By PATRICK CAIRNS
The last few weeks on the markets will still talked about for years to come. Between the middle of February and the start of this week, the FTSE 100 dropped more than 31%.
The scale and speed of this fall was remarkable. In 20 trading days the market lost more than 3% eight times.
On Monday 9 March, the FTSE 100 was down 7.7%. On Thursday the same week, it fell another 9.3%. These are two of the index’s largest daily declines in history.
Hit by the virus
This sharp market reaction has reflected the level of concern and uncertainty around the repercussions of Covid-19. We simply don’t know how severe or how long the impacts on human life, businesses and economies will be.
To a large extent, markets are therefore pricing in a worst case scenario.
Anybody watching their portfolios would have understandably felt a bit battered by the scale of the sell-off. All of the gains that the UK stock market has made over the past ten years were lost in just the first 12 weeks of 2020.
While this is unquestionably harsh, this extreme event also highlighted some important investment realities. Long-term investors can gain a few important lessons from this crash.
The real risks are those we don’t see coming
The first is that many market watchers and economists have been worrying for long time about what might upset the global economy. The past 10 years have been the longest uninterrupted period of growth on record, and the longer it has gone on, the more worried people have become about what might end it.
There were many suspects, such as the trade war between the US and China, growing government debt around the world, and Brexit. In the end, however, it was none of the things that analysts were already worried about that sent markets into a panic – it was something nobody saw coming.
This is often the case with markets: the real risks are not the things that we know about. It is the things that catch us by surprise.
The coronavirus outbreak was a complete ‘black swan’ event – something entirely unexpected that arrived with no warning. Even just a few weeks ago, there was no way anybody could have anticipated its impact. This means that there was no way any investor could have prepared for it.
How to guard your portfolio
The irony of this is that there are many advisers and fund managers who take great pride in telling everyone how they construct their portfolios for certain outcomes. They write articles with titles like “how to Trump-proof” your portfolio or “how to position your portfolio for Brexit”.
They inevitably make good arguments for why you should want to hold certain investments, and not hold others. Their logic is hard to fault at the time.
Back in 2018, for example, some experts were advocating buying exposure to commodities like oil to protect against the likelihood of higher prices and a weaker dollar that a trade war would cause. This seemed perfectly reasonable.
Two years later, however, we know that this was poor advice. Inflation has not become a problem, the dollar has continued to strengthen, and ultimately the oil price has collapsed.
Knowing what you don’t know
This highlights two issues. The first is that it is extremely difficult to make predictions about anything. Even if we know that something like a trade war is going to happen, we still can’t know what its impacts will be.
And, secondly, even if we could prepare for all the risks that we know about, the risks that we don’t know about can still wreck our plans. Nobody was writing articles six months ago about how to prepare your portfolio for a global pandemic.
For investors, what the market crash this month has shown is that we should always be aware of how much we don’t know. Stock markets will always be unpredictable precisely because there will always be disruptions that we simply cannot prepare for.
What that means is that guarding your portfolio against Trump or Brexit or the whatever the next market shock will be will always actually require the same approach – diversify your investments, don’t take more risk that you can tolerate, and be prepared to hold out for long term outcomes, even when the short term news is as bad as it has been over the past few weeks.