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What to Do When the Stock Market Falls

Left unchecked, investors’ behavioural biases lead them to make irrational decisions, such as buying when a market is expensive

Dan Kemp 20 April, 2018 | 8:36AM

Stock market trader Wall Street trading floor volatility fall crash bear market recession

To seek protection? Or to stay fully invested? That is the question… Whichever way you look at it, the nine-year bull market has got many investors thinking. And it is at these moments of inflection that behaviour can have its greatest influence on markets.

This behaviour is paramount and directly linked to Warren Buffett’s maxim to “be greedy when others are fearful and fearful when others are greedy”. Left unchecked, investors’ behavioural biases lead them to make irrational decisions, especially buying when a market is expensive, as well as selling when it’s cheap.

Investors are often fooled by strong recent returns, thinking they’ll continue. Investors similarly forget about their innate loss aversion – where humans are inclined to dwell on further declines as downturns worsen, leading to procyclical behaviour that often leads to poor financial outcomes.

Supporting this rhetoric, empirical evidence infers that cheap assets have a far wider margin of safety than their most popular equivalents, with valuations directly influencing longer-term outcomes. It is important to acknowledge that cheap assets rarely have fundamentals that are perfect, as they often carry significant uncertainty and are thus punished by negative investor sentiment. The opposite can also be true, with asset prices regularly surpassing what is justified relative to the fundamentals. 

The latter is the challenge we face at the current time. Specifically, the US equity market sits in the fourth quartile of valuations, with the technology sector among the most pressured from a valuation standpoint. This leaves an important part of the equity market universe vulnerable to sluggish returns at best, or a major downturn at worst, which is one development every investor should be aware of.

Time to Sell Up and Move Out?

So, let’s reflect on what this means. When the biggest market is expensive, should we simply fill portfolios with the other assets that are less popular? Move it all to cash instead? Or, can a multi-asset approach help to deliver better outcomes?

In this regard, it is critical to remember that asset allocation is the primary driver of long-term returns. Therefore, factors like the equity/bond split, geographic allocation and duration levels will have a meaningful impact on outcomes.

Related to this is knowing the limitations of our shorter-term predictive abilities. The reality is that financial markets carry significant levels of uncertainty at all times in the cycle and sound portfolio management is to be positioned for a variety of outcomes, not just one.

This is one significant advantage of a multi-asset approach. While fixed income is similarly – if not more – expensive, a multi-asset portfolio provides a better hedge against various potential economic and market outcomes. There are simply more levers to pull, including better risk controls and an ability to secure cash flows over a full market cycle.

The last point to iterate is the concept of a margin of safety. If markets were unanimously expensive, we must appreciate that the margin of safety is lower than it would ordinarily be. This would be problematic in an absolute sense, as the range of outcomes becomes skewed to the downside. Therefore, when faced with such probabilities, it would become prudent to seek shelter – in cash for example – as it would help to control our own behaviour and become effective ammunition against the increasing likelihood of an adverse outcome.

However, markets are rarely universally priced, including today. We have a situation where many markets look expensive – some grossly expensive – but many others are not. Therefore, sound portfolio construction will use this knowledge to balance the probabilities to maximise reward for risk.

What About the UK Market?

Turning to local market nuances, similar challenges apply. In fact, it could be considered even harder given the concentration risks some local markets can expose investors to. There are two ways to think about this exposure. First, is the level of home bias we want to expose ourselves to. For example, do we want a 50% local/50% global mix? Or should this depend on the opportunity set? We certainly believe in the latter and will use hedging where appropriate to reduce any unnecessary currency risk.

The second is the importance of sound behaviour. One thing we know for sure is that chasing past performance is a dangerous path to investment success. By positioning a portfolio in those areas displaying the most attractive reward for risk; a valuation-driven investor can reduce the cyclical nature of their returns and thereby add a cushioning effect on returns in down markets. This is a key tool we are advocating to reduce the impact of any valuation shock.

What does this mean practically? Well, in our multi-asset portfolios, we retain limited exposure to U.S. markets despite the fact they represent a large portion of the global index. Instead, we maintain a diversified approach among other markets that rank considerably better based on our valuation and risk models. Examples would be U.K. equities, Japanese equities, emerging markets and parts of Europe that have been hampered by negative sentiment.

Summary

On the whole, we believe every action should come back to the original ambition: can we improve the likelihood of a positive outcome and therefore help an investor achieve their goal? This will change depending on an investors risk tolerance, however we generally find that the above ideas are a good hunting ground and could help protect capital while improving reward for risk.

Ultimately, experience has taught us to see the investing world through the lens of absolute and relative valuation; cautiously but positively awaiting opportunities to buy great quality assets at times when their price is below the intrinsic value.

Said another way, human predispositions can lead to poor collective behaviour – creating market cycles and an evolving reward for risk. We expect 2018 and beyond to be no exception, requiring a guarded stance when most assets look expensive.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA

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