There is a vast body of research to support the ‘stay put’ approach in emergency times across markets. This is why most professional long-term investors choose this path – leave short-term timing to people who have to do it

 

One of the hazards of the investment landscape is the occasional occurrence of ‘black swan’ events – unusual developments that aren’t predictable but can lead to unusually large short-term stock market dislocation.

Long-term investors need to not only be aware that such things do happen, but to know what to do when they materialise, if they are going to protect their capital and generate superior long-term returns.

A black swan is a very rare bird; hence its application to describe events such as Covid-19.

Unpredictable by definition

Whilst most of us were aware of Covid-19 in January, virtually no one forecast its current implications and the resulting impact on global stock markets.

The fall in markets was both swift and brutal. The MSCI UK index of ‘blue chip’ companies fell 32% from 21 February to its recent trough on 23 March. In 2008/9 it took almost five months to fall by the same percentage.

Source: MSCI

Evidence from unit trust and ETF transactions suggests that most long-term investors didn’t ‘lighten up’ in early February, ahead of the setback, because they too didn’t see it coming – Black swan events are, by definition, unpredictable. They have remained invested throughout the recent market turmoil. The main sellers have been ‘leveraged’ investors (hedge funds etc.) that have been investing using borrowed funds (‘on margin’). They have been distressed sellers because they are under pressure to repay the money they have borrowed – they are not long-term investors and are now nursing often considerable losses.

Armageddon can be avoided

The reason not to sell is clear once you consider the likely course of events.

Let’s suppose someone has £1,000 in the MSCI on 21 February – just as the market starts to correct.

Having not seen this coming, most nervous investors wouldn’t start to panic until the third week – when we then know that this is for real. By then the markets are in a state of irrational panic. Even traditional ‘safe havens’ such as government bonds and gold are falling. Mainstream equity markets aren’t functioning properly; the only way to sell is to accept a distress price, way below the apparent value being quoted. Property funds are closing, ETFs and investment trusts trade at significant discounts and many unit trusts have changed their pricing to penalise sellers.

Let’s assume our investor is desperate to sell in the middle of week 3 (on 12 March) and accepts a 5% penalty to do so. On the morning of 13 March, he has £671 in the bank; a fall of 29% then a 5% penalty.

 

Being in cash when the rally happens leads to a problem: fear of missing out

 

Scroll forward to the end of March – a fortnight later.

He still has £671. The person who stayed in has a holding worth £767.

Even though our investor didn’t sell at the bottom (the market had further to fall) he has missed out on the initial bounce back. This ‘relief rally’ eventually materialises because the market now accepts that the setback has gone too far; Armageddon will be avoided, even if there are still problems ahead.

This rally is as unpredictable in its timing as the initial fall, but is usually significant. Missing out on it and incurring the costs of distress selling have a major impact on an investor’s long-term returns – much more so than being exposed to the market fall in the first place.

Don’t fall for the FOMO

Being in cash when the rally happens also leads to another problem: fear of missing out (FOMO). How and when do you get back in? Is the bounce for real or is it a ‘suckers’ rally’? It’s easier to stay in – the market recovers eventually and you will benefit. You are there already.

There is a vast body of research to support the ‘stay put’ approach in times of market turmoil – just have a look on the internet. This is why most professional long-term investors do it – leave short-term timing to people who have to do it. Most of them don’t get it right.

You benefit from the initial recovery so you aren’t a victim of FOMO – you can afford to wait for the recovery to develop properly before thinking about putting more money in to take advantage of the rally.

Tame the black swan. Don’t feed it…