Written by Tom Stanley, Investment Adviser, 30th September 2022
Don’t be scared by the title of this note, I am not about to step you through Accounting 101. The idea of my note this month is to provide some practical and pragmatic frameworks that may help you stay the course and follow in the footsteps of the ‘Oracle of Omaha’ (Warren Buffett) and his above message.
With interest rates rising and inflation persisting it continues to be a very ‘noisy’ and tough year for all investors (young and old) – Headlines like the following don’t make is any easier:
“The 60/40 strategy is on pace for its worst year since 1936: Bank of America” (Yahoo Finance)
As emotional and social beings, it is, understandable that headlines like this shake us to the core, and make us want to crowd for the exit – While running for the exit in the event of a fire may be reasonable, why should we resist the urge when investing?
Our tendency to follow the crowd means that if we do no exercise critical thought as investors, we are likely to get sucked into the latest craze (see Tulip Mania) and run when the going gets tough. This unfortunate reality is best summarised by the below sketch illustrating the outcome of mis-managed fear and greed.
Warren Buffet, has become one of the most successful investors in modern history by running counter to this cycle (even at 92 he continues to be active, buying more stocks in September as markets sold off). Buffet’s quote above regarding fear and greed points to our inner hypochondriacs that tend to take hold of the negative headlines, and project the worst possible outcomes into the future. The issue is the future often turns out ‘less bad’ than expected. From a data driven perspective, this phenomenon is seen when comparing sentiment surveys, and the future performance of markets – The below chart from last week’s (Sept 28th) AAII Survey shows we just hit the most bearish (negative sentiment) reading since 2009. According to SentimenTrader “This week joins just 4 others in 35 years with more than 60% of respondents being ‘despondent’ in the AAII survey. One-year returns after the others: +22.4%, +31.5%, +7.4%, +56.9%”.
Four observations over 35 years is not a lot of data to work from, and I am not saying things will not get worse from here given the threat of nuclear war, 40-year highs of inflation, and the toughest time for your average investor since 1936. I am simply acknowledging that usually when there is no sign of any light at the end of the tunnel, a flicker of light emerges. Buffett’s comment above hits on having the courage to be invested when things start to look ‘less bad’ as these tend to be the periods when markets start to rebound (and sometimes quickly). How quickly? Ben Carlson of a Wealth of Common Sense did a deep dive into Bear Markets since 1945, his table below shows how quickly a Bear Market can resolve itself.
So why does it take so much courage to go against the grain and ‘be greedy when others are fearful’?
Daniel Kahneman & Amos Tversky’s were among the first researchers to start to unpack why (see book recommendation). Kahneman and Tversky’s focus was not originally finance, it was psychology, and seeking to unpack some of the mysteries of human behaviour and decision making under uncertainty. One of their Nobel Prize winning findings that is now fundamental to ‘behavioural finance’ was the discovery of ‘loss aversion’ as a concept. Simply put, loss aversion is the idea that humans feel the pain of a loss much more acutely than the euphoria of a win (by up to a factor of 4). This emotional response to loss is reasonable, pervasive, and primal. To our ancestors, loss was often tied to binary outcomes i.e. life or death – with this context it makes sense for us to naturally err on the side of caution! (Why are we wired this way? I don’t know, but natural selection may have played a part with ‘natural’ risk takers removing themselves from the gene pool over generations).
Will the current bear market be long or short? Is now the perfect time to buy? I don’t know, I would be lying if I said I thought the road ahead is easy. But, if I zoom out to a 10-year view… do I expect people, companies, and society to continue to find better, fairer, and healthier outcomes across the world? I am hopeful, and based on that hope, I am willing to lean into the wisdom of the ‘Oracle of Omaha’ and continue to invest (albeit cautiously).
Taking a 10-year view may sound easy for someone in their 20’s or 30’s focusing on ‘accumulating’ wealth, what about those who are in the process of ‘decumulating’ – i.e. drawing an income (or are soon to draw an income) from their investments? This is where my note gets practical.
For the ‘Decumulators’ (retired or soon to be retired):
Bear markets are about holding your nerve and sticking to a longer-term investment strategy. The idea we leverage for our clients is to ensure funds are invested based on the time when you will need them (sometimes called asset liability matching). Most of our clients in this ‘decumulation’ category are balancing: 1. Living their best life as long as they can; 2. Near term certainty of income; and 3. Not running out of money in the long term (or leaving a legacy) – We find the most practical way to achieve balance across these goals is through building an investment strategy based on ‘compartments of capital’. Using this idea, a ‘Decumulator’ may have the following investment buckets:
- Short Term Funds (Cash & Term Deposits): Anywhere from 1-5 years of desired income (depending on required certainty and overall returns).
- Medium Term Funds (Mixture of Defensive & Growth Assets): Typically funds for use in 3-7 years’ time. Has a reasonable chance of a negative return in any 1-3 period but should be positive over a rolling 5 years
- Longer Term Funds (Predominantly Growth Assets): Funds that are not likely required for 7+ years. The value of this ‘compartment’ will bounce around, but the idea is for these funds to generate capital gain to ensure longer term goals such as ‘not running out of money’ or ‘leaving a legacy’ can be fulfilled.
This approach plays on the idea of ‘Mental Accounting’, a concept we naturally adopt in our day to day lives – we often earmark funds for ‘fixing the car’, or ‘renovating the kitchen’, or ‘going on holiday’ – the above strategy taps into this approach, and allows us to better tolerate uncertainty and stick with our longer term plan. This approach may seem complex, and while some may have the luxury of not ‘needing’ to be invested, the below chart illustrates the reverse wealth effect of inflation over the years (from a US lens), and highlights why over any 5+ year timeframe ‘Decumulators’ should consider the potential drawbacks of a ‘low risk’, ‘cash only’ strategy.
For the ‘Accumulators’ (those building towards a goal longer term goal (10+ years)):
While my message may seem odd, wrong, or even frustrating right now… ‘Accumulators’ should love bear markets and look to the current markets as an opportunity! This comment may pain you as your investment balance has fallen, but as you do not need your funds in the near term, a bear market to you is more like a well-timed Briscoes sale, where you can get all the household things you were going to buy anyway at a 30% to 50% discount! To illustrate this in numbers, I point to the below hypothetical bear market scenario for a regular saver (Accumulator):
- Over 24 months the market earns 0%
- In the first 12 months the market goes down 30%
- In the next 12 months it recovers to even
- An investor puts in $1,000 per month via a regular saving plan
The ‘Accumulator’ with a regular savings plan has stumbled across the idea of ‘Dollar Cost Averaging’ – And they have generated an per year return of +17.59% through an extremely volatile and uncertain time where markets have returned 0% over 24 months… Purely by staying the course and taking advantage of ‘cheaper’ prices!
Many of us often sit on the fence waiting for ‘a better time to invest’, but what does ‘better’ mean? Is it when prices have recovered? Then you would have missed the above returns… Based on Buffett and the psychology explored above, shouldn’t we be looking for what ‘feels’ like the worst time to invest? The issue is swimming that hard against the current is not easy… so a repeatable process is likely the best answer for most.
In closing, neither of the ideas explored above are going to change the news that bombards us all daily, or make markets turn up. However, understanding the power of ‘Mental Accounting’ and ‘Dollar Cost Averaging’ will arm you with a psychological edge as an investor, and if nothing else give you a ‘process’ to lean on so you can be deliberate and thoughtful, rather than emotional and impulsive when you inevitably become uncomfortable.
“In investing, what is comfortable is rarely profitable.” — Robert Arnott
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