Warren Buffett is a source of many quotes about investing, but one of his most famous is: “Investing is simple, but not easy”. He explains that the basic logic behind investing is actually relatively straightforward.
However, in practice there are a number of hurdles that don’t make it easy for anyone – let alone those starting to invest for the first time. That is because we are all human and we are prone to natural behavioural biases and emotions that push us to make decisions based on gut instinct rather than best practice.
One of these biases is called ‘loss aversion’ and it’s a powerful psychological factor for investors. The fear of loss is, in fact, deemed to be at least twice as powerful as the delight due to a gain, as demonstrated by Kahneman and Tversky in 1992. As soon as we see investments lose value, the instinct to preserve capital kicks in and we sell to prevent as many of those losses as possible.
The same simple, but not easy, analysis applies to the attempt to prevent us reaching that point by timing the market, i.e. we seek to buy investment at a point where it is unlikely to go much lower in value, and sell when it is nearing its highest price possible, and when there is not much more upside to be able to eke out. It should be simple to call out that a price is high for a variety of reasons. These reasons include that the company’s stocks and shares may be trading significantly above its ‘fair value’ – i.e. the sum of the company’s assets (tangible and intangible) minus its debts and liabilities – or that its stocks and shares are trading far above any historic highs, to name a couple.
The issue is, however, that while we should often be able to predict whether markets will react to a particular news headline and how they should react, we don’t know by how much they will react and how quickly, which is the really crucial information. There are just as many reasons why a stock might be performing badly. Now multiply all those decisions by the number of stocks in an index or fund.
For those who doubt that this might be the case, you only have to search through investment headlines between 2018 and 2019, when the phrase ‘bull markets don’t die of old age’ was being bandied about incessantly. The US equity market rally before the coronavirus pandemic struck had been the longest on record and many people remained invested after the deadline set by the timeline of the previous bull run as they weren’t able to call the top of the market.
For those still unconvinced of the impossibility of calling the top or the bottom of a cycle – potentially because they did once and have wined and dined on that for many a year – let me throw in another complication. This is based on a review of the best and worst days in a stock market’s history. It’s simple to understand how much better off you’d be if you were fully invested for the best days and out of the market for the worst, but it’s not that easy to do so. And here’s the chart to show why this is so difficult to achieve using the MSCI Developed Markets Index as an example, with the green dots flagging the top 100 best days and red dots indicating the top 100 worst days since the launch of the index:
A close up of the chart highlights the dilemma.
The charts show how the majority of the worst days are very closely followed by the majority of the best days, and the other way around. This may be because investors realise that, in their race to disinvest or invest, they went too far. They may have thought that the price was too far above the fundamental value for that investment or significantly below – with the latter something we see in many investments at the moment. That process may take a few hours, days or even longer to play out – especially if you have taken a financial hit. For example, it took stock markets around two weeks to overcome its shock due to the 2016 Brexit vote, but it only took about two hours to stabilise after the news broke of Trump’s election victory that same year.
Meanwhile, the activity might be driven by a completely different set of investors weighing in. Investors after all are not a homogeneous group of individuals that all price in the same information in the same way. People trade investments based on different rationales and differing amounts of information and opinions. That is what makes it hard to assess what is priced in.
It is also really difficult to understand whether the market is reasonably priced because markets are known to be forward looking. What isn’t that well known is that the forward-looking view might encompass the next two years, if the events happen at all.
This may be part of the reason why the US equity market, in particular, but others as well, have risen significantly in value despite the economic news highlighting all the doom and gloom. The Federal Reserve has stated that it will support asset prices and investors can largely ignore the bad news and focus on the good news. Perhaps markets are instead looking forward to the time when we have a vaccine for COVID-19, life will revert to normal and strong economic growth will reassert itself.
If there was one final blow to the notion of timing, however, it would be this. Today’s portfolios are not made up of one individual asset class that is affected by one headline that causes the swings so feared by investors. Yesterday’s investors were told that a diversified portfolio may include between 10 and 20 stocks, and you were unlikely to have invested internationally. Today’s portfolios are constructed of thousands of investments across multiple companies, geographies, industry sectors, types of investments and – in the case of Nedbank Private Wealth – currencies. So the theory of trying to time the market is simple, but the reality is not easy.
This global diversification also means, however, that you don’t have to tempt fate and try to time the market. That’s because your portfolios are designed to perform – or limit the downside – across the vast majority of market conditions. The coronavirus pandemic is a once in a 100-year event, that no one has experienced. But if we were to see the likes of it again, I for one will already be signed up for in-depth online investment discussions to help navigate the storm.
Clients of Nedbank Private Wealth can get in touch with their private bankers or relationship managers directly to understand how their portfolios are responding to market events or call +44 (0)1624 645000.
If you would like to find out more about how we can help you manage your investments, please also contact us on +44 (0)1624 645000.
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Based in our Isle of Man office, James is responsible for delivering the end-to-end investment management process, overseeing the implementation of the Nedbank Private Wealth house view within our discretionary managed portfolios, and for developing our investment proposition.
He has over 18 years’ investment experience and has been responsible for the Nedbank Private Wealth managed discretionary portfolios since 2007. James holds the Certificate in Investment Performance Measurement from the CFA Institute.