Why now is the time to prepare and protect portfolios

While we are naturally drawn to these exciting moments of athletic brilliance, we often forget that they are forged over a lifetime of arduous and distinctly unexciting practice.

The same is true of investing.

The image of the swashbuckling trader who steps into the fray and wins big while others are panicking has almost become a cliché. The reality is usually far less exciting.

In fact, to the extent there is any ‘excitement’ it often comes from poor decisions.

Plenty of evidence suggests that trying to second-guess the market over shorter periods is nearly impossible to do well, even when using relatively sophisticated methods.

Behavioural studies show that all sorts of things can go wrong under pressure: our survival instinct kicks in, our time horizons narrow, and we focus on avoiding pain rather than maximising long-term reward.

Investing — which was so fascinating and fun when we were making money — suddenly becomes incredibly stressful when this is not the case.

How can you help your clients avoid falling into this trap?

The right frame of mind

It starts with taking a long-term perspective. Plenty of evidence suggests that trying to second-guess the market over shorter periods is nearly impossible to do well, even when using relatively sophisticated methods.

As one example, consider Yale professor Robert Shiller’s cyclically-adjusted price-earnings ratio (CAPE). This measure of broad market valuation adjusts the S&P 500 index’s price-earnings ratio by looking at average inflation-adjusted earnings over the previous 10 years.

The CAPE is often touted as a predictive tool because it has a good correlation with subsequent long-term returns, and it is currently high (expensive) relative to its history.

But CAPE is far less helpful for judging the short-term direction of the stockmarket.

Looking back since 1881, the US market’s valuation, according to CAPE, explains only 10 per cent of the variation in the S&P 500’s subsequent three-year real returns, and only 5 per cent of the variation in subsequent one-year real returns. For periods shorter than a year, the measure has essentially zero predictive power.

Timing is especially tricky for investors, in part because short periods can have a large impact on long-term results.

As the saying goes, it is time in the market that matters, not timing the market. An investor who missed just the three best months of the MSCI World index since 1990 would have missed out on over 30 per cent of world markets’ cumulative return over that horizon.

The same health warning applies when selecting funds.