5 July 2016

John Barton

Director & CEO

In times of uncertainty, there is a strong natural tendency to stay still, to defer action, to wait and see. Think of it like inertia – the tendency for things to continue as they are in absence of a new force changing the equilibrium. Of course time marches on and most people tend to forget that deferring a decision to change because of a lack of clarity about the future is in fact a decision to stick with the status-quo, even when there may be a very sound case for making changes.

With the recent happenings in Britain shifting an already unsettled investing environment into a space of greater volatility, it is a reminder that we are living in both curious and challenging times. Although now is obviously a time for considerable caution, it is certainly not a time for sitting on one’s hands and blindly backing the status quo.

With future returns from a conventional portfolio approach increasingly likely to be poor, now is the time to reassess portfolios to ensure they are well-diversified and risk-aware. With that being said, it is also important to recognise our behavioural and emotional biases to ensure we don’t make unnecessarily rash decisions that may compromise our long-term strategy and objectives.

We have a very human tendency, especially in times of heightened uncertainty, to have memories like goldfish. We allow ourselves to remember, and be heavily influenced by, events that have happened in the most recent past. This phenomenon is known as recency bias, where we over-weight recent events (as they are fresh in our memory) and under-value longer-term context and events. This unconscious preference ignores more systemic patterns and puts us at great risk of drawing inaccurate conclusions leading to poor decisions. Why? The emotional connections we make with events and the personal experiences we remember naturally far outweigh the dispassionate world of research and statistics. The further in the past the event is, the less likely we are to feel strongly towards it. Brexit is an emotional trigger now, but in 6, 12, 18 months it is less likely to be. We can even see the impact a few days can make as many equity markets recovered their initial ‘Brexit losses’ within that period.

Whilst Brexit is front-of-mind today, it is worth remembering that there is always ‘something’ to worry about. The future is always uncertain – it’s just that sometimes we’re more aware of the uncertainty and the range of future possibilities feels more varied. In 2000 it was the bursting of the dot.com bubble that had us all concerned about the future of the global economy. In 2001 it was the new reality of global terrorism that confronted markets following 9/11. In 2005 Hurricanes Katrina and Rita left markets reeling, as concern about the ability of the US to cope with natural disasters on such a scale were raised. After each of these events, and countless others just like them, volatility increased as investors cycled between greed and fear. Brexit, and the broader EU dramas that will no doubt follow, will be no different.

Knowing that things will inevitably settle down at some stage isn’t necessarily sufficient for most of us though. The fact is many of us are feeling more uncertain, more unsettled, more unsure than usual. Our fight or flight response is kicking-in. When it comes to investing the fight or flight response often results in selling everything to cash or sitting on hands and doing nothing. Not surprisingly, I would like to argue that these responses are unlikely to be the best course of action. Instead of sitting on our hands waiting for something to happen my thesis is that we should use current market instability as a prompt to reconsider the traditional investment approach.

 

So what should we do?

Begin with the end in mind

Why are you investing? What are you hoping to achieve? The more specific you can be the better. It is not sufficient to say ‘I’m investing to build my wealth’ or ‘I’m investing so that one day I can be financially independent’. You might, for example, be well served to think of your investment objectives as your portfolio’s ability to meet your future spending needs. ‘Reframe your thinking and take control of your future’ explores how instead of thinking about your investments in terms of their market value (how much you are worth), you should consider thinking about assets in terms of their ability to produce an income (and what lifestyle they can sustainably fund). One of the areas in which a professional adviser can add real value to your situation is by helping you to articulate a clear set of investment objectives that suit you and your family. By clearly understanding what it is you’re trying to achieve you will be better placed to assess the myriad investment options available to you.

 

Take a stock-take

Before you can plot your journey to a new destination, you must accurately understand where you are today. Ensure that you understand your current resources including assets and cash flows and your current commitments (debts and lifestyle expectations) so you can begin to make some informed decisions about what’s possible and what’s not. Again, a professional adviser can be tremendously valuable in working through this process and in helping you consider the trade-offs available to you

 

Divide and conquer

Most of us tend to think about our investment portfolio as a single pot of money. Instead think about it as a number of smaller portfolios with different objectives for different elements of your overall strategy and requirements. Think of your future spending as a series of liabilities that need to be funded by cash flows generated from a range of portfolios custom-built for that purpose This approach will enable you to assess your needs more reliably and empower your decision making ability regardless of the broader market context of the day.

 

Accept the free kick

It is often said that the only free kick available in investing is diversification. Modern portfolio theory tells us that appropriate diversification within an investment portfolio can provide the same expected return with less risk along the journey or a higher return for a given level of risk – in other words you really can get more, for less!. Whilst diversification is a noble goal, as many investors found out during the GFC, all diversification is not created equal. Having a broad mix of shares, property securities and bonds (your classic ‘diversified’ portfolio) doesn’t feel particularly diversified when everything goes south at the worst possible time. The challenge is to find genuinely uncorrelated assets and/or to affordably implement effective hedging strategies to provide down-side protection. This is an area that the right adviser can deliver material value – at a time you need it most.

 

Consider a partnership

Going it alone is tough. It’s not just the market research you have to keep on top of, it’s also the emotional aspects (like recency bias) of investing that often work best when you have someone by your side working with your interests in mind. Working with an adviser doesn’t mean having someone to make your decisions for you, rather it’s about having someone in your corner providing input and insight, helping you to make informed decisions as market dynamics, risk and uncertainty unfold.

 

In the end, our role as individual investors, whether on our own or in partnership with a professional adviser, is to take the time to understand the risks we are taking (or those we are considering), to assess a fair price for accepting those risks and to actively monitor the risks within our portfolio as effectively as possible. Of course, we must always recall that risk and return are two sides of the same coin. We only have access to returns in excess of a basic cash rate because of uncertainty. In short, we must accept uncertainty as an integral element of reality – and ultimately embrace it as an ally.

Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.