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.”

It seems logical to believe that the performance of a country's stock market is linked to the state of its economy. After all, if GDP growth is strong, company profits are good, and that should help share prices.

Economic prospects are even often used to identify which stock markets are likely to perform in future. If a country is experiencing positive GDP growth, then investors are encouraged to see it as a good place to put their money.

What the evidence reveals

Yet several studies have shown that this link is actually weak. A comprehensive analysis of 21 countries over more than 100 years by the authors of the book Triumph of the Optimists found mixed results between GDP growth and stock market performance.

An MSCI analysis in 2010 found similar results. Most notably, for the 60 year period from 1958 to 2008, Spain and Belgium enjoyed real growth in their economies of between 3% and 4% per year, yet the real returns from their stock markets over this same time were negative.

One of the clearest examples of the potential breakdown between a country's economic performance and that of its stock market has been Japan. Since 1989 the country has grown its economy at over 1.5% per year, yet the Nikkei 225 Index is still well below its December 1989 peak. That is a period of more than 30 years in which Japan's GDP growth has not been reflected in broad market returns.

A closer look

This doesn't only occur over the long term either. It can also be play out from year to year.

The tables below, which consider the last 90 years of GDP growth in the US, make this clear. On the left are the 15 calendar years during this period in which US growth was weakest, and on the right are the 15 years in which it was strongest.

What stands out is that in more than half of the worst years, returns from the stock market were still positive. In six of them, the S&P 500 was up more than 20%, even though GDP growth was zero, or negative.

Not quite as striking, but nevertheless noteworthy, is that even in some of the best years for the US economy, the stock market fell. Incredibly, in 1941, when GDP growth was 17.7%, the S&P 500 declined 12.8%.

Understanding the gap

It is clear from these studies that the state of a country's economy should not be seen as a guide for how its stock market is likely to perform. As MSCI notes, there are three main reasons for this.

“First, in today’s integrated world we need to look at global rather than local markets. Second, a significant part of economic growth comes from new enterprises and not the high growth of existing ones; this leads to a dilution of GDP growth before it reaches shareholders. Lastly, expected economic growth may be built into the prices and thus reduce future realized returns.”

Investors should therefore be cautious about basing their decisions on economic data. This has even been apparent in the UK over the past five years.

The story in London

Since 2014, the local economy has mostly staggered along at growth rates below 2%. Yet, the FTSE All Share Index has delivered an annualised return of 9.4%, which in today's low inflation environment is a real return of close to 8%.

If an investor had stayed out of the market due to fears around Brexit and the country's general lack of economic momentum, they would have missed out on this period of growth.

Similarly, those who argue that the US stock market is going to continue to show good returns almost always base their argument at least in part on the fact that the US economy is still strong. As history is shown in the case of Japan, however, a growing economy does not necessarily equate to good returns for investors on the stock market, particularly if share prices are already high.

Trying to guess which markets may or may not deliver the best returns in future based on the economic prospects of the country in which they are based is therefore not a way to investing success. Investors are far better off building a strategy diversified across markets that they can stick to no matter the economic environment, and reap the rewards over the long term.

Photo by Vlad Busuioc on Unsplash

This year marks the 300th anniversary of one of the world's most famous financial catastrophes: the South Sea Bubble. It is a story with complex origins, but the pattern of events in 1720 has unfortunately been repeated in similar ways many times since.

It is not necessary to know all the details to appreciate what happened in London three centuries ago. However, it is worthwhile to look at how ordinary people were drawn into mistakes that left many of them ruined.

Money from nothing

At the start of 1720, stock in the South Sea Company was changing hands at £128 per share. The company was only moderately profitable, and the trade it ran between Britain and South America was small.

Its directors, however, were full of stories about how the riches of that continent were ready to be brought to Europe. Since the South Sea Company did have exclusive rights to provide the Spanish colonies with slaves, and to send one trading ship to the continent per year, these stories did have a kernel of credibility. They were, however, easily inflated.

The South Sea Company's main business had always, in fact, been supporting the British national debt. Since 1711 it had provided millions of pounds in funding to the government by selling its own shares.

It had become so important to the state that King George I was appointed as the company's governor in 1718. In 1719 it agreed to restructure more than half of the national debt in a way that would reduce the government's interest payments.

Growing interest

This gave the company room to issue even more shares on the public market. To make them more attractive, the directors not only pushed the idea that its South American trade was set to take off, but also came up with a scheme that allowed investors to buy these shares in instalments rather than having to pay the full price upfront.

This made them available to many more people, a lot of whom had no real idea what they were buying. They were however seduced by the rising share price and the tales of South American wealth.

By February, shares had climbed to £175, and in March they reached £330. May took the stock to £550.

Not wanting to miss out on this opportunity, more people bought more shares, and the price went up further. In August, the stock was up almost ten times in just eight months, at over £1 000, and the euphoria was at its peak.

However, just as suddenly as it had began, the bottom fell out of the market. At the price being asked, there were simply no more buyers.

Within months, demand for the shares collapsed. By December, the company's shares had slumped back to £124 and many people had lost huge amounts of money.

Repeating history

The lesson most often associated with this series of events is that investors should be wary of anything that becomes a 'sure thing' in popular opinion. Almost everybody was certain that shares in the South Sea Company were only going to keep going up, and the rapidly rising price appeared to confirm their view.

The danger is that when this kind of thinking takes hold, it does become a self-fulfilling prophecy for a while. The price of South Sea Company shares kept going up because people kept buying them. However, at some point the limit of buyers will be reached, and from there the crash back down can be brutal.

