Why you need to understand animal instincts when it comes to investing your money

Let’s agree on one thing – we are living during uncertain financial times. The US election, Brexit, COVID, a potential UK tax-raising budget in March 2021, to name a few.

At the time of writing, the result of the US election is unknown. Does it even matter if a Donkey overcomes an Elephant or not? It will matter on a social level, but how about a financial one?

The following chart from Dimensional Fund Advisers would suggest it doesn’t matter to the investor.

Investors (shareholders) are investing in corporations, not a political party. The focus on a corporation is to serve their customers and generate profits. Regardless of who is president (or Prime Minister in the UK for that matter).

A president, even a powerful one, can’t influence the global economy on their own. There are a host of other external factors that come into play.

Perhaps you don’t mind what happens in the US if you are a UK domiciled investor with an ISA or pension plan.

The following chart from visualcapitalist.com may change your mind.

As the saying goes, if the US sneezes, the world catches a cold.

Looking at the data differently will give you another idea of the scale.

The US is almost the same size as the combined 3 to 10 positions combined.

This is where the bulls and bears come in. Will the global markets continue to rise (a bull market). Or will there be a collapse (a bear market)? Or a period of choppy uncertainty? Nobody knows, and please ignore anyone who claims they do.

What about the UK?

Ministers in Boris Johnson’s cabinet are divided about the government response to Covid.

The ‘doves’ want to protect the economy, jobs, and mass unemployment. Rishi Sunak is a dove.

The ‘hawks’ such as Michael Gove and Matt Hancock are calling for even tougher restrictions.

It is a challenge for these outlooks to coexist in harmony, and one side must be ‘wrong’. But only time will tell. In the meantime, the valuations of investments, ISAs, and pensions continue to fluctuate.

So what to do?

If you could invest by simply looking at what has done well in the recent past - and by that we mean the past few years - then life would be so much simpler. Rear-view mirror investing is not the best way to build portfolios for the future.   

Consider the past three years or so. Looking through a rear-view lens, you wouldn’t want to have a large position in the UK or emerging equity markets. Or global commercial property or value or smaller company stocks, which fared poorly. 

Returns lagged the broad US market, which in turn lagged the growth-oriented stocks, particularly technology companies (the so-called FAANG stocks). In an extreme rear-view mirror scenario, a hindsight investor would invest heavily in US growth stocks going forward. 

That would be a very concentrated bet and would ignore the fact that all future growth expectations are captured in today’s prices. 

These companies need to perform better than these expectations for prices to rise. 

What is evident is that each part of a sensible portfolio waxes and wanes over time. At the end of the 2000s the rearview mirror investor would have avoided the broad US and World developed markets. Yet in the 2010s they were exceptionally strong performers and emerging markets and value stocks suffered relative to the US and the UK was a laggard.  

To want to place all your investment eggs in one basket - and in particular the one that has just performed best - is a little naïve. No-one knows what the 2020s will bring and diversification is a key tool in mitigating the unknown. 

In an environment when cash delivers a negative return after inflation, and the expected returns for both bonds and equities are reduced as a consequence, incremental returns are not to be sniffed at. 

Do not look back and wish you had owned a different portfolio but take comfort from the fact that your highly diversified and soundly structured portfolio gives you every chance of a successful outcome in an unknown, forward looking world. 

What about the swans?

A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight.

Black swan events can cause catastrophic damage to an economy by negatively impacting markets and investments. Even the use of robust modelling cannot prevent a black swan event.

Basically, not worth worrying about.

If you would like to discuss how a globally diversified investment portfolio will see you through troubled times, please contact us at hello@capital.co.uk.