On March 4th 1933, in the very depths of the Great Depression, President Franklin D. Roosevelt commenced his inaugural speech with a message that has become a blueprint for responding to all economic crisis: “the only thing we have to fear is…fear itself”.
Once again, fear is at the front of mind for most investors as we face another recession against a background of high inflation and weak recent investment returns.
Recessions are especially dangerous for investors as they provoke the poor decisions that can have devastating and lasting consequences on investments.
They are consequently the occasions when financial advisors can have the most positive impact on the futures of their clients by helping them make good and rational long-term decisions.
However, it is not only end-investors that make poor decisions when the economic environment becomes challenging; professional investors are equally susceptible to the behavioral biases that lead to poor outcomes.
Strategies to combat the fear-driven mistakes alluded to by President Roosevelt can help both end-investors and professional investors. These strategies can be divided into two groups.
Avoiding mistakes
The mistakes we make tend to emerge from well-understood behaviors to which we are all prone. For example, when we feel threatened, we tend to either move away from the threat, tackle it head-on or do nothing.
This is known as the ‘flight, fight or freeze’ response. It can manifest in investors by a desire to sell investments and de-risk portfolios at the wrong time, over-trade portfolios or ignore opportunities to improve the expected returns.
The best way to combat these reactions is to avoid provoking the feeling of threat. It is challenging to do this in the middle of a crisis and so preparing in advance is essential.
As advisers and investors, we know that we and our clients will encounter regular crises and so desensitizing ourselves and our clients to these crises is an essential part of our role.
What we can do in a crisis is to focus on the future rather than the past. Humans naturally expect the near future to be similar to the recent past and so emphasizing recent returns (for example, with vivid performance charts) can provoke the responses we are seeking to avoid. It is therefore far better to focus on the expected returns that have improved as prices have fallen.
We can also reduce the risk of poor decision making by isolating ourselves from the financial media that is designed to generate a reaction to the latest news and market movements.
As we do this, it is important to avoid being seduced by a compelling narrative about what the future may hold.
These narratives are favored by commentators and often delivered with a high level of confidence.
In reality, the future is both uncertain and irreducibly complex. Consequently it is important to consider a wide range of potential outcomes rather than becoming attached to an attractive story.
Accessing opportunities
While the uncertainty of the future confounds forecasters, it is an enabler of investors as it creates opportunities for mis-pricing that can be exploited.
Such mis-pricings, tend to occur during periods with a dominant consensus among investors about the future path of earnings.
Taking the opposite view in these situations can enable investors to accumulate or sell investments at very attractive valuations, leading to a significant improvement in long term returns.
However, it is important to remember that on most occasions the market consensus will be the best guide to the future and consequently, ‘knee jerk’ contrarianism is unlikely to be a path to success.
Investors must therefore be able to discern when these genuine opportunities occur. This, in turn, requires an ‘anchor’ to help them maintain their position against a strong tide of investor opinion.
At Morningstar Investment Management Europe Ltd., we use valuation as that anchor. By comparing the expected return of an investment across a range of economic scenarios to the current price, we can assess whether an asset appears unusually attractive or unattractive and hence has the potential to deliver unusually high or low returns.
As it can take several years for the price of an asset to return to its fair value, such analysis is naturally long-term in nature avoiding the temptation to over-trade.
Judgement and time
Such opportunities often appear in niche asset classes and therefore require a broad research capability and ‘go anywhere’ mindset.
While much of the initial work can be done quantitatively, deep research requires judgement and time. This is time that can’t be used elsewhere to support clients or undertake marketing activities.
Consequently, periods of economic turmoil are best tackled by specialists working together to ensure that both the portfolios and needs of the investors are well supported.
Like Roosevelt in 1933, we have no idea about what the future holds and so instead need to concentrate on what we can do to increase probability of a favourable outcome for our investors.
We can start by improving the way we make decisions. In doing so, we will no longer need to “fear …fear itself”, but can instead use the as a source of opportunities to enable investor success.