Avoid the temptation to invest through the rearview mirror
Dan Kemp is the Chief Investment Officer for Morningstar Investment Management in the Europe, Middle East, and Africa region. Below is an excerpt of a presentation he gave on the economic impacts and outlooks in a Covid-19 world.
It goes without saying that we live in extraordinary times. We’ve never before had a deliberate stop on the economy in peacetime. And it’s not surprising that we witnessed a very sharp fall in asset prices in February and March 2020. Living through these periods can be unsettling, but I think we need to remember that market crashes are a feature and not a bug of investing. Crashes reset valuations and provide the opportunity for investors to improve their portfolios–and particularly to improve the expected returns of those portfolios long into the future.
To use an agricultural analogy, we can think of crashes as providing the fertile soil into which we sow the seeds of future returns. Unfortunately, unlike the turning of the seasons, the precise timing of crashes is unpredictable. You don’t know when they’re going to occur. Moreover, you can only sow seeds into ground that is cleared of the last harvest. Investors who left the previous crop in the ground too long hoping for a bigger harvest were poorly prepared for a crash and face the problem of trying to decide what to plant and what to harvest at the same time.
Now, we at Morningstar Investment Management, like anyone else, don’t know when a crash is coming, but the investment team spends a lot of time thinking about whether the current environment is favourable for investors and whether our focus should be on planting or harvesting. And as prices of some equity markets became very stretched over the past couple of years, we’ve generally taken a little bit less risk in portfolios, so we were reasonably well prepared for what happened in February and March.
Providing you’re not caught with your harvest rotting in the fields, investing during a crash is pretty straightforward. You simply buy more as prices fall and the margin of safety for future returns looks better and better. The questions become: what you buy, how much you buy, and how quickly you buy. We responded to those falls in February and March by rebalancing portfolios. That’s the first and most efficient step. Then, toward the end of that March period, we added more equity risk.
The current situation is now much more difficult. The opportunities we saw a month ago have declined. U.S. equities in particular have risen sharply, and simply adding more risk is less attractive than it was. Now we are much more focused as an investment team on finding the best opportunities. We’re especially interested right now in sectors that have been hit the hardest during the downturn–for example, global energy and high-yield bonds. We’ve been adding those positions to the portfolios.
We’re also seeing opportunities in markets that fell sharply but haven’t really participated in the recovery. U.K. equities are a good example of that, and some emerging-market bonds have become relatively more attractive as well. Of course, all these decisions are being underpinned by the deep fundamental research that’s the hallmark of our investment management team.
Another challenge faced by investors in volatile times is that they tend to look at the path behind them and use that as a guide to the future in front them. We can think of this a little bit like driving a car just using the rearview mirror or plowing a field (to stick with the agricultural analogy) just looking behind you. We know that leads to poor outcomes. You see that when people talk about the fact that we are past the worst, or that asset prices have risen too quickly–that indicates the path behind them is influencing the way ahead. The truth is that, frankly, we don’t know what the near-term future holds. So, our portfolios have to be prepared for a range of possible outcomes. We also have to prepare our clients, as we can only empower their success if they stay invested.
I’ve learned some things that may help you as you think about long-term investing, or for advisors who are asked questions by others. The first is that we have to acknowledge people’s concerns. We need to listen to them before they’ll listen to us. There’s no point just brushing past their concerns. We need to take those concerns seriously. Second, we need to understand that different people need different responses. Some clients need reassurance. Others will need evidence or data to help them make their own decisions. Some groups will need to be challenged out of wrong ideas or bad ways of thinking. Third, we need to focus on price/fair value and not on those past returns. By looking only at near-term returns, we can get the completely wrong idea. If you want to see how this works, I’d recommend going to the home page of Morningstar Direct and looking at the difference in the way that you feel when you look at year-to-date returns, which are a sea of red, versus the valuation lens, which shows a much more gentle blue (meaning that many assets are currently undervalued).
And then fourth–and most importantly–we need to focus on goals. The question is not how much is in your portfolio, but whether you’re on track to meet your goals. An investor who has clear goals and a portfolio that’s matched to those goals is likely to be more empowered and therefore successful.
Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in. This document is issued by Morningstar Investment Management Australia Limited (ABN 54 071 808 501, AFS Licence No. 228986) (‘Morningstar’). Morningstar is the Responsible Entity and issuer of interests in the Morningstar investment funds referred to in this report. © Copyright of this document is owned by Morningstar and any related bodies corporate that are involved in the document’s creation. As such the document, or any part of it, should not be copied, reproduced, scanned or embodied in any other document or distributed to another party without the prior written consent of Morningstar. The information provided is for general use only. In compiling this document, Morningstar has relied on information and data supplied by third parties including information providers (such as Standard and Poor’s, MSCI, Barclays, FTSE). Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third parties accept responsibility for any inaccuracy or for investment decisions or any other actions taken by any person on the basis or context of the information included. Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment or the return of capital. Morningstar warns that (a) Morningstar has not considered any individual person’s objectives, financial situation or particular needs, and (b) individuals should seek advice and consider whether the advice is appropriate in light of their goals, objectives and current situation. Refer to our Financial Services Guide (FSG) for more information at morningstarinvestments.com.au/fsg. Before making any decision about whether to invest in a financial product, individuals should obtain and consider the disclosure document. For a copy of the relevant disclosure document, please contact our Adviser Solutions Team on 02 9276 4550.
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