Our thanks to James Robertson, Chartered Financial Planner with Active Financial Planners Ltd for this insightful overview of how the financial markets have been affecting us all, as investors.
It would appear that it’s not only ourselves that over-indulge over Christmas and New Year period, needing a welcomed period of abstinence in January to get back on track, but investment markets do too!
Joking aside, but pausing, taking stock (no pun intended), and understanding what is actually happening can be a good thing for us all.
The COVID-19 pandemic has impacted on every aspect of human life, from physical health and emotional wellbeing to financial security. So, it’s understandable that investors’ confidence in financial markets may also be dented. Clients ask the question – ‘should we move out of equities and into cash?’. Yet swapping long-term growth potential for short-term capital security can prove costly.
It can be very tempting to switch from equities to cash when markets start to look shaky, but history tells us that fortune favours those who hold their nerve – markets in March 2020 taught us that.
There is again this time, a relatively straight forward explanation, and it relates to inflation.
Inflation surge
Inflation is the biggest current economic talking point, with current and projected figures spooking both markets and investors. The headline figure of the UK’s preferred measure of inflation, the consumer prices index, vaulted 5.4% during December 2021, its highest level for 30 years. Across the Atlantic, US inflation has surged to a 39-year high of 7%.
The long-anticipated return to rising inflation is proving a dilemma for Central Banks. On one hand, corrective action is needed to prevent inflation from spiraling out of control. On the other hand, raising interest rates too aggressively in a bid to stem further inflation will hit the purse strings of consumers. This comes at a time when many individuals and families are still in the process of restabilising their finances after seeing businesses and livelihoods hit hard by the pandemic.
Markets have reacted to inflation concerns by showing signs of fragility. The US equity market has dropped almost 10% since the start of the year. This volatility is spilling over into other global markets, the global equity index has fallen 7.5% over the same period.
The Economist newspaper (5th Feb. 2022) reckons that in the short-term interest rates will have to rise and so this may affect the value of shares. For the more technically minded, future cash flows from earnings will have to be discounted at a higher rate to today’s net present value leading to a fall in valuations. This has been most pronounced in some of the so called “tech” stocks – many of which have fallen by more than 20% in January alone
However, in the long run the world’s ageing population and the current savings glut will keep a lid on inflation and so interest rates. This points to an unpleasant financial squeeze, rather than a return to the 1970s. The US Federal Reserve has indicated it wants to get interest rates back to 2% by 2024.
Reacting with Logic
For some, watching your portfolio lose value over a short period of time can provoke an understandable urgency to take corrective action to protect wealth in the event of uncertain markets. This is a natural and primitive response, which in psychology theory is termed loss aversion.
The theory asserts that humans have a cognitive bias where the pain of losing is psychologically more powerful than the pleasure of gaining. The despair of losing a large amount of your investment portfolio is, therefore, likely to endure for longer than the joy of crystallising a sizeable gain.
The key, however, is to apply logic. The way markets plummeted during the 2008 global financial crisis offers a case in point of what can happen when economic conditions become severe. Indeed, the crisis left a bitter taste in many investors’ mouths, but the way markets have rebounded in the decade since emphasises that making rash, short-term investment decisions – such as moving from equities into cash – can cause lasting damage to portfolios’ performance.
Recent history delivers another powerful lesson on the benefits of blocking out short-term noise and retaining focus on long-term goals. On 23 March 2020, as the severity of the pandemic began to be understood, the UK equity market fell 35% from for the first time in more than a decade. Yet fast forward just a few months to the end of June, the UK market had rebounded by over 25%, steadying to see out 2020 only 8% lower than at the start of the year. During 2021, despite the effects of the pandemic still being felt, the UK equity market climbed 16.4% – its highest annual rise since 2016.
‘Time in the Market’ rather than ‘Timing the Market’
Switching from equities to cash when markets are bearish is based on the premise that markets can be timed. The most lucrative way to invest is selling stocks when they are high and buying them when they are low, or ‘buy the dip’ as it’s commonly known. By investing for the long term – time in the market – short term fluctuations are ironed out with more predictable returns over the longer term. Timing the market can seem alluring – everyone loves a bargain – but it’s a tactic that is rarely applied with any accuracy. Market movements are inherently random, and even with the best will in the world cannot be predicted with any true accuracy. This known as the random-walk theory.
There are real risks to being overweight in cash. Given that interest rates, despite starting to rise in both sides of the Atlantic in a bid to curb inflation, remain close to historic lows, any money held in cash will see its buying power eroding in real terms. The US Federal Reserve is poised to implement several rate rises during the course of 2022, but interest rates will almost certainly continue to lag inflation.
I believe that you should resist being influenced by market behaviour and revisit your initial and ongoing financial objectives. Prudent investment planning is not about buying and selling to capitalise on each and every transient market event. Investment portfolios should be tailored to your specific investment objectives, investment time horizon, attitude towards investment risk, and capacity to bear financial loss.
Your portfolio should be regularly monitored and reviewed – at least annually – against agreed goals and financial objectives. As stressed above, churning equities for cash to protect portfolio assets from potential dips could result in missing out on any potential upswing once markets rebound.
Investing would be far easier if markets moved in a linear upwards trajectory, but we know from experience this is not the case. It would also be easier if cash deposit rates outstripped inflation, but this is also not the reality and is unlikely to be for some time. It can be tempting, and indeed reassuring to exit the market when it begins to wobble, but history tells us that holding one’s nerve is not only the best course of action, but often the safest.
I do hope that this helps you to understand a little bit more the reasons behind recent market movements.
If you have one, pick up the phone to your financial planner or wealth manager, and discuss these issues with them. Reassure yourself how any movement (both up or down) impacts you against your original investment objectives.
As always, Investors should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future returns.
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