I cannot tell you how bad things will get in the future for this virus or tell you how much it will affect your investments. My advice as always is to simply sit tight. If it gets really cheap, there is a potential opportunity and we will advise accordingly.

I have produced a table below to show how world equity markets have performed in recent epidemic scares.

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MSCI World Index: World epidemics and global stock market performance.

Source: Charles Schwab, Fact-set data for 1,2&3 month performance. Dimensional Matrix Book 2019 for That year and 1 year later. The MSCI Index captures large and mid-cap representation across 23 developed markets countries. With 1,646 constituents, the index covers approximately 85% of the free float-adjusted market capitalisation in each country.

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So how should we approach the news about COVID-19, better known as the coronavirus. We know that human beings are finely attuned to what we see as an immediate threat. It’s how we evolved. But it isn’t always helpful.

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What about the impact on your investment portfolio?

Stock markets fell heavily in the last few days and there’s no shortage of market “experts” in the media warning of further “turmoil” to come.

But the simple fact is that they just don’t know. Yes, coronavirus could develop into a global pandemic. Or it could blow over in a matter of months. In any event, predicting what impact all the different possible eventualities might have on the economy, let alone the financial markets, is nigh on impossible.

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Focus on what you can control

A very important principle in investing is to focus on what you can control and let the rest go.

You have no control over coronavirus or the markets. Unless you’re a professor of epidemiology, don’t kid yourself either that you have any unique insight into how the virus might develop. And remember markets could go sharply up or down from where they are now for reasons totally unrelated to COVID-19.

But, if you’re anxious about the markets — and it’s a natural human reaction to be so — please feel free to give us a call.

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“If history teaches us anything, it’s that great investment gains go to those who are diversified, optimistic and patient. In other words, if you spread your investment bets widely, favour stocks and have a long-time horizon, good things should eventually happen.”

A perennial temptation for investors is the urge to quit the market at the top and to get back in at the bottom. While the lure of market timing sells millions of books and is standard fodder for financial television, the reality rarely lives up to the promise.

History is littered with the failed dreams of market timers. Less than five years after the nadir of the financial crisis, some pundits were saying US stocks were over-valued. Another five years on and the market had gained more than 60%.

Not even the gurus have much of a record. Back in 1996, Federal Reserve chairman Alan Greenspan warned of "irrational exuberance" in the stock market. But we now know that the market went on climbing for three years before the dot-com bubble burst.

Even if your logic about valuations is impeccable, there’s no guarantee the market will come around to your view. As someone once said, markets can stay irrational longer than you can stay solvent.

But the most overlooked challenge with market timing is that it requires you to make TWO correct decisions: Firstly, you must get out at the right time. Secondly, and often more challengingly, you must know when to get back in.

Think back to the global financial crisis. Plenty of people were throwing in the towel by early 2009. But how many got back in in time to enjoy the big bounce that followed in the second and third quarter of that year?

The fact is markets don’t move in a straight line and big gains (and losses) can come in relatively short periods. Not even the professionals have much of a track record in successfully negotiating these unpredictable twists and turns.

So, if market timing is a mirage, what can you do? Here are five alternative options that make more sense — and none requires you to possess a crystal ball.

1. Take a long-term perspective

"The historical data support one conclusion with unusual force,” the index fund pioneer Jack Bogle once wrote. “To invest with success, you must be a long-term investor." Instead of trying to time the ups and down of the markets, why not simply change your time horizon? Over the very long term, patient investors have almost always been rewarded. Of course, not everyone can take the long view. Those, for example, who are about to retire or who need to access their money in the next two or three years, don’t have that luxury. But if you don’t need it for, say, 15 years of more, you can afford to look at the big picture.

2. Construct a portfolio for all market conditions

Everyone should have a balanced asset allocation — certainly a mix of stocks and government bonds, and perhaps property as well — that matches their capacity for risk. A defensively-minded person may only have 50% of their portfolio in stocks, with the rest in bonds. The right mix also depends on your age, goals and circumstances. Whatever your risk capacity, diversification is key. Spreading your risk across different asset classes and geographies will reduce the impact of a steep decline in one particular market. Ultimately, it’s your asset allocation that is going to be the most important driver of your investment outcome.

