October 16th, 2018

Keep Calm and Carry On?

By Andrew Craig

Reading time: ~ 12 minutes

Many people have got in touch with me in the last couple of weeks to ask if I think it is time to sell out of “riskier” assets and funds given the “risk of a massive crash”. Given this fact, I thought that I would take some time to write a quick email on the subject.

A couple of years ago I wrote an article where I said:

“People who have taken no time to study it or really understand it, think that the stock market is horribly risky. This is perhaps unsurprising given that the media goes bananas every time there is a ‘massive crash’ and that is most people’s ‘reality’ when it comes to investment. The 99% of the time that a sensible, diversified portfolio will gradually and entirely effectively build your wealth doesn’t make front page news…"

Human beings are hard-wired psychologically to focus on the extraordinary to the exclusion of the unremarkable. Journalists are particularly prone to this phenomenon given that this is what sells copy (precisely because we are all hard-wired this way). Given this subject matter, I find it amusingly coincidental that the book I most recently finished reading is the brilliant and utterly fascinating “Stumbling on Happiness” by Harvard Professor of Psychology, Daniel Gilbert.

In the book, Professor Gilbert gives numerous examples of how we remember things that are out of the ordinary or exciting massively more than things that are ordinary or dull.

As an example – he cites a common belief that many of us hold - that we are somehow inherently doomed to always chose the slowest moving queue at the supermarket. Of course, this is statistically not the case. Each of us is factually just as likely to choose a fast-moving queue on any given day as we are to get stuck behind “…the bovine grandmother waving coupons…” at the cashier (his words, not mine).

As he says: “This doesn’t really happen that often, but because it is so memorable, we tend to think it does.” Standing in a queue that is moving quickly or at a perfectly normal pace is totally unremarkable and so we never remember all the times this happens. What we do remember is when “…the guy in the bright red hat who was originally standing behind us before he switched to the other queue has made it out of the store and into his car before we’ve even made it to the cash register…”

This reality is particularly relevant to investment and part of the reason so many people fail at it. Why? Well - with financial markets crashing as they have done in recent weeks, you will see lots of headlines like "£120 billion wiped off shares in a day.” You will see read a fair bit about “Blood in the streets…” You will hear that the FTSE, Apple, Facebook, Amazon and so on have fallen a long way from their recent highs and all of this will be read out to you with the most serious of serious faces on the daily pointlessness that is the televised evening news.

But when you read these articles or see these news bulletins on television, I would encourage you to stop for a moment and put your ‘blue head’ on (as the All Black rugby team like to say). In other words, take a step back, take a deep breath and think more deeply about what is actually going on.

£120 billion may have been wiped off UK shares. Facebook may be a shadow of its former self. Crucially, however, where was the headline the week before that said: “UK stock market alone has created nearly £1 trillion of value since 2009”, or “World economy as a whole has grown from $32 trillion to $85 trillion in the last fifteen years!”?

The gradual and significant increase in wealth that comes from investing over many years and sticking to your guns never, ever makes the front pages of our newspapers and no television anchor ever says “Great news - the stock market has increased by 3% this month…” Never. Ever.

As a result we all have a horribly distorted view of and understanding of financial markets and this is incredibly damaging to most people’s chances of becoming wealthy. The most effective antidote to this reality is to understand it. Which is why I started Plain English Finance and spend hours of my time writing this stuff. 😉

Why it pays to be a long term bull…

Markets have come off a great deal recently and there may be even more of this ahead of us, but it serves us best to remember that this is an unusual state of affairs. In my view these periodic corrections are actually far less interesting than just how amazing human progress has been and continues to be and to the fact that this reality is reflected in rising financial markets over time.

One of the great UK fund managers, Nick Train of Lindsell Train investments, tells us: “In 1919 the average American had to work 1,800 hours to earn enough to buy a fridge; by 2014 one could do so for less than 24 hours' labour and the product would be far superior…”

If you read books like “The Rational Optimist” or “Abundance: The Future is Better Than You Think”, you will get an even stronger sense for just how phenomenal the progress we have made in the last century has been for literally billions of us alive on the planet today.

Again – as Nick Train puts it:

“…I believe the odds in investment are very much in your favour if you adopt a positive outlook. Betting against the bull market in the FTSE All-Share Index, a bull market that began in 1962 and is still running, is betting against the trend and in most circumstances betting against the trend is a losing bet. Now, I’ve been in the investment business for coming up for 40 years and I’ll admit I wasn’t always a perma-bull. For years I too thought it sounded mature and responsible to evince caution about near- and medium-term prospects. I had to teach myself to be bullish. But I promise you, as soon as I started looking on the bright side not only did my investment performance begin to improve, but I felt and looked younger too…”

He also cites this wonderful quote from the great British historian Thomas Babington Macaulay:

“By what principle is it that when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?”

I think this is my new favourite quote and certainly even more relevant today than it was when he wrote it in 1830.

BUT…
So the long term outlook for investment is good, likely even great and we all do well to remember this throughout the roughly 1-2 years out of every 10 where there is a correction and the papers start screaming about “blood in the streets”…

…this reality notwithstanding, as ever - this isn’t the whole story.

