Don’t be your own worst enemy

“The investors chief problem, and even his worst enemy, is likely to be himself”. – Benjamin Graham

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I recently celebrated another birthday where my wife managed to completely throw me off guard with a surprise ‘staycation’ in Brisbane. My friends are typically not good at keeping secrets and I normally would have seen some of the signs but somehow, they managed to get me to The Calile hotel in Brisbane (surprise number one), then to the restaurant (surprise number two), without me having any clue. In retrospect there were certainly signs on the wall that, had I been a detective, could have deduced what was happening, but in real time this is easier said than done.  

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The same can be said about financial markets. Before I entered the industry as a young man I idolised fund managers, as they sat in their ivory towers as God like figures who had the ‘secret Sauce’ to investing. I had read books on some of the greatest traders in the world and thought that that is what I wanted to do when I grew up. They had the answers to everything – geopolitics, appropriate market pricing, sentiment, technology, conflict, inflation and could therefore navigate these events better than everyone else. I did everything in my power to make sure that I would have the same skillset that my idols had like finishing my finance degree and then going on to earn the Chartered Financial Analyst designation along with countless other qualifications, but it turns out that there is no better teacher than life and experience itself.

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What this taught me was that there was no secret sauce, no one had a crystal ball and these fund managers that I thought were Gods also had bad years, it goes with the territory. This is not to say I did not learn to make money in markets as what I learned was a system that I do believe is the secret to long term wealth creation throughout any market cycle.

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As financial advisors, we get sent a lot of research whether it be from fund managers trying to court us, institutions wanting us to use their services, friends with common interests or clients. There wouldn’t be a month go by in a bull or a bear market that I wouldn’t get sent a note from someone about something they read on a blog or in a newspaper or in an email that was predicting a huge market crash. In recent years, those concerns are typically anything from levels of debt in global economies, geo-political tensions, interest rates or an election. The point is there is always something to worry about it! What I have observed is that often a commentator might predict a market crash 10 times over 10 years before they get it right as a broken clock is always right twice a day.

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One of the things that I learned in my studies was that you can find a data set to support absolutely any argument you like so these articles were always supported with data that makes perfect sense in the way that it was framed, but that doesn’t make it right. If investors are to flinch every time they think a market is going to crash they can often do more damage than good as you actually have to make two good decisions, one to get out and another to get back in, which again is much easier said than done.

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There is a famous study (Source) about legendary investor Peter Lynch and his Fidelity Magellan fund from 1977 to 1990. Under his management the fund averaged 29% pa however according to Fidelity investments, the average fund investor actually lost money… how can this happen you may ask?

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According to Dalbars 2021 investor behaviour review (Source), the average equity investor underperformed the stock market by 1.5% over 20 years through to 2020. These investors tended to follow the heard which meant often selling out of underperforming strategies to buy into performing strategies. The problem with this is that last year’s worst is often next year’s best and this attitudes effectively has you continuously chasing your tail. This was illustrated in the Magellan study. Ie in 1980 the Magellan fund returned 70%, the next year he underperformed and investors who were disappointed with the performance jumped ship locking in their losses… had they stuck for another year they would have averaged more than a 25% return and had they just kept the fund from inception to close they would have earned the fund performance of 29% pa.

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According to Morningstar, to beat the S&P 500 return you would need to predict the direction of markets 2 out of 3 times consistently. They calculate that had you missed the best 10 days of market return from 1997 to 2017 then you would cost yourself 3.7% return pa. That happens to come out at about 2x your money that you didn’t earn over 20 years if you compound it over the time. The point is it is very hard to time markets and it is a very dangerous game.  (Source).

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There was a great article in the Weekend Australian on the 4th of March 2022 titled “Switch Hit: Moving your super when a crisis hits can prove expensive”. It did a study of investor behaviour when volatility increases and in particular the covid crisis. From the peak to trough in the market the ASX shed 36% in just 22 trading days. We all remember this well and at the time it was hard to watch, it was not fun to wake up in the morning to see a sea of red across the screen day after day.

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Market activity like this does make you question yourself and if you are making the right decision. With the benefit of hindsight, we can say that we did make the right decision then but according to this article, many people without good advice unfortunately did not. The analysis showed that up to 4% of industry fund members switched from their funds default growth option into a more conservative option or cash. Following the market recovery only 25% of those had switched back out of cash by the end of June costing these members between 17% for those that went to conservative options & 30% for those that went to cash.

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Trying to pick the direction of markets in the short term is as good as flipping a coin as you never know when markets will be hit by a left field event but the longer you can put your time horizon out, the more rational markets become. A recent blog post by the US author Ben Carlson (A Wealth of Common Sense) breaks down the chance of a positive return over various time periods. Unsurprisingly, the longer your time horizon the bigger chance you have of a positive return; this is represented clearly in the graph below. To me this shows that statistically the right time to invest is always going to be today if your time horizon is long enough and this is something we constantly remind clients.

