What should you do when markets fall?
Last week was a volatile one on the global stock markets. Even for experienced investors, times like these can be quite unsettling.
So, what if anything should we do now?
Lars Kroijer is a former hedge fund manager and author of Investing Demystified. He advocates a simple, low-cost and highly diversified investment philosophy.
Lars, it’s been an eventful few days on the markets. What should investors bear in mind when prices are falling quickly? And what, if anything, should they do?
One thing that’s important, and I can’t say it enough, is this; Let’s say that markets trade at 100, and now they’ve fallen to 80. You still can’t beat them. The fact that markets fall that much may change your life, and your personal circumstances, in such a way that you should act. Maybe, all of a sudden, you should take less risk because you can afford less risk. But don’t think that you can beat the markets just because they’ve changed.
For investors who have a plan in place, and an asset allocation that matches their risk profile, it’s almost invariably best to do nothing. It can be hard, though, when people are making scary predictions. Should people switch off the financial news?
That wouldn’t be terrible advice. A lot of people can be experts on CNBC, Bloomberg and so on. I have been one myself, so that tells you something! Do you really think any of those people can predict the market? I say no. Even if they could, would you be able to identify which ones are right and which ones are wrong when they say such contradictory things? I say no. Are you entertained? Hopefully yes, but that’s a different issue. What do you get from that? I hope you get some idea about the risk of your portfolio. It should start you thinking if someone gets up there and says, I think the pound is going to collapse, or I think the S&P 500 is going to be down by 90%.
By the way, you get to go on TV a lot more if you say really controversial things. It’s better entertainment, better ratings. Do think about that.
Ultimately you have to ask yourself how this will impact your risk. Don’t switch around a lot. Don’t change your mind every five minutes. In fact, the less you change your mind the better. If you’re thinking for the very long term, which is something I highly encourage, you will likely do better from lower transaction fees and by essentially ignoring the noise.
As usual, opinions on where markets are heading next are many and varied. Some say that last week was just a blip, others that it marks the start of a big bear market.
Markets are virtually impossible to predict. If you take the view that you know the markets are going to decline or the markets are going to go up, you’re essentially saying that you know something that the $100 trillion aggregate stock markets don’t know, which is an incredibly bold statement.
I can certainly have the view that, relative to earnings, the markets have been trading expensively compared to what they’ve done historically. But that’s not the same as saying that, as a result of those higher prices, the markets are going to decline. I don’t know anyone who’s been constantly right in making those predictions.
OK, so let’s say you weren’t prepared for what happened last week. What should you do to ensure that you can withstand the volatility we’re inevitably going to see in the future?
Let’s take a super simple world where you can either invest in equities or government bonds (which, by the way, isn’t a bad portfolio to be thinking about). My argument is that an overwhelming number of people have no chance whatsoever of outperforming the financial markets. I often think of it as my mum versus the people I know from my time in the hedge fund industry, and it’s certainly not a fair match. My mum should never be in there, buying Facebook versus Google, or anything like that.
So, what should my mum do? If she wants equity exposure, she should buy the cheapest, broadest, most tax-efficient exposure to the equity markets that she can find. She needs to look for a product (and there are many index-tracking products that do this) that buys her the world in proportion to the market caps that the markets have ascribed to them. That’s equities done. That was easy!
Then you should combine that with something of little or no risk — perhaps a government bond that has roughly the same time horizons as you have for your investments. So it might be a five, 10 or 20 year bond, or a number of them. Now you have two products. One is very high risk and the other is very low risk.
So, what next? My mum should think about her risk. Her risk is what determines how much she should own of each. If she’s a very high-risk investor, she should buy a lot of equities, and if she’s a very low-risk investor, she should buy a lot of government bonds. And if she’s in between, she should be somewhere in between. This is why it’s a hard question, because it depends on who you are and what your time horizon is.
If you look at the financial markets overall, there’s a tremendous tendency to make all of that really, really complex, with lots of different products. There’s also this agenda to charge you a lot of money to sort through that myriad of opportunities.
What I’m saying is that it doesn’t have to be that hard. You can create a very powerful portfolio, very cheaply and very simply. But that doesn’t mean you can predict which way the markets are going to go.
In your book, a key theme is the importance of diversification — not just across different asset classes, but also different geographical regions. Why are you so keen on a global approach?
Your risk is something that you should think continually about. In fact, it’s something that most people are guilty of not thinking enough about. And I think this is why a world equity index tracker is so sensible. If you think about the portfolio of most individuals, very often it’s their house, their education their job, their spouse. Those are all things that correlate highly in value. They’re all tremendously dependent on the local economy.
So if you add to that concentration by buying local stock, that’s an unnecessary lack of diversification. You should absolutely diversify, and a global equity index tracker is the most diversified investment, in terms of equities, that you can possibly get your hands on.
That’s such a sensible and logical piece of advice. Why, then, is home bias — the tendency to overweight stocks from our country — so pervasive?
To a certain extent I think it’s historical. In the past it’s just been very expensive to trade abroad. Most people couldn’t just gain exposure to an Australian mining company, for example; hundreds of years ago it would take weeks to sail your gold down there.
Now it’s instant. You can invest in crowd-funding campaigns around the world very cheaply, and with blockchain technology, currency exchanges are going to be much easier and cheaper going forward.
I think there’s a still a mindset that we should do stuff close to home. But you can’t diversify those things I mentioned — your house, your job, your future inheritance, your spouse’s career. All those assets are hard to diversify. Yet if you look at the portfolio of institutional investors in the UK, for instance, you might find that they hold 40 or 50% of it in UK stocks. Why is that? Very often there is no good answer.
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