Take the Long View: Coronavirus – The Investor’s Perspective

What is the mortality rate? Will there be a vaccine? How long will this last? We don’t know the answers. Still, a recession is inevitable and investors are panicky. It is possible that “it’s different this time”, but investors tend to think it’s different every time. In the face of this, investors have a strong natural instinct to do something… most typically, sell! But, is that the right answer? Here are a few things to keep in mind at a time like this.

The equity market is naturally volatile, and that’s good

At an abstract level, remember that we have to endure short-term volatility in order to enjoy the attractive long-term returns that the equity market offers. There are periods that feel like sickening roller coaster rides. Currently, it’s as bad as it gets. But if this weren’t the case, equity investors wouldn’t be well compensated. The chart below illustrates this. There is a sizeable market decline every year (the circular dots represent the worst intra-year decline for the Canadian TSX Composite each year since 1985). On the other hand, each actual calendar year return (shown as the vertical bars) is, by definition, better than the worst decline for the year, and most of the bars are positive.

For the full 35 years, the average worst intra-year decline has been 15%, with the single worst close to -50%. But the calendar year return has been positive in 25 of the 35 years. And for the entire period the return has been 8.6% per year.⁽²⁾ Not bad compensation!

Stay in the market

We know that the markets are “efficient”, but we also know that we (the markets are collectively all of us) can get things wrong – sometimes badly overreacting in either direction. “Efficiency” just means that you can’t use existing price patterns to predict anything useful about where the market may go in the short-term. This, along with natural volatility, proves that the markets are inherently unpredictable over shorter time periods.

If we know that the market goes up over the long term, and acknowledge that we can’t predict the path, then it’s better to be “in the markets, all the time” to fully capture the compensation. The big problem is that the story doesn’t end here. Humans, it turns out, have foibles. Whether by divine design or earthly evolution, we have some, uhm, programming flaws.⁽³⁾ To wit, an investor’s emotions of fear and greed can overcome his/her rational mind. We want to capture the market’s longer-term compensation. Unfortunately, we have a tendency to capitulate when fear or greed peaks – effectively, a tendency to do the wrong thing at the wrong time. The best way to combat this is to pick and stick to a strategic asset allocation that suits you. Then, realising that there will inevitably be bad times, hold a diversified portfolio of quality, reasonably-valued stocks. These will grow in good times and survive the bad.

Avoid overconfidence

Even successfully staying in the market isn’t enough. Another behavioural foible is that we overestimate our ability. This occurs because, when we look back in hindsight, we tend to actually believe we suspected the outcome all along. So we think we can do this looking ahead. For instance, people believe that surely, they are smart enough to tailor their portfolios to the current outlook – say, hold more cyclical stocks in good times and more gold stocks in bad times? Unfortunately, this is just another version of trying to repeatedly predict unpredictable market moves. A short-term trading orientation means that you need to get both trades (the buy and the sell) right and at the right time. In turn, this means that you are making a prediction about where the company is going and how the markets will respond.

“I know that I know nothing.”
~attributed to Socrates

The “wise” investor’s version of Socrates’ view is this plea, “May I have enough wisdom to know that I’m not very smart”. Try as one might, we can’t predict the unpredictable. A long-term investing approach is challenging enough, but more feasible than a trading orientation. “All” one needs to do is identify companies that have sustainable competitive advantages, are well run, and are priced at a reasonable valuation. These tend to do well over longer periods by virtue of dividends and earnings growth, not market moves.

Don’t look back at the peak

A final human behavioural foible is that we tend to look back at the most recent market peak to measure our regret (which is how humans “feel” losses). Given inherent market volatility, there are almost always higher market peaks behind us, as is indeed the case today. Most Canadian investors are diversified beyond Canada, and a portfolio with equities from multiple countries tends to even out the peaks and troughs relative to the Canadian equity index. Finally, any fixed income and cash further dampen volatility.

***

The current investment environment is unsettling and all the more emotionally draining due to concerns about the health of one’s family and the extent of the unknowns. However, the coronavirus crisis will inevitably pass. As an investor, remain aware of your natural behavioural foibles and always endeavour to take the long view.