3. Periodically rebalance your portfolio

Generally, the less you tinker with your portfolio the better. That’s not to stay you shouldn’t touch it at all, but any changes you do make should be done in a strategic, structured and disciplined way that reflects your needs and circumstances. A good discipline to adopt is to rebalance your portfolio periodically, to restore your original asset allocation. This means, every year or so, selling sone of the winners and buying some of the losers. It seems counter-intuitive, but effectively it forces you to sell high and buy low, which is just what you should be doing. It's a much better strategy than falling victim to knee-jerk responses to the latest bout of market volatility, which inevitably involve emotional, short-term decision-making.

4. Pound cost average

Another option, if you really are worried about the stock market and want to reduce your risk, is “pound cost averaging”. Say, for example, you have a sizeable sum of money — an inheritance, say — that you want to invest. Instead of going all in and investing the full amount in one go, you can drip feed small amounts into the market over a period of time. Incidentally, financial economists don’t think this approach makes much of a difference from an investment perspective and you might end up with slightly lower returns. But it’s a useful way of helping you sleep at night and minimising regrets.

5. Increase the size of your cash reserve

Finally, another strategy could to consider is to hold a larger cash reserve — either within your portfolio or in another account. Everyone should hold enough cash to cover around six months of living expenses, in case of unexpected medical bills, or losing a job, for example. But nervous investors may prefer to hold rather more than that. The advantage of increasing your cash reserve is that, in the event of a market downturn, you can see it as a buying opportunity and use your extra cash to increase your market exposure.

SUMMARY

In summary, timing the market — while superficially an attractive idea — is fraught with danger. If you get lucky, great, but there’s no method to it. We’ve seen that not even the gurus are much good at it.

The good news is that second-guessing the market just isn’t necessary. With the right outlook and a methodical process, you can achieve better results — and enjoy a smoother ride along your investment journey.

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Picture: Veri Ivanova via Unsplash

Ever been on holiday where the weather wrong-footed you? The brochures promised tropical bliss, so you packed accordingly. Instead, you are greeted by bone-chilling wind and rain. Shivering and exposed, you resemble an undiversified investor.

As with the weather, financial markets can be unpredictable. Yet, in their own glossy brochures, investment providers often promise the equivalent of endless sun. Excited, investors pile in like bucket shop holidaymakers. This rarely ends well.

But there’s an answer to this cycle of unrealistic hope and illusion-shattering reality. It’s called diversification. Described by Nobel laureate Harry Markowitz as the only free lunch in investing, diversification is the equivalent of an all-weather wardrobe.

Smart holiday-makers, knowing that resort weather is never as consistently glorious as the marketing suggests, will pack for a range of climes. Alongside the shorts, sunscreen and T-shirts will be warm sweaters, umbrellas, and novels for rainy days. 

Likewise, diversified investors will not hang their hopes on one asset class, or one sector, or one country, or one stock. They’ll spread their exposure across and within stocks and bonds, across different markets, industries and currencies.

Diversification increases the reliability and predictability of returns. Looked at another way, it smooths the way and reduces the sudden bumps in the investing road. The ups may be less spectacular, but the downs will also be less stomach-churning.

Like well-prepared travellers, diversified investors are ready for a range of outcomes. If the stock market is roaring ahead, they can have sufficient exposure to enjoy the benefits of that growth. But when stocks are down, they can also be protected under the relative shelter of government bonds.

Diversification works because different parts of financial markets aren’t perfectly correlated. As one asset class goes down, another may go up. Stocks, a growth asset, and bonds, a defensive one, are the classic example.

But diversification also applies within asset classes. In your stock portfolio, you can spread your risk across sectors. Instead of putting everything in technology or materials or financials, you can have a bit of everything. And instead of sticking to one country, you can diversify internationally, across developed and emerging markets.

You can diversify within a bond portfolio as well, spreading your holdings between government and corporate bonds, between long-term bonds and short-term bonds and between bonds of higher credit and lower credit.

And if you really must cut the holiday short because of an emergency at home or some other unpredicted event, you can have a portion of your investments in cash.

Ultimately, diversification works because you are giving yourself more choices. You are less reliant on any one variable. In this way, you are reducing idiosyncratic risk relating to single industries or stocks or countries.

