The world is watching with great concern the spread of the new coronavirus. The uncertainty is being felt around the globe, and even the Developed World has seen unheard-of measures of complete country-lockdowns over the past week. It is expected that more and more countries will need to go into lockdowns in order to stymie the spread of the virus. It is unsettling on a human level as well as from the perspective of how equity markets respond.
But, rather than panic-selling your portfolio in the equity markets and panic-buying in the supermarkets, we should actually have faith both in humanity as a whole and in the power of our markets in general.
Regular readers of this blog will know about the fundamental principle that markets are perfectly designed to handle uncertainty, processing information instantaneously as it becomes available. We see this happening when markets decline sharply, as they have recently, as well as when they rise. Such declines can be distressing to any investor, in particular to investors who operate beyond their risk profile, but they are also a demonstration that the market is functioning as we would expect. After all, Nobel Laureate Professor Eugene Fama famously won the 2013 Nobel Prize in Economics for his insight that markets are indeed efficient (his so-called “Efficient Market Hypothesis” = EMH). We have experienced the efficiency of the markets in the recent sharp drop in equity valuations over the past two weeks.
Sharp market declines occur when market participants are forced to reassess expectations for the future. The expansion of the SARS-COV-2 outbreak, triggering the Covid-19 disease, is causing worry among governments, companies, and especially among individuals about the impact on the global economy. Apple announced earlier in February 2020 that it expected revenue to take a hit from problems making and selling products in China. European countries were forced to go into nation-wide lockdowns triggering instant economic recessions for the foreseeable future in these countries. Airlines are preparing for the toll Covid-19 has already dished out to international travel and will likely continue to dish out over the next couple of months or even quarters. And these are just a few examples of how the impact of the coronavirus is being assessed.
The market is clearly responding to new information as it becomes available on a minute-by-minute basis. The market is pricing in unknowns continuously. As risk increases during a time of heightened uncertainty, so do the returns investors demand for bearing that risk, which pushes security prices lower instantaneously. Our investing approach is firmly based on the academic principle that prices are set to deliver positive future expected returns for holding risky assets. Readers who are interested to study this on a deeper level should familiarize themselves with how investors demand a higher discount rate for future returns during times when uncertainty in the market increases, as it has over the past weeks.
We can’t tell you when things will turn or by how much, but our expectation is that bearing today’s risk will be compensated with positive future expected returns. That’s been a lesson of past health crises, such as the Ebola and swine-flu outbreaks earlier this century, and of market disruptions, such as the global financial crisis of 2008–2009, and of globally-disruptive events of the maximum scale, like World War II. Additionally, history has shown no reliable way to identify a market peak or market bottom. These beliefs argue against making market moves based on fear or based on speculation, even as difficult and traumatic events transpire. While we currently are forced to watch a global pandemic like Covid-19 unfold right in front of our eyes, we should still keep a clear head and take emotions out of the equation before we panic-sell our portfolio.
A professional adviser can help investors develop a long-term plan that the investor can stick with in a variety of market conditions, especially during times of market panic as we have experienced in the past couple of weeks. Financial professionals are trained to consider a wide range of possible outcomes, both good and bad, when helping an investor establish an asset allocation plan. All of our readers and clients will have experienced the painstaking exercise we undergo to find our client’s individual maximum risk profile, our client’s ability to take on risk and the implications the individual chosen risk profile has during market melt-downs (see the overview of the 10 risk profiles in the picture above). Indeed, during our risk-profiling exercise we make it a point to highlight the inevitability of future market downturns and we prep our clients to be emotionally able to handle such future portfolio downturns.
Amid the anxiety that accompanies developments surrounding the current coronavirus outbreak, decades of financial science and long-term investing principles remain a strong guide for every investor, especially for our readers and our clients.
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