Global Head of Quantitative Research and Asset Allocation - Citi Investment Management
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Sharp falls in financial markets are psychologically very testing. But hard evidence shows that staying invested, avoiding market timing, and rebalancing portfolios in line with a long-term plan are the rational approach
In times of heightened fear and uncertainty, rational behavior is too often the first casualty. In certain places, for example, the COVID-19 outbreak has prompted some consumers to strip supermarket shelves bare. Such activity has intensified the sense of alarm, strained supply chains, and deprived others of the chance to buy even small quantities of essential items. In financial markets, some investors have responded to the sharp falls in risk assets by liquidating their portfolios. While a few of those that do so are genuinely forced sellers, many more hope to avoid further short-term losses by holding cash before buying back in at a lower level.
The emotions behind the recent panic-selling are understandable. After all, it can be extremely testing psychologically to watch portfolios suffer steep declines, particularly against the backdrop of the worst global pandemic for a hundred years. Unfamiliar and unsettling measures such as lockdowns only add to the mental pressure. However, while we cannot know how the COVID-19 crisis might evolve or exactly how much containment measures may hurt the economy, there are things that we do know with certainty. Focusing on these hard facts makes much more sense than fixating upon the unknown, especially doom-laden extrapolations.
First of all, we know that market timing doesn’t work. Selling out of equities and switching into cash with the aim of buying back later on has consistently proved an expensive mistake throughout history. The reason for this is simple. The worst days for equities that market timing seeks to avoid tend to occur in close proximity to the best days. We got a timely reminder of this just recently, when US equities first suffered waterfall declines, followed by their strongest three-day gains since 1933. Missing out on such days tends to do lasting portfolio damage. Between 2000 and 2019, an investor who missed the ten best days would have made a total return of just 33%, compared to 167% for an investor who held throughout that period.
We also know that globally diversified portfolios have helped mitigate risk over time.i Between 1952 and 2019, a global multi-asset class allocation would have produced a higher risk-adjusted return than any other individual asset class.ii In the twelve months to mid-March this year, developed and emerging market equities suffered declines of 20.9% and 23.3% respectively. By contrast, a globally diversified portfolio aligned to a US Dollar Global Risk Level 3 allocation would have fallen by 12.3%. Global diversification and the futility of market timing are two of the principles that make up Citi Private Bank’s Investment Philosophy, and are embedded in our investment process.
So, what should you do now? First, we recommend keeping your core investment portfolio fully invested and aligned to the long-term plan – or strategic asset allocation. If recent market movements have caused your portfolio to drift away from the plan, you should rebalance it so as to bring it back into line. Such rebalancing tends to take profits on assets that have appreciated and reallocates the proceeds to lower valued assets, potentially enhancing your long-term returns. If, on the other hand, you currently have excess cash, we suggest gradually putting it into work. Long experience shows that investing in the wake of substantial market drops has helped to achieve solid returns.
Amid today’s ongoing uncertainty, focusing on hard facts and submitting to the discipline of our Investment Philosophy and Process offer a way of helping to keep calm and stay invested. This rational approach can prevent making portfolio mistakes that permanently damage wealth.
i Diversification does not guarantee a profit or protect against loss. Different asset classes present different risks.
ii Asset allocation here represents an AVS Risk Level 3 allocation, which includes allocations to equities, fixed income, commodities, cash, and hedge funds. Risk Levels are an indication of clients’ appetite for risk. Risk Level 3 – Seeks modest capital appreciation and, secondly capital preservation. The returns shown were calculated at an asset class level using indices and do not reflect fees, which would have reduced the performance shown. Past performance is not indicative of future returns. See glossary for definitions