Markets at highs: Panic or stay calm?
Singapore’s sovereign wealth fund, GIC, was recently in the news, reporting a declining annualised rate of return for the second straight year. The CEO says returns are expected to remain low over the next decade.
He opined that the fund was preparing itself for a period of “protracted uncertainty” and low returns. One of the main reasons was that the investing environment had become tough, given how high stock market valuations were and how low bond yields had become.
GIC is well-known for hiring many capable and accomplished people to form the ranks of its investment staff, so how concerned should ordinary investors be when reading such forecasts?
First, let us look at stock market valuations. Global equities have reached record highs this year. Should investors cash out and wait on the sidelines when this happens?
History has shown that stocks at record highs do not give us any meaningful intelligence to act upon. Take the stock market in the United States, for instance. From records dating back to 1926, there were approximately 320 months — a third of the entire 90-year span — in which the stock market reached a new record high. In four out of five years (or 80 per cent of the time), the market crept up to even higher levels in the following year. From this simple observation, we can conclude that stock markets at record highs do not necessarily lead to poor returns.
A study conducted by investment firm Vanguard in 2012 showed that popular stock market valuation ratios, such as cyclically adjusted price earnings, debt-to-GDP, normalised price earnings and the dividend yield model, also had very little success in predicting future stock returns. From their results, it appears that there is no strong relationship between high stock market valuations and future market returns. In fact, when studying annual returns from 1926, the stock market was positive 69 per cent of the time.
While it is impossible to predict the short-term movements of the market, we know that, in the long run, the stock market has provided investors with a positive return — with the probability increasing to 100 per cent if one has a holding period of 20 years or more. Which leads us to the inevitable question: What actually drives expected returns for stocks?
A simple way of valuing stocks is to calculate the future cash flows of the company you intend to invest in, and then discount it in today’s dollars. The discount rate of the stock is the investor’s expected return. Stock prices are set by the interactions of buyers and sellers who agree to transact at a price that both parties feel is advantageous to them.
Since we already know that the stock market has historically been positive nearly 70 per cent of the time, it shows that buyers expect a positive return when they buy. If not, nobody would be willing to buy stocks.
Think about it — if you knew beforehand that you would lose money investing in a property, it is highly unlikely that you would make that transaction. As such, buyers of stocks, like other asset-class investors, expect a positive outcome from their investment, which is one of the main drivers of stock market returns.
Second, what to make of the “protracted uncertainty” flagged by GIC? The two options facing investors in an uncertain climate are either to do nothing, or to do something. In the first scenario, you can just sit back and wait it out. However, the flip side is that you could be waiting a long time, and possibly suffer the opportunity cost of watching markets climb upwards while missing out on investment gains. In which case, the second option may be advisable. What should investors do, though?
The tried-and-tested concept of dollar-cost averaging is one possible investment strategy. You need not worry about where market prices are headed, but just phase in your investment in accordance with a fixed schedule, for example, on a monthly basis. You buy slightly less if stock prices are high, or more if stock prices go down. Following this simple strategy relieves the stress of trying to time the markets and allows you to still be invested, albeit at a measured pace.
Another strategy to ensure that your investment portfolio holds up well, even if the market tanks, is exactly what GIC prescribes: To build a “resilient and diversified” portfolio. Admittedly, the ordinary investor cannot access the complex investments that GIC holds — such as private equity and infrastructure assets. The simplest way for an average investor to build a diversified portfolio is to invest in a globally diversified stock portfolio through low-cost funds and indexed vehicles.
In terms of building resilience, investors need to understand how much their existing portfolio could potentially lose. Using a value-at-risk statistical metric, you can measure the level of risk in your portfolio. Choosing a risk level that you are comfortable with and its corresponding asset allocation will help you ride out market cycles without undue panic.
All too often, investors chase returns without knowing the level of risk they are taking on. It is only when they suffer more losses than expected in a market downturn that they panic and sell, thus permanently locking in those losses.
Investors can thus glean some lessons from GIC’s investment strategy. Investing for the long term in a diversified portfolio with a risk level that you are comfortable with puts the odds on your side and helps you achieve an optimal outcome regardless of the current market climate.
ABOUT THE AUTHOR: Aw Choon Hui is the deputy CEO of GYC Financial Advisory, a licensed financial adviser and registered fund management company.