Friday Highlight  

Composure in tough market conditions

Composure in tough market conditions

September and October were torrid months for global markets.

From a high on August 28, the MSCI AC World in sterling was down by over 9 per cent by October 24. The FTSE 100, which had been falling for longer, was down over 10 per cent in October from highs reached in May, even with dividends included. And what’s worse, this was the second sell-off this year. 

Both indices had fallen by very similar amounts over the first quarter of 2018.

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Market falls are unsettling for investors, leading to questions like, “what if this time is different, what if markets never recover? Should I be doing something different?”.

It’s tempting to be lured into safe haven assets like cash, but that would be a mistake.

The naked truth about risk

Risk is the reason why excess returns are available. It is uncertainty that causes assets to be priced at a discount so that investors can expect to be rewarded for taking that risk.

If an asset was suddenly perceived to be less risky, it’s price would immediately shoot upwards and the future expected return would fall. Risk is the reason we are able to retire.

But risk isn’t just some academic concept. Bad things (like the financial crisis of 2008 or the technology bubble popping in 2000) need to actually happen periodically to preserve the “equity risk premium”.

In other words, if bad things didn’t happen and people perceived equities to be less risky, assets would price at a premium and expected returns would need to be moderated. The same goes for any sell-off in any asset class.

These episodes are expected. Below is a statistical simulation over 40 years of a profile six portfolio with an expected return of CPI plus 4.5 per cent and expected risk (volatility) of 12.4 per cent.

The risk and return achieved in this single simulation is almost exactly as expected; however, the path is clearly not smooth.

Because of compounding, this chart tends to obscure risk in early periods and exaggerate it later on.

Below, I have used a log or exponential scale on the y-axis to more intuitively represent returns over long periods, which is why the CPI plus 4.5 per cent line is now straight and not curved with compounding. Values are “real” and exclude inflation.

This would be a very satisfactory outcome for an investor in this portfolio who saved from the age of 25 to 65. But this investor would have had to endure a few bumps along the way.

Given the turmoil experienced in markets in October, we used the simulator to see how “normal” such falls are for a portfolio with the same asset allocation as the UK PortfolioMetrix profile six portfolio.

The chart below shows how many times in 40-year investment periods monthly losses exceed 2.5 per cent, 5 per cent, 7.5 per cent and 10 per cent respectively. This is derived from running 500 simulations and taking the average: