In just two years, major world events have run a terrifying course, from a health pandemic and ensuing market and social distress to a geopolitical threat turned full-scale war in Ukraine. The tragedy has been significant, and our thoughts are with all of those who have lost loved ones or had their lives severely disrupted.
World events of this scale introduce heightened risk and volatility into financial markets and can lead to significant market downturns and related drawdowns in investment portfolios. In the context of long-term investments, such events, and their ensuing volatility, have less of a long-term impact on your investment outcomes than you may think. Indeed, the most influential agents are unlikely to appear in the headlines; they are much closer to home: you, your independent financial adviser and your investment manager. Nomi Bodlani discusses.
Major world events can negatively impact the markets, but markets bounce back
While there might be numerous causal factors behind each market downturn, a defining feature of market crashes is the panic sell-off caused by fear, negative outlook and human psychology. Events like the COVID-19 pandemic and the war in Ukraine combine with fear and herd mentality to create a selling frenzy in which investors offload seemingly risky assets, causing prices to crash. At the same time, many investors seek to switch to perceived safe-haven assets (e.g. cash and gold), which may not be in your best long-term interests, and you may land up locking in losses.
But markets correct, meaning the impact can be temporary. History has shown time and time again that deep drawdowns (over 30%) are typically followed by high subsequent one-year returns. Longer term, this trend is not just typical ― it is almost always a given. Looking at South African equity market drawdowns since Allan Gray’s inception in 1973, the median five-year return following a drawdown that is greater than 30% is 27% per annum, with five-year returns after such a drawdown ranging from 14% per annum to 54% per annum.
As investors experiencing a market crash, or nervously watching as one unfolds, the prevailing pessimism and market volatility make it hard to believe in attractive future returns. History doesn’t repeat itself exactly, but there is sufficient evidence that its pattern is one of hope for patient investors.
Of course, the market bouncing back does not mean that your investment portfolio will bounce back equally. Similarly, a well-constructed, actively managed portfolio can also beat the market. Balancing risk and return in a manner consistent with the goals of the particular fund rests on the skill of your investment manager.
Our job is to uncover opportunities for attractive future returns and position funds for success across multiple scenarios
In situations of extreme market volatility, our job as the investment manager is to remain disciplined and assess the impact on the fundamental value of businesses. While many investors use share prices and media reports to pick the companies they want to invest in, at Allan Gray, we work hard to establish the true value of a business as a whole, including its ability to make a sustainable profit over time and under different conditions. We then cautiously invest where we see value and where businesses appear to have the potential to survive and thrive beyond prevailing conditions. When changes in price and sentiment are more volatile than changes in value, it makes for great investment opportunities. This is because we only buy shares that are trading below our estimate of their true worth. As bottom-up stockpickers, we are less concerned about the market and economy than the factors that make individual shares attractive.
This is not to say that it is not possible for the underlying value of the assets we invest in to be impacted by tough conditions. However, it is important to distinguish between the environment and the prices one is paying for assets in that environment. If sentiment is low and those assets are already pricing in a poor economic outcome, they can still generate healthy investment returns.
So how can you protect yourself from the next COVID, Russia risk or European debt crisis? As Tim Acker, one of our portfolio managers, succinctly puts it: “You build in a margin of safety, you buy companies that are good businesses and trade at attractive valuations that should do well regardless of what happens. You also make sure you are not overexposed to any given risk.”
In addition, partnering with an independent financial adviser (IFA) who can make sure that your portfolios are well diversified to achieve the same end goal, is key.
Passing through the storm
During a market downturn, the best course of action is usually to do nothing. Most investors are not good at timing the market. Exiting the market on the way down will result in losing out on the subsequent recovery. This is also where the expert guidance of an IFA comes in: to help you control the temptation to disinvest when the going gets tough.
As US lawyer Benjamin Roth noted in his diary detailing his observations during the Great Depression: “Business will always come back. It will remain neither depressed nor exalted. The stock market forecasts business in only a limited way. The beginning of a stock market movement usually is caused by the trend of business but in the end the movement is carried too high or too low – by the extreme optimism or despair of human nature.”