostly incorrect) reports of the overnight falls in the Japanese stock market. It was a classic panic. A minor one, but nonetheless one from which we can all learn, or at least remind ourselves of some truism’s…
Economic predictions, whether by economists or otherwise, are notoriously inaccurate. In some instances as near as dammit 100% wrong. (Read Recession Scare. Should You Care)
When markets are this volatile, at the behest of fairly minor economic statistics or notoriously inaccurate predictions, even greater care than usual is required.
Human beings are inherently bad at investing. When faced with uncertainty, which is what you take on when investing, the emotional part of our brain pings into action. This is not helpful.
When this uncertainty increases we become even more emotional. That uncertainty triggers fear, and greater uncertainty triggers even more fear. And fear equates to bad investment decisions.
When there is an investment mania, in this case centred on US equities but with the participation of investors all around the world, there is inherently even more emotion infecting financial markets – a stock market mania is the polar opposite of a rational market.
In life we crave certainty, it is a basic survival instinct. But it is a bummer for investors. This base instinct means that most investors are continually seeking information, and the more extreme their emotional state, as now, the more they will do this. So they seek out economic analysis (notoriously wrong) and stock market predictions (ditto), thereby increasing the likelihood of even worse decision-making.
The investor brain, already badly positioned to deal with the issues at hand, is now over-loaded with mountains of data, which taken individually are mostly of little or no value, and taken as a whole put a bomb under the investors ability to make a coherent decision. (Read Cut Out Noise. Now)
Having an investment plan is not a perfect solution. Stuff still goes wrong. But it massively increases the likelihood of your longer-term success. To not have a plan is like going up a mountain with no means to navigate, and no preparation for bad weather or accidents – don’t do it!
There is not one “right” investment plan.
Your first stage is asset allocation e.g. how much in UK or US equities, how much in government bonds or high yield bonds. You might mirror world indices or be more specific e.g. concentrate on world equities where there is good value by some measure. Some might use a computer model. There is no perfect answer, and solutions differ between individuals and between institutions. Make a choice which suits you, your risk tolerance, your temperament, your available time, your experience, and your life stage.
The second stage is your investment selection within each of the elements of your asset allocation. If funds are your thing, you might, for example, choose passive funds or you might use momentum, agnostic as to passive or active funds – the latter is reflected in our Dynamic Ratings.
These are the first two elements of your plan, asset allocation and investment selection. Nowhere in this plan does it say “I must subscribe to xyz economic analysis” or “I must read this blog every day for tips”. Your plan does not require that you relentlessly accumulate data from a pot-pourri of sources every day.
Your plan so far is about your attack i.e. where to buy and what to buy. That is the easy bit.
It is the third stage, your defence, which is the most difficult and where most investors go awry in the biggest way. Occasionally your process for asset allocation or fund selection will mean you buy a pup – but the damage should be limited by your defence – which defines when to sell.
Your defence has to be clear. Write it down with absolute clarity. This is easy. We use a stop-loss e.g. if a fund falls by a certain amount we sell it. Some of you might have a defence based on moving averages being breached – that is OK as long as it is clear what action you will take at a certain point.
It is acting on the stop-loss which is the greatest problem.
It is a well researched fact that most investors tend to sell winners and retain losers. This is because selling losers is emotionally painful – it is as if you are acknowledging you are wrong, admitting defeat. Humans are not good at that, especially men. This is the opposite of what an investor should do. The world’s most successful investors over many decades will endlessly repeat – sell losers, hold winners. That is undoubtedly our experience.
Practicing applying a stop-loss is extremely important – you don’t want to have to do this for the first time when your whole portfolio (the bulk of your life savings?) has just plunged in value.
If you have a simple stop-loss of 10%, you probably sold your Japan fund on Monday last week. Sure it bounced very quickly, but if you hold this as a multi-year feature of your asset allocation, buying back in 30 days (that is our guide) means there is little damage to your longer term performance, and you have accumulated some useful experience.
Remember the stop-loss is not a market-timing tool. Rather it is to defend your capital value against the risk of much sharper falls – you should simply act on it, and not get stressed trying to second guess markets.
For our part, our stop-loss rules are a bit more nuanced – perhaps yours are too.
The stop-losses with our Dennehy Wealth discretionary portfolios will have different levels depending on, for example, the asset class and fund. If the asset class is vulnerable to sharp overnight falls (e.g. various Asian markets including Japan) our stop-loss might be set at 15%. This will be all the more so if our holding is an investment trust, which is inherently more volatile than the equivalent unit trust/OEIC.
We also have categories for “crash types” and “crash triggers” – internally we use the term crash for any sharp fall – it makes us pay attention!
For example, assume the overnight crash might fall into the “flash crash” type, where we expect a sharp recovery both within that day, and the following day or two. In this instance we press the pause button for 24-48 hours. If it does bounce sharply, and confirms a flash crash, we do nothing. If that bounce doesn’t occur, we sell.
The recovery from the Japanese crash was rapid, and we sat tight. Out of interest, from the very recent Japanese peak (31st July) to date, only 12 out of 840 Japanese funds are down by 10% or more.
The greatest value of that flash crash is that it provides time for all of this reflection, for example:
- Does your investment plan need some tightening? Is it even written down?
- What is the rationale for your asset allocation?
- Ditto for your investment selection?
- What is your defence? Is it clear and have you applied it?
- Do you need to adjust your stop-loss strategy for today’s environment?
- Are you using our unique Stop Loss Tool? If not, why not?
- Are you still comfortable self-managing all of your portfolio?*
Do share your thoughts with us on how the last fortnight was for you, for better or worse. You can email here. The more we can share experiences, the greater the help to the whole FundExpert community.
Last but not least, markets over the last week. The Nikkei 225 in Japan is up over 9%, and 3.6% just last night. The US tech indices also moved sharply, advancing nearly 6%, with Brazil and the S&P 500 not far behind. India was a laggard, but down very slightly. The UK indices were up 1-2%, steady progress.
Overall, world stock markets found their feet in the last week after a small wobble.
As we said in March, our technical analysis projected that the “US index keeps moving ahead over the Summer. Perhaps a classic Autumn peak?”. Our analysis this week continues to confirm that outlook for the US and most global markets including the UK.
Based on our technical analysis these are projections not predictions. Predictions are a mugs game. When we make a projection we start by assuming we can be wrong, and will adjust them when the facts change – we aren’t emotionally tied to it.
And again, do please share your thoughts and experience of the last fortnight. We never reveal your name and the more we can share experiences, the greater the help to the whole FundExpert community. You can email here. Thank you in advance.
* If you are no longer totally comfortable managing your portfolio, and perhaps that of your family, do get in touch with us, the Dennehy Wealth team, and have a chat about our solutions.