Think of what happened during the tech boom of early this century. Piling into technology stocks worked very well, until it didn’t. At that point, many investors were left like a sun-seeker in an Ibiza cold snap with a suitcase full of swimsuits and sandals.

There is still residual risk related to the market itself, of course. This so-called systematic risk is something you can’t diversify away. But the main point is you should do everything you can to increase the reliability of outcomes and eliminate risks you simply don’t need to take.

The outcome is greater peace of mind and an understanding that when markets get unsettled, as they inevitably do from time to time, you’ve packed your portfolio for a range of eventualities. 

Call it all-weather investing.

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Pay less attention to weather forecasts

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What will happen in the global financial markets tomorrow, next week or over the coming month?  It’s tempting to speculate, isn’t it? Indeed, speculation about the short-term direction of shares, bonds, currencies and commodities represents a good chunk of the output of the financial media every day.

To be fair, people have a natural curiosity about the future, particularly when their is money at risk. This makes it understandable that the media would seek to satisfy that need in its coverage.

Markets are inherently uncertain

The problem is financial markets are inherently uncertain. Prices move randomly in the short term and there is little to be gained for investors by trying to second-guess them.

This point is easier to understand if you reflect on the fact that what moves prices is news. It might be an earnings report involving an individual company, a regulatory ruling affecting an industry, a data release relating to an entire economy or a geopolitical development that affects the whole world. 

Prices are always changing as new information comes into the market. And the biggest changes in prices tend to occur on the news that no-one expected. For example, opinion polls might suggest a certain political party is certain to win a major election. Markets will price for that eventuality. But if there is an upset, prices will adjust very quickly.

An impossible task

What this means is that successfully speculating on short-term movements in security prices with any consistency requires an ability to accurately forecast the news. We’re not sure about you, but we’ve yet to meet such a person.

But it’s even harder than that! Even if you could forecast the outcome of news events — say a G7 statement or an interest rate change or a merger — you still need to be able to forecast how the market will react.

Now that’s especially tough because what moves prices is the degree to which the news lines up with what’s priced in. You might get a weak employment figure, for instance, but the share market might still rally if the headline figure is not outside the bounds of expectations.

The fiendish difficulty of forecasting markets is also partly because set-piece events that dominate media attention do not tend to occur in isolation. A big economic announcement might have been expected all week, but what if it is overshadowed on the day by a development in the Middle East that upends the oil market and drives equity prices lower?

We look for tidy narratives

In fairness, we doubt the media will ever give up on constructing speculative “stories” about markets by linking fundamental news about the economy or earnings to price changes. It fills a niche and there’s a real appetite among the public for tidy narratives that link cause and effect.

But for the individual investor it is best to distinguish between the daily noise of news and security price movements from the long-term signal of capital market returns. The latter are more predictable.

We know that over time, there is a return on investment. If capital markets did not ultimately reward investors, there would be no appeal in investment!

But the returns are not there every day, every week or even every year. Timing them is tough. What’s more, we don’t need know which individual asset classes, markets or securities will deliver the strongest returns next.

Like a patchwork quilt

This is best illustrated by the Periodic Table of Investment Returns, from Callan Associates in California. This shows the annual returns for various asset classes over 20 years, defined by indexes and grouped by colour.

Each column illustrates the returns for each year. Those with the biggest returns are at the top and those with the lowest are at the bottom. It looks like a patchwork quilt, doesn’t it? In fact, it’s hard to see any pattern at all.

Sometimes, emerging markets will top the table. Other years, it will be cash or bonds or real estate. The long-term premiums from these assets are available, but they are not evenly distributed.

Diversification is key

That means to succeed as a long-term investor, you need to take a bigger picture view, focusing firstly on how you allocate your capital across different asset classes like stocks, bonds, property and cash and secondly on ensuring you are diversified within these asset classes.

By having a little bit of all those asset classes, you are guaranteed to reap the returns when they do kick in and you don’t have to worry about market timing.

Finally, success over the long-term requires discipline and sticking to the plan that is made for you, attending to what you can control (asset allocation, diversification, cost, taxes and rebalancing) and ignoring as much as you can the daily noise that preoccupies the media.

