Five Things To Remember In Difficult Times

“I have not looked at any of my holdings and don’t intend to. I don’t want to be tempted to jump because I think I’d be more likely to jump in the wrong direction than the right one. My advice has always been to choose a sensible diversified portfolio and stop reading the financial pages. I recommend the sports section.”

Quotation attributed to Richard Thaler, professor of behavioral science and economics, University of Chicago Graduate School of Business.[1]

These are difficult times – nobody knows how and when markets will stabilise. We appreciate the emotions they arouse. But you should take some comfort  that our planning process is not driven by what is happening in the market at any point in time. It focuses on achieving your long term financial objectives, based on reasonable projections of long term investment returns.

However, to give you the best chance of receiving those long term returns requires discipline to stick to an agreed strategy both when markets are performing well and when they are performing poorly. Admittedly, when markets are under the severe pressures we are currently experiencing it is human nature to want to take flight and forego the discipline.

But experience suggests that it is times like these that distinguish the successful long term investor from the fair weather, “buy high-sell low” speculators, who start out with best intentions but succumb to their emotions when the going gets tough. Now while we don’t know for sure that what worked in the past will work in the future, unless you think this is the end for the capitalist growth engine we are pretty confident that it will.

Below we discuss five aspects of our approach that we think are worth bearing in mind to help you to fight the inevitable emotions:

1. Your risk exposure is personalised for you and your circumstances

We have devoted a lot of time and effort together in modelling your life situation and objectives to determine a long term risk exposure (i.e. your target asset allocation) appropriate for you and your circumstances. This exposure has been chosen taking into account your tolerance for risk, your capacity for risk, your need for risk and your specific lifelong cash flow requirements.

Importantly, it is a long term strategic exposure that allows for both up and down markets. If your risk exposure is causing you current discomfort, it may be helpful to remind yourself that your decision to accept that risk exposure was well considered.
Every market participant is experiencing some pain from this current market downturn. Those who are hurting most are those who did not have a well considered approach to risk leading into the downturn. And those who are likely to experience most regret are those who do not have a risk exposure tailored to their circumstances and objectives when the market eventually recovers.

2. Your investment approach is applicable through all market conditions

Your investments continue to be managed according to the same philosophy and decision framework that we applied through the recent up markets (and prior down markets). The approach is robust, uncomplicated and not dependent on market conditions. It is an approach that we continue to believe will give you the best chance of delivering the long term outcomes you have planned for.

3. Your exposure is well diversified

Your portfolio is well diversified across and within asset classes. Diversification is often misunderstood and underestimated.

Why would you hold elements in your portfolio that are not performing? For the simple reason that predicting the future is much tougher than most people imagine – in fact, we believe predicting the future reliably is impossible. Today’s winner often becomes tomorrow’s loser – that is the very nature of risk. When we blend these ‘winners’ and ‘losers’ in a portfolio and focus on the outcome of the portfolio as a whole, the benefits of diversification appear.

For those with defensive assets in their portfolios, we remind you that their primary purpose is to dampen your risk. We have never advocated chasing return with this part of your portfolio – that is not its purpose.

Your defensive assets are restricted to high credit quality securities that are well diversified across a range of issuers. While this may not get you the extra basis point returns offered by higher yielding but higher risk securities, you know with a very high degree of confidence that the capital value of this part of your portfolio is assured.

4. Avoid the urge to value your position on a daily basis

While the current turmoil on markets may create an urge to revalue your portfolio on a more regular basis, this practice generally leads to higher levels of emotion that translate into a greater need to react – to do something – when the best response is likely to be to do nothing.

The closer you follow the market, the more likely you are to be distracted by factors that are irrelevant. These factors are commonly known as ‘noise’. The level of ‘noise’ (irrelevance) increases with the frequency of observation. It is suggested that when we view our performance over a one year period we observe 0.7 parts of ‘noise’ for every one part of performance.

This ‘noise’ ratio increases to 2.3 parts of ‘noise’ for every one part of performance when we increase our observation frequency to monthly. As our observation frequency increases further so too does the distraction level of ‘noise’ – if viewing on an hourly basis, we’ll be distracted by 30 parts of irrelevant information for every one part of relevant information.

We recommend that you should view your investment portfolio similar to the way you treat your home or a direct property investment. We expect that you do not enquire about the value of your home or investment property on a daily basis and only become actively interested if there is an intention to sell.

If appropriately chosen, your commitment to your investment portfolio should also be very long term – daily, weekly, quarterly or even annual changes in valuation are really irrelevant. Just because you can revalue and transact daily doesn’t mean it is a productive thing to do – in fact, we would argue it is more likely to be counterproductive to both your financial and mental health!

Unless your circumstances or objectives have changed, a serious look at the ongoing appropriateness of your portfolio once a year should be more than often enough.

5. Remember that past collapses have all felt like the end of the world

A common characteristic of almost every bear market is a mental projection that this is the end of the world as we know it. It has been said that the four most dangerous words in finance are “this time it’s different”. These words are most often uttered in the midst of market manias and market collapses.

For a trip back though history, we quote a recollection of the conditions experienced in the market collapse that occurred in the early 1990’s.

At that time, the Anglo-Saxon economies of the US, Canada, the UK, Australia and New Zealand were all either in or flirting with recession.

The recession came on the heels of an era of financial excess, as exemplified on Wall Street by the junk bond king Michael Milken and in the movies by Gordon “greed is good” Gekko.

In the US, excessive and imprudent lending for real estate had contributed to the failure of hundreds of community-based ‘savings and loans’ institutions, triggering a multi-billion dollar government bailout.

In the United Kingdom, consumers who had leveraged themselves heavily to real estate suffered a severe blow when rising interest rates pushed house prices sharply lower, both in real and nominal terms.

In Australia, too, market deregulation had given way to an era of increasingly reckless lending by financial institutions, which until that point had had little experience in managing risky commercial loans.

The consequence in Australia was the failure of a number of major financial institutions, including the state banks of Victoria and South Australia, the Teachers’ Credit Union of Western Australia, the Pyramid Building Society, merchant banks Tricontinental, Rothwell’s and Spedley’s and the Estate Mortgage trust.

At that time, the crisis seemed intractable and insoluble. Journalists and economists talked of systemic breakdown and a global challenge for market capitalism, much as they are now.

Now, while no two market crises are ever the same, it is fair to say there are parallels between today’s downturn and the events of early 1990s, particularly in the damage caused by excessive leverage and insufficient oversight by many financial institutions of the risks they were taking on.

We recommend that you take a moment to reflect on the path of the Australian share market over the past 27 years by reference to the attached chart. Additionally, for those who wish to go back further in history we have included a link on our website that compares US bear markets of the past century. Hopefully, it will provide some perspective to the current situation – unfortunately, we can’t say when this downturn will end. [3]

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Five Things To Remember In Difficult Times
Bull and Bear Markets

[1] Young, Lauren. “Where the Pros Are Putting Their Own Money.” Business Week, October 6, 2008.
[2] Excerpt courtesy of “The More Things Change …” by Jim Parker, DFA Australia Limited, October 2008.
[3] You may note that this chart ends at July 2008. The fall to the end of September 2008 was 31%.