3 minute read
Long-term investing lessons during the COVID-19 crisis
RAYHAAN JOOSUB Head: Multi-Asset and Asset Allocation, Sentio
The COVID-19 crisis this year wreaked havoc on global economies and financial markets alike. However, while global economies are still in the grips of the crisis, financial markets have made a remarkable recovery since the lows in March of this year. So, whatwere the lessons that we can take from this amazing development?
Liquidity and financial markets
Let us first understand the reasons behind this amazing market rally. For one, central banks were extremely quick in understanding the gravity of the crisis and therefore reacted quickly by cutting rates and launching an aggressive QE policy. This liquidity supported financial markets with credit spreads narrowing and equity prices rallying off their March lows in spectacular fashion, despite the economy being in terrible shape. So, clearly one of the lessons is that the equity market leads the economy – but that is only partly true. Liquidity drives financial markets and central banks understand the important linkages between financial markets andthe real economy. Harsh lessons were learnt post the global financial crisis in 2008 and central banks will now do ‘whatever it takes’ to support financial markets in order to avoid the ‘second round effects’ into the real economy. In the graph below, we show the importance of financial liquidity, which tends to lead equity markets. A clear lesson here is that once a crisis does ensue, it’s probably too late to sell. In fact, volatility is your friend during a crisis, and you should rather take advantage of the attractive prices of risk assets to add to your portfolio.
Source: BCA, Bloomberg
Source: Sentio Capital Management
Appropriate investment strategy
But how do you deal with the large portfolio drawdowns and the volatility that these ‘Black Swan’ events bring about? Well, the first thing you need is an appropriate investment strategy that is well designed to your financial goals in terms of required returns, but also the strategy must be well suited to your temperament, as this becomes crucial when markets are falling. If your investment strategy is too aggressive, you will not be able to stomach the losses and invariably cut your losses at the bottom, which will lead to disastrous consequences for your long-term financial goals. This is because the initial market recovery, post a large sell-off, is most often the strongest period for equity markets. Missing out on those periods of market recovery can lead to very sub-par investment returns in the long term.
Strategic asset allocation
So, what makes a good investment strategy? Broadly, it involves designing a strategic asset allocation benchmark that is appropriate to your required returns and risk tolerance. This strategic allocation must effectively give you exposure to the risk premiums available in the market to achieve your return objectives, but must also be adequately diversified to provide you protection during troubled times and thus minimise the impact of market drawdowns on your portfolio. The graphic above shows the average returns of assets during normal and crash markets, and shows the benefits of foreign bonds, foreign cash and derivative hedges in order to diversify a South African equity portfolio during troubled times.
Designing the strategic asset allocation requires a good mix of return-generating assets and diversifying assets in order to balance your return and risk objectives; and this strategy should be followed in a disciplined manner, irrespective of market conditions. This will force you to buy into weakness and sell into strength – and avoid costly errors like selling at the bottom of markets.