Although the long term prognosis for investment is great – it is also really important that you identify what kind of investor you are and, related to this, it is also really important to take account of what age you are if you want to maximise your chances of real investment success.

A key consideration here is the time you have in front of you to achieve your financial goals and the amount of volatility you are willing and able to endure (psychologically) along the way.

Can you handle it?

Long term readers of these emails will hopefully remember an example I use fairly often of the exceptional and little known performance of UK smaller companies going back all the way to 1955. Professors Elroy Dimson and Paul Marsh of the London Business school have shown that investing in UK smaller companies (an inherently risky and 100% stock market investment) has achieved an annual return of no less than 15.4% going back to 1955! You read that right. 15.4% a year for sixty years (enough to make you an ISA millionaire in reasonably short order)!

BUT (and it is a reasonably big BUT) - there is a problem with this type of investment: Although this performance track record over no less than sixty years is amazing (and almost entirely unknown by the vast majority of people other than a small minority of folks in the City), the 15.4% returns didn’t come smoothly every year. Some years smaller companies powered ahead by 30% or even 40% or more. On several occasions between 1955 and the present day, however, they fell by more than 50%.

It is a very rare person indeed, psychologically, who can see their ISA or pension account 50% in the red, stick to their guns, ignore the noise and carry on investing regardless – confident that it will all be fine in the end.

For most people, enduring these sorts of falls will generally cause them to give up in fear, crystallise their 50% loss and then never invest in the space again. This means that they have locked in that large loss and, even worse, will then not enjoy those amazing 15.4% returns they would have got by sticking to their guns over many years because, having suffered the huge loss, they will almost certainly avoid the stock market from that point onwards.

Time…

The other problem with owning “higher risk” assets such as smaller companies (or, for those of you who have asked specifically – funds like Fundsmith or Scottish Mortgage) – is that - even if you are “averaging in” to your investments, stock market corrections can take quite a long time to get back to previous highs. In the most recent stock market crash of 2007/8 it took until 2013 for the S&P500 to get back to pre-crash levels.

People investing regularly each month would absolutely have benefited from the smoothing effect of being in at the lows from the bottom up, but it still would have been some time before they got back into robust profit. For many people this increases the risk that they give up on investment altogether and turn the theoretical loss that comes during a stock market dry patch into the real loss of selling out of your investments and compounding that disaster by then sitting in cash for the next few decades (a massive loss over a life time).

For this reason, for many people it may be a better idea to invest in lower risk assets and make a relatively low but consistent return over time than to invest in higher risk funds that risk scaring you out of your investments when markets are crashing…

…and how old are you – Sequencing Risk…

This is particularly the case if you are at or near retirement. There is an idea in investment called “sequencing risk” which considers when in someone’s life a potential loss occurs.

For someone in their twenties or thirties, losing a significant percentage of your money will certainly be very annoying but will be far less devastating than it will be to someone at or near retirement.

First, a younger person’s pot will generally be far smaller than an older person’s, meaning they will lose less in absolute terms. Secondly, they will have another few decades to build their asset base back up. For someone older, a large loss (or ‘drawdown’) will have a potentially disastrous impact on their quality of life in retirement. Losing £5,000 from your £10,000 pot in your twenties is an entirely different problem to that of losing £500,000 from your £1,000,000 pot at sixty – as should be clear.

To conclude

As John Stepek, editor of MoneyWeek magazine, put it rather brilliantly in one of his recent articles.

“There are many roads to ruin in the markets – some of them longer than others – but one sure-fire way is to set out as a buy-and-hold investor and then attempt to turn into a market timer during a bout of market panic. This will do more damage to your portfolio than following one approach or the other...”

It is very important for your long run success that you work out the kind of investor you are and keep a very keen eye on how long you have left until you’re going to need the pot of money that you are building.

For most people – timing the market is a very bad idea. It is very hard and requires that you spend a great deal of time learning investment skills and following the market. A far easier approach is to invest whatever you can afford regularly every month without fail from today until the time you want to use the money / retire.

If you have a relatively long time between now and then and are confident that you are emotionally and psychologically strong enough to continue to invest without fail through the big market crashes that will come every decade or so – then by all means allocate a fair bit of those monthly payments to “higher risk” funds.

If, however, you are at or near retirement and / or the sort of person who will feel physically sick when your £10,000 fund is now worth £6,500 (or, even worse, your £100,000 fund worth £65,000 or £1,000,000 pot down to £650,000!), then you should “know yourself” and look to invest in a much lower volatility fund.

Whatever you decide, you should do this without caring about or listening to the news. I would argue that the occasion of your 30th, 40th, 50th and 60th birthdays and so on should be when you take a look at whether you’re invested in the right things for your purposes and NOT when there is a crash in the news.

At those points you can work out whether you’re in the right mix of things and on the right track and you’ll be far less likely to make the mistakes born of panic and silly headlines from a press that focuses 99% of its attention on things that only happen 1% of the time.

I hope that helps.

I will end by repeating one of my favourite quotes from the US author, Mark Twain:

“I’m an old man and I’ve known many troubles in my life, but most of them never happened.”

It serves us well to think like that at times like these.