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Source: A Wealth of Common Sense

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The current market is still clearly concerned with the outlook for interest rates and the impact that rates will have on markets, particularly growth assets over time. The markets are currently pricing in 6 interest rate rises this year so technically if there are any less than that this year then that should be net positive for markets this year. My view is that as long as the war (Ukraine/Russia) continues and oil and commodity prices remain high, that will do the job for the Fed to slow the economy. Why would the Fed (US Federal Reserve) want to rock the boat when people are already battling balancing their budgets. Higher oil prices have the same impact as a tax does so this should reduce net demand. There is even a very small chance that central banks could turn more accommodative which would be a boost for risk markets.

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Another study by Ben Carlson unravelled the affect that interest rates have on financial markets over time (below). He found that there have been several periods in history that rising interest rates have coincided with rising growth assets and vice versa. Interest rates don’t necessarily always cause growth assets to underperform. Personally, I don’t like the definition of growth and value at all and prefer to look at the companies we invest on a quality basis. If we are buying into a good story and business, we believe is going to take market share and do well regardless of the economy, it doesn’t matter where interest rates are. The market can be a very irrational at times and with higher volatility comes much opportunity!

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CNN has a proprietary system it uses to measure Fear & Greed in markets which I have posted above, now we are not far off the beginning of the index representing extreme fear. As you can imagine when things are going well people exhibit FOMO (fear of missing out) behaviour and times like now when you turn on the news and all you get is negative stories the heard tends to exhibit FUD (fear, uncertainty, doubt). Historically, when the S&P 500 VIX index has exhibited extreme fear with the VIX above 40 markets have, on average returned above average over the proceeding years.

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The elephant in the room is obviously the war in Ukraine. Primarily, we express our absolute dismay at the tragedy that is unfolding with the Russian invasion of Ukraine, our thoughts are with anyone affected by the conflict. Our role as investment managers is to focus on any geopolitical event will have on financial markets so this is where I will focus today.

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History can tell us a lot about how markets react to crisis and to wars and surprisingly, I have found in my research that markets are historically quite resilient to war and certainly do not incur permanent damage to portfolios. Historically it has paid off for investors to not sell into the fear and instead to remember that there have been several hundred examples of conflicts in the past, yet we sit here today and most major markets have hit their long-term highs in recent times.

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Let’s look at the first major conflict within the past century or so being World War 1, this shut the NYSE down on the first of August 1914, was closed for 4 months but after opening the market rose more than 88% recording the highest year for the Dow Jones on record. If we look at the start of the war to the end, the Dow Jones rose 43% or 8.7% annualised.

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Even the most catastrophic events can be recovered from rapidly. From the start of World War II, the Dow Jones finished up a total of 50% or more than 7% a year

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If you look at the War on Terror from September 11, in the two years following the attack, the US launched a large-scale military operation in Iraq and Afghanistan and the market struggled with the general market falling 7.4% over the 2-year stretch and the tech sector dropping 12.9% over the same period. (source)

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However, from the US invasion of Iraq in 2003, the market only took 13 days to bottom and after 3 months was up over 13% and 25% after 12 months. What markets hate is uncertainty and I believe the years preceding the Iraq invasion were times of uncertainty, as soon as the first bomb was dropped, this represented certainty in what the next few years would look like.

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My colleague Ryan sent around an interesting analysis of most major conflicts since 1939 and the overwhelming observation was that markets typically returned above average returns 12 months after the start of a conflict with the worst 12 month return on record being negative 18% and the best being +36.3%.

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Let’s pretend for a moment that you have the worst luck of any investor in the world and you invest exclusively at the market tops over 42 years. I have made this reference several times over the years in writing these notes, but it is an important lesson. The analysis was done again by Ben Carlson, a US Investment advisor and author.

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In the analysis, Ben assumes that Bob made his first investment in 1973, just before a 48% crash for the S&P500. He then made his next investment in September 1987 just before a 34% crash, Bob then made his final two investments in 2000 before the tech crash and 2007 right before the GFC. After 42 years, Bob had turned a total of 184k invested into $1.16 million for a total profit of $980,000 or 9% net return p.a. Clearly there were years in this analysis where his return looked much worse but when you added it all up over 42 years his return was 9%pa.

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The key here was Bob never sold his stocks and instead rode the stock markets long-term trend higher. Remember also this is assuming that Bob had the worst luck in the world and that he only achieved index returns.

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No one knows how much longer the war in Ukraine is going to last, but as we saw above, markets are forward looking. Investors try to predict the future, not price the present. As soon as we get some certainty over how long the conflict might last markets can price it in properly. We do not know what is going to happen with global inflation and interest rates but what we do know is that it is not necessarily a bad thing for assets in the long run. Now, there is even talk about a potential global recession which could halt the rate rises completely.

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If there is anything that history has taught us it is that it is always darkest before the dawn, no one knows when this market will turn, it could be today, tomorrow, 6 months or 12 months but the fact is that it will and we will see markets break through all-time highs once more. As Mark Twain has said  “history never repeats itself but it certainly rhymes.”

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Tim Whybourne

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