This pandemic is a once-in-a-century crisis that has unleashed demand and supply disruptions in the global economy after the Great Depression of 1929.
The contrast to 2008 Great Financial Crisis are fundamentally different. The GFC started as a subprime crisis that went on to threaten the global financial system and then impacted the economy and households. This time around, the crisis started as a medical pandemic, which led to scores of deaths and businesses forced to shut shop due to lockdown. The financial system has been safeguarded by upfront concerted actions with rate cuts, huge liquidity injections, monetary and fiscal stimulus and direct intervention by central banks.
Many business models will never come back and millions of jobs that were lost may have been lost permanently. The way people live, work, consume, spend, save and invest is changing forever and will require all service providers to recaliberate as well.
In this backdrop, here is our prescription for the financially savvy, “on the road to financial freedom” investors:
1. The coronavirus pandemic will lose significance sooner than anticipated, as better treatments, herd immunity and vaccine launches will consign it to the ranks of one more “few hundred thousand deaths per annum” disease. Of the 60 million people who die annually, nearly half die from the top 10 diseases like cardiac ailments, cancer and diabetes. COVID-19 has been a severe challenge to humanity, but we are already 75 per cent through the pain and the solution to it is on the horizon. Investors need to be courageous and mindful and relook at their financial plans with hope and confidence.
2. Making a comprehensive and clear record of all financial holdings for our family should be the top priority. A “family must know” file can be created, manually, with all details of all accounts, investments, insurances, loans, passwords. Along with this, a simple will can be created, leaving everything, movable and immovable to a spouse or parent or family member as desired.
3. The lockdown has helped investors evaluate their priorities and led to a surge in essentialism, with people focussed on the high priority parts of their life. Investors should use this clarity to re-evaluate their investment objectives, time horizons, risk appetite and cash flow projections. Changes need to be made in strategic asset allocations as a result. For example, we are advising all to increase their emergency liquid fund from six months of expenses to two years of expenses, given the surge in income losses.
4. Research has shown that strategic asset allocation is the most important driver of portfolio returns over the long term. It explains more than 75 per cent of the variability of returns. The other three components of security selection, tactical asset allocation and market timing together account for the remaining less than 25 per cent. It’s critical to use this opportunity of time, clarity and prioritisation to rejig the strategic asset allocation to prepare for a vastly changed world.
5. On the tactical asset allocation front, a move to the highest quality is critical. The economic pain will stay for at least two, maybe more years, even as the medical emergency normalises fast. It is also important to be invested in good, healthy, growing businesses, as they will be most likely to weather storms. As Warren Buffett puts it, “It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone.” Discard the lemons in your portfolio and focus on getting into top quality companies as a long-term investor.
6. The investment process itself need not be complex. Simplicity has a huge premium on the path of financial success. Borrowing a simple financial guidepost from Ben Carlson’s, “A Wealth of Common Sense”:
As Warren Buffett once said, “Intelligent investing is not complex, though that is far from saying it is easy.”
7. The costs of not following these simple guidelines are huge for investors. For example, mutual fund flows show that a majority of investors pour money into the market at the top at stretched valuations and then pull their money out at the bottom when valuations are attractively depressed. This has been shown to lead to an average loss of 2 per cent per year in market gains. Increased trading activity from overconfidence can lead to another 1.5 to 6.5 per cent in relative losses as per studies of trading trends of investors. Investing through market cycles for long term works for most investors. Studies have shown that if an investor was invested through a 20 year period from Jan 2000 to Dec 2019 in the US market, missing out on the 10 best days out of those 7,300 days eroded returns by nearly 60 per cent. Missing out the top 20 days led to nearly a 98 per cent drop in returns. Investors pulling out money from mutual funds in India in June 2020 may have been one of the worst investment decisions of their lives. Over estimation of market timing abilities is a common point of failure for all types of investors.
8. Discipline and humility go hand in hand in the markets. There has been a surge in so called Robinhood traders worldwide with untrained, novice traders using no fee discount brokerages to enter the stock trading arena with an over estimation of their abilities. So much so that legendary investors were made fun of. A quote from a decade old book illustrates this very well:
“Buffett being penalised for underperforming versus managers riding the long side of the dot-com bubble is a perfect illustration of a common investor mistake—failing to realize that often the managers with the highest returns achieve those results because they’re taking the most risk, not because they have the greatest skill.”
9. We would like to urge investors to widely diversify their holdings into uncorrelated assets. Herding behaviour of crowds chasing overvalues momentum plays has led to most financial bubbles from the tulip mania in Holland in the 1600s to the South Sea bubble to the dot-com bubble and more recently the housing bubble in the US that ended with the Great Financial Crisis of 2008.
As the combined capitalisation of the top four stocks on the US Nasdaq, Amazon, Apple, Microsoft and Google commands a greater market capitalisation than the entire Japanese market. A car company making 500,000 cars is valued higher than the top nine car majors making more than 12 million cars per year, we are entering a bubble zone.
Non participation is not an option. Sitting this out will also have costs.
Diversification is the best antidote to this. Diversify and hold on for the coming roller coaster ride. Eventually we will make it to the other side, but
the churn in the cycle will be testing and trying.
The author is a Private Investor