American economist, Heyman Minsky, famously observed that it is impossible to design a crisis-proof financial system. Although investors are generally aware of the risks and rewards of equity investments, nobody wants to lose money in financial markets, therefore, investing in turbulent markets can be very disconcerting.
In periods of extreme market stress, the predominant advice to clients is to stay invested. Selling out of the market during these times tends to be detrimental to the long-term goals of clients. In most cases, staying the course is the most prudent option. However, some clients ask whether this could be the time to buy more equities since prices are heavily depressed. The answer will depend on a client’s risk capacity (the ability to endure investment losses), and ultimately, risk profile (the factors that help shape risk-taking behaviour). Risk capacity and risk profiles vary from client to client, therefore, the decision to buy more equity investments during these times should only be taken after considering these factors.
For an investor with a low-risk capacity, a huge drop in the markets leads to an even lower risk capacity. An investor with a high-risk capacity, on the other hand, faces a different situation. A decline in market values leads to a higher risk capacity. If the decline is severe enough, the risk profile may significantly change and could warrant a portfolio change. Risk capacity has a multiplier effect on risk tolerance. If the client’s risk capacity remains neutral after a severe drop in market prices, the risk profile will match risk tolerance. However, subject to certain behavioural constraints, if risk capacity significantly shifts above neutral, the risk profile moves up as well, while a significant shift in risk capacity below neutral leads to a downward shift in risk profile.
Although there are theories about the relationship between risk and expected return, there is no theory on the levels of risk one should find in the marketplace, therefore, we cannot determine a “natural” level of risk. We can only estimate from historical data the levels of risk investors are likely to confront. Furthermore, determining an appropriate risk capacity and risk profile is not an exact science, but there are different tools and techniques available to help advisors determine a suitable risk profile for clients.
During periods of markets stress, the role of the financial advisor as a behavioural coach becomes overly critical in helping the client stay on track to achieve their financial goals. This is the time for the advisor to be on the lookout for behavioural risk attitudes – the unstable, short-term behavioural readiness to take a risk. This is different from risk tolerance, which is a reasoned disposition to take a risk in the long term. Behavioural risk attitudes are context-dependent and transient and can have negative effects on long-term goals if they are misconstrued to be a guide to long-term risk preferences. Behavioural risk attitudes include loss aversion, probability distortion and ambiguity aversion. In addition to being unstable, behavioural risk attitudes generally result in irrational levels of risk aversion.
When there is severe market stress, the investor is faced with three lines of action:
Sell out of the market to avoid further losses;
Buy into the market to take advantage of the depressed/cheap prices (buy low); or
Selling out of the market is the instinctual thing to do. The goal is to cut losses to prevent further investment loss. This is what a risk-averse client is likely to do. However, if one looks at risk as the probability of not meeting one’s investment objectives, then selling out becomes “counter-intuitive” for a risk-averse client. First, this implies converting a paper loss into a realised loss. Secondly, this increases the probability of missing out on the recovery that will eventually come, and which generally cannot be predicted or timed. This, in turn, decreases the probability of achieving one’s investment objective and thus, selling out of the market can be construed to be taking on higher risk. It is a money-losing strategy regardless of the direction of change in risk profile.
If selling out of the market is risky, how would one describe the opposite – buying into the depressed market? After all, isn’t this the all too popular notion of buying low? While this is true, the decision should be based on the risk profile and the change in risk profile that occurs as a result of the decline in market values.
It is also important to note that the huge decline in market prices comes with a huge increase in market volatility. From the charts, it can be seen that the huge drop in the FTSE/JSE All Share Index also saw a huge increase in the SAVI risk index (fear index), which measures the market’s expectation of volatility. The SAVI was at one of its highest points, only second to its previous 2008 peak during the 2007-09 global financial crisis.
The VIX risk index also shows extremely high volatility. Daily moves in US stocks around this period are comparable to those last seen during the Great Depression. Only professional volatility traders usually take on such extremely high risk.
Understanding the inherent market risk at a time when prices appear very cheap, is very important when deciding to buy into the market. If risk capacity is significantly above neutral, it means the client is not reliant on their investments to fund their lifestyle. A significant market decline means investible assets are now an even smaller component of total net wealth. This means the investor can afford to take more risk with those investible assets.
It is important however to take cognisance of the extreme amount of risk inherent in the market at such points and the possibility of further massive declines (black swans) in market values as well as the possibility of a drawn-out recovery. It is impossible to predict exactly at which level the market will bottom-up, it is also impossible to forecast the length of time for recovery. Ultimately, it is the risk capacity that will determine whether an investor should buy into the market to take advantage of depressed prices.
If the investor chooses to do nothing, paper losses are not converted to realised losses. There is no point getting out of the market now when prices have declined heavily. If the investor gets out hoping to buy in at a lower price, they won’t. They will most likely wait for the new bull market to be confirmed and surpass the price at which they sold! If an investor holds an adequately diversified portfolio, it is possible to weather the storm without selling out of the market to meet expenses. The investor will also not miss the recoveries that eventually follow huge market declines.
Doing nothing also means the investor is not taking on extremely high risks to benefit from highly depressed prices. For most investors doing nothing is the most prudent strategy. It is also the approach with the least risk.
The Centre for Financial Planning Studies (CFPS) and Moonstone Business School of Excellence (MBSE) have developed a verifiable CPD course –Managing Client Portfolios in Times of Crisis– in light of the recent coronavirus crisis to serve as a guide to advisors in managing the portfolios of clients during these uncertain times. The course delves into the value of financial advice and presents a discussion on the different arguments on financial market efficiency and their implications for investors. Upon completion of the course, participants will gain an understanding of financial market interconnectedness and their implications on market behaviour and the risk implications of the different investment options in times of crisis.