Staying anchored in an uncertain market

In our experience dealing with investors, we observe that when a market meltdown happens, many who claim to be long-term investors are not really in for the long haul. Indeed, investors who claim to have a high-risk tolerance are only in when the going is good.

This sudden change in behaviour becomes apparent when markets correct and the investor’s definition of “long-term” suddenly shortens to days or weeks. Almost everyone is happy to be invested when markets are rising, but how do we guard against our own instincts telling us to run when markets fall and news headlines scream that the end of the world is nigh?

One possible way is to devise, before any market crisis occurs, some penalty to dissuade us from cutting and running at the first sign of market distress. This is similar to how certain investment managers impose “gates” or lock-in periods which force investors to stay invested over a minimum period of time. Investors can create their own unique set of rules to do the same.

Let’s assume that the value of your investments suddenly plummet and your instinct is to sell.

A simple rule you could follow would be to allow yourself a maximum initial liquidation of between 20 and 50 per cent of your holdings. Taking this simple step partially satisfies your need to get out of the market, but at the same time ensures that you do not sell everything at the bottom of the market, and gives you some skin in the game to participate in any sudden rally.

Another method is to follow institutional investment committees and fiduciary advisers in the United States and Australia. At the inception of your portfolio, work with your adviser to draw up an investment policy statement, which is a written description of the philosophy, strategy, asset allocation and implementation of what you want to achieve with your investments. Once written, put it up in a prominent location as a reminder of why you started on this investment journey in the first place, and the agreed strategies for reaching your goal.

A critical part of this exercise is for your adviser to tell you about their action plan in the event of a market crisis, and what you can expect to happen to your portfolio.  Going through such a mental rehearsal of a hypothetical market meltdown long before an actual one occurs (and writing it down) would prepare you to ride out such an event with much better investment outcomes. There is surely much wisdom in the age-old Scout’s motto, “Be Prepared”.

GOALS-BASED INVESTING

One other strategy is goals-based investing, which requires that you allocate your different financial goals into different “buckets” that are then funded and invested independently. Even a goal like retirement can be broken down into different buckets, such as essential expenses and discretionary spending. As different financial goals have different capital requirements, each goal can have its own unique time horizon, asset allocation and risk tolerance.

Most investors typically invest fully into a single portfolio based on a singular personal risk profile, to fund all their financial goals. But, if you think about it, different goals like saving for your children’s education, retirement, going on sabbatical, holidays and buying a new home, have varying degrees of importance. For example, if your investment plan for a big overseas trip does not work out well, you might be disappointed, but you could always go another year. The same cannot be said if your retirement plan fails and you have to work many more years in a job that is taking a toll on your health while waiting for the plan to yield the expected return.

In the wake of the 2008 global financial crisis, many investors had a hard time coming to terms with the level of losses suffered and consequently abandoned their plans at the worst possible time. Goals-based investing helps to break up your investing goals into smaller chunks with different plans and risk, thus allowing you to experience different investment outcomes as compared to an investor with only one plan and, consequently, one outcome.

Planning for different goals, with corresponding investment plans, helps you mark out different finishing timelines and provides you with something to look forward to over time. It gives context to your investments and keeps you on track whenever you might panic in a crisis or get discouraged about the performance of a plan. You no longer invest just because “everyone is doing it” or you “need a high return”. Instead, you have a plan and purpose, and know why you are actually investing.

Of course, investors typically want an investment with a high rate of return. However, when we share with them the corresponding value at risk to achieve those returns, most recoil in horror. Interestingly, we later find that some of them have already close to what they need for retirement or another financial goal. What is needed to close the gap and beat long-term inflation requires a much lower rate of return and, correspondingly, a much lower risk. Thus, with proper planning and advice, investors only need to take the risk appropriate to their goals.

At the end of the day, just saying you made 7 per cent per year from your investments doesn’t mean much. But if you had invested systematically, stayed calm in crises, retired well, bought your dream house and sent your children to the schools they wanted, then the return you got – whether 3 per cent or 7 per cent – was just a means to those ends.

That is when you would be able to say that you had invested well.

ABOUT THE AUTHOR: Aw Choon Hui is the deputy CEO of GYC Financial Advisory, a licensed financial adviser and registered fund management company.