By the way, this doesn’t mean you shouldn’t take an interest in the news. We all want to know what’s going on in the world after all. But it’s a caution against using daily news headlines to drive your investment strategy. 

Prices, like news, are simply unpredictable.

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There’s no getting away from the fact that investing — especially investing in equities — involves risk. But risk can mean different things to different people. There are also many different types of risk, so let’s have a look at some of the main ones.

Market risk and volatility

For many people, the most commonly perceived risk is market risk. If the share market falls sharply, you lose money, on paper at least. But this only matters if you plan to sell tomorrow. If your horizon is long, these daily ups and downs will matter less.

If you’re investing internationally, the ups and down of currency markets can affect the value of your portfolio in your home country. And if you’re invested in bonds, risks are posed by rising inflation, changing interest rates or a bond issuer defaulting on their payments.

Allied to market risk is volatility. The degree your investments rise and fall from year to year can affect your outcomes in a couple of ways. Firstly, there’s the stress that volatility can cause. Some people just aren’t as well equipped to deal with the ups and downs. Secondly, volatility can also have a real cost on your portfolio, as we shall see.

Diversification: the only free lunch in investing

You can deal with volatility through diversification. That means spreading your investments so you are not overly dependent on individual asset classes, countries, sectors or stocks. So, when one component zigs, another may zag. Think of it like shock absorbers in your car. Without them, you’re going to feel every  bump in the road. With them, the ride will be much smoother.

Diversification is often described as the only “free lunch” in investing. The flavour sensation of higher returns also can come with the indigestion of higher risk. But you can moderate the range of possible outcomes by ensuring you are not too exposed to any one ingredient. Think of it like a buffet full of different dining choices.

Of course, you could just stick to your home country. It’s what you know, after all. But this “home bias” also carries risks as well. Just as the performances of asset classes and individual sectors vary, so can those of countries. Think of Japan in the 1980s. Its market appeared unstoppable. Then it spent more than two decades in the doldrums.

Occasionally, the media gets excited about individual industries. Think about what happened in the early 2000s when the world was going crazy for technology stocks. It was a great bet while it lasted, but then it all came crashing down. Again, you can deal with this by spreading your allocation across different sectors, by diversifying internationally — and by keeping an exposure to all the drivers of expected return.

Falling in love with individual stocks is another risk you don’t need to take. If your gamble pays off, great! But it’s speculation. It’s not investment. You’re taking a bet that those companies will continue to dominate. Back in the 1960s, the media swooned over the ‘Nifty Fifty’, blue chips that would never let you down — names like Xerox, Eastman Kodak, IBM and Polaroid, all of whom were disrupted over the years. Nothing stays the same. That’s why you diversify.

Other types of risk

As for foreign exchange risk, you can “hedge” (a type of insurance) overseas returns to your home currency. But there is no evidence that this makes a difference to long-term returns. If you fully hedge your exposure and your home currency rises, all well and good. But if your home currency falls, you risk missing out on the kicker you get by converting the now more valuable foreign exchange. One answer is to hedge 50% of your overseas exposure and leave the other half unhedged.

While bonds are less volatile than shares, they still have their risks. The three main ones are rising inflation, increasing interest rates and default.

Inflation reduces the purchasing power of bonds. The income you were counting on suddenly buys less than it once did.

When a central bank increases interest rates, the prices of existing bonds can drop because their coupon rates look less favourable. Default occurs when a bond issuer can’t repay what they owe. Again, you can manage these risks by diversifying across different countries and currencies, and across government and corporate bonds.

Liquidity risk refers to difficulty in getting access to your money. So-called “alternative” investments often carry this risk. You can manage liquidity risk by always having sufficient cash on hand to keep you going in an emergency.

Finally, there is longevity risk, which means outliving your money. We’re all living longer, which isn’t necessarily a bad thing. But how do you ensure your savings last you through retirement? And therein lies an irony. Unless you’re willing to take sufficient risk as an investor, you may end up with a retirement pot that simply isn’t big enough. That’s right — one of the biggest risks you face as investor is not taking enough risk.

Check out more of the latest news from IFAMAX:

Pay less attention to weather forecasts

How women view money and investing differently

A little encouragement goes a long way