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Lessons from a crisis

15th May, 2020

“Those who cannot remember the past are condemned to repeat it.”

Stock market crises may not feel much fun at the time, but they can provide a handy lesson in the right way to run a portfolio. It is easy for investors to be swept along with trends – technology, healthcare, AI – leaving their portfolios vulnerable when problems arise. For advised clients, it should be a useful reminder of why their advisers work so hard to achieve a balanced portfolio on their behalf.

Too often the lesson that investors learn from a market crash is simply to avoid the last problem area – technology in 2000, banks in 2008 and today, travel, leisure or oil. Not only does this risk missing out on opportunities, it is an unrealistic way to avoid risk because history has shown that the next crash is unlikely to hit the same sector as the last one.

What wider lessons can be drawn from this market crash that will ensure investors are best prepared in future?

The unpredictability of markets

In many market crashes, the problems are easy to spot in retrospect: the vast over-valuation of zero-revenue technology companies or the debt in the banking sector for example. This crash was unique in having come out of nowhere at a time when many investors were expecting an uptick in economic growth and risk appetite.

The lesson? You never know what’s round the corner, so don’t bet on red or black. No matter how strong your conviction, taking significant binary positions in your portfolio leaves you vulnerable. Diversification is key: those holding government bonds, or cash, or selected absolute return funds will have been very glad they had some ballasts in their portfolio at this difficult time.

Panic selling is a fast route to losses

While the circumstances of this crash have been very different, it has followed a familiar pattern, notably a speedy sell-off followed by a meaningful rally. This should remind investors that the strongest gains often come quickly after a significant sell-off. Those investors who aren’t there for the rally may struggle to find the right moment to reinvest.

Any investor who sold out amid the panic of the early days of the crash could have crystallised losses of over 30% (the FTSE 100 fell 33% from 19 February to 23 March). Unless they have been lucky enough to buy back in on 23rd March – the day the UK lockdown started – they would have missed out on the subsequent rally of around 20%. They will also miss out on any dividend payments.

This should be a stark reminder of the difficulties of market timing. Ultimately, trying to second-guess the highs and lows of markets is a fool’s errand.

Someone’s making money

There are winners in every strange new environment. Today, those winners are online shopping portals, video-conferencing groups, biotechnology and pharmaceutical groups. In many cases, the Covid-19 outbreak has not established new trends but sped up existing trends – people were already starting to work from home, shop online, while demographic trends supported the pharmaceutical sector.

This argues for a portfolio that strives to look forward rather than back. Investors should be trying to identify how the world might look tomorrow, rather than basing a portfolio allocation on the way asset classes have behaved in the past.

Environmental, social and governance factors matter

Research is mounting that incorporating environmental, social and governance criteria is important for long-term returns. It turns out that it is also important for resilience during a crisis.  An HSBC research note found that climate-focused stocks have performed better than others by 7.6% from December and by 3% since February. Shares with high ESG scores beat others by about 7% for both periods.

On reflection, there are sound reasons for this. If a company is well-run, it is less likely to have excessive debt or to have taken chances on its supply chain. This will give it more financial resilience. It is more likely to have a management team that will act well in the crisis, supporting its reputation. It is more likely to have built contingency into its business modelling and to be better prepared for crises as they arise.

These are difficult times and even though markets have rallied, there may be more pain ahead for investors. However, each crisis makes better investors of all of us.

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