The more subtle lesson, however, is that most of the ordinary investors who were buying the company's stock did not know or understand what they were buying. Not only was trade in shares still novel to them, but they did they not appreciate that the South Sea Company's shipping operations were not its main focus. They also had no idea of the complexities involved in its relationship with the British government.

A recent Bloomberg article noted how more and more ordinary investors today are buying complex financial products that have become available to them due to technology. These include forex, leveraged exchange-traded products and cryptocurrencies.

These products are not necessarily going to create bubbles, but they do seem 'sexy' because they can make rapid gains. This, however, is exactly what makes them dangerous. Anything that can go up quickly can can down just as quickly, and these sudden price movements can be devastating.

The South Sea Bubble should stand as a reminder that successful investing is not about chasing the most exciting opportunities. It is actually the opposite: be boring. Diversify, keep your costs down, and let the market do its work over time.

Photo by Annie Spratt on Unsplash

In a recent research paper entitled 'How to increase the odds of owning the few stocks that drive returns', global asset manager Vanguard revealed a telling statistic. Between 1987 and 2017 just under half of the 3 000 largest stocks listed in the US delivered a negative return.

Over this 31 year period, 47.4% of companies in the Russell 3000 Index saw their share prices decline. Some of those went bankrupt, delivering a negative 100% return.

What's more, the return of the median stock over these three decades was just 7%. In other words, if you picked the average stock, your return was insignificant.

This was over a period when the total return from the Russell 3000 Index was 2 100%. As the chart below illustrates, this performance was driven entirely by just 7.3% of stocks that returned over 1 000%.

Source: Vanguard, Wealth Logic LLC

Needles in the haystack

Of course, this is something of an over-simplification. Just because a stock declined over a full 31 year period, doesn't mean that it didn't make significant gains in between.

For instance, Superdry's share price may be 80% down from its 2018 peak, but an investor who bought the stock in mid-2012 and sold out of it before it collapsed could still have earned a return of 700% or more. It was, therefore, still possible to make a big return, even though Superdry's performance since listing is ultimately negative.

However, the broad lesson holds: there is an extremely small pool of persistent winners in the stock market. An investor picking a share at random is far more likely to under-perform the market over the long term than to out-perform it, and has almost a 50% chance of losing money.

This illustrates how difficult it is to be a successful stock picker. There are very few companies that are going to deliver a long term out-performance. It may be possible to beat the market through buying and selling stocks like Superdry at the right time, but that comes with additional risk. If you get it wrong, the consequences can be severe.

Fewer needles, more haystack

Research from the National Bureau of Economic Research (NBER) in the USA also suggests that not only are the 'winning' companies rare, but they are becoming even more so. A 2016 paper entitled 'Is the U.S, public corporation in trouble?' found that, on average, listed companies in the US have become larger, but they have also become less profitable.

Profitability is one of the key factors in share price returns, as investors are effectively buying a share of the company's future earnings. The higher those earnings are likely to be, the more investors will be willing to pay.

What the NBER found, however, is that the profitability of the market as a whole is being driven by a smaller and smaller concentration of companies.

“Over the last 40 years, there has been a dramatic increase in the concentration of the profits and assets of US firms,” the NBER authors note. “In 1975, 50% of the total earnings of public firms is earned by the 109 top earning firms; by 2015, the top 30 firms earn 50% of the total earnings of the U.S. public firms. Even more striking … we find that the earnings of the top 200 firms by earnings exceed the earnings of all listed firms combined in 2015, which means that the combined earnings of the firms not in the top 200 are negative.”

The growing concentration of not just earnings, but many measures of corporate strength among listed companies is illustrated in the table below:

Source: National Bureau of Economic Research

Compare this against the table below, which shows how, on average, profitability has fallen significantly over this 40 year period:

Source: National Bureau of Economic Research

What are your chances?

“Though performance has worsened for the average firm, the winners have done very well,” the study points out. “One way to see this is that four new firms entered the list of the top five firms by market capitalization in 2015, relative to 1995. Specifically, Apple, Google, Microsoft, and Amazon replace AT&T, Coca Cola, General Electric, and Merck. In 2015, these four firms combined had earnings of $82.3 billion, representing 10 percent of the earnings of all public firms combined.”

This shows just how small the pool of 'winning' stocks has become. Successfully identifying them beforehand would be extremely profitable, but it is also becoming more and more difficult to do.

Photo by Chris Liverani on Unsplash

A key tactic in staying disciplined as an investor is developing the skill to separate short-term ephemera from long-term trends. A sharp drop in the market today, however disconcerting, is not important if your horizon is years away.

Highlighting the benefit of resisting the knee-jerk response to news is Warren Buffett, who once famously said that the most important quality for an investor is not intellect but temperament. 

He’s undoubtedly right. There are plenty of smart people in the investing world. But often the key difference between the successful and unsuccessful are not smarts, but patience.

Look at it this way. Most TV news bulletins conclude with two features — the finance report and the weather report. Both involve a person standing in front of a chart, describing what happened in the markets or meteorological conditions that day and what might happen tomorrow.

For sure, the weather is an interesting talking point in social situations. But we know longer-term that what counts is the climate and that this changes more gradually.

Likewise, what happened on the market today or yesterday is interesting. But if your horizon is 10 years or more it is unlikely to be as significant a factor as to how you allocate your assets, how diversified you are, and, most of all, how disciplined you can remain.

As investors, we spend a lot of time looking at the financial equivalent of weather reports, agonising over passing showers, and ignoring the long-term shifts in the investing climate.

In other words, our focus on today’s events reveals a tension between how we experience the passing of time day-to-day – through news and weather and market movements - and how time gradually shapes us and our investments in the long-term.

The difference between the two is in our temperament.

Check out more of the latest news from IFAMAX:

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Weekly round-up: Week 48, 2019

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:

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