Preparing for the next market crisis

All investors will be familiar with the disclaimer that tells us: “the value of your investments may go down as well as up.” Volatility is part and parcel of stock market investing and so are occasional financial crises. In contrast to a bull market recovery, a crisis tends to be announced by a severe shock, impossible to predict, and ignited by a spark hitherto unseen.

Despite knowing that crises are inevitable, investors frequently ignore lessons from previous crises. In many cases they sell when it least makes sense. History shows that markets recover and for those with the constitution and investment time horizon to stomach the fall, perseverance can prove fruitful.

Although we examine a variety of angles particularly relevant to those involved in running or overseeing the finances of charities and non-profit organisations, the principles set out in this paper are important for everyone investing in financial markets. Mindful of the unique circumstances of each investor, we cover a range of scenarios, looking to provide advice on how to apply the theory to your day-to-day workings. We examine:

1. The statistics behind the major financial crises of the past: their frequency, severity, probability and recovery timeframes. We also look at the barriers to successful market timing and the impact that misguided decisions can have on long-term returns;
2. The psychology underlying so-called “irrational” behaviour, which from an evolutionary point of view makes perfect sense but which, when applied to investment markets, can wreak havoc on long-term performance goals;
3. Importantly, preparation techniques for trustees, intended to aid successful navigation through the next major downturn.

What statistics tell us about market moves

Short term market oscillations are commonplace. A peak to trough intra-year market correction of 10% or more has been proven to occur in three out of four years.

But on only three occasions since the 1960s have we have seen the stock market truly implode: in 1972, 2000 and 2007. On these occasions there was an average decline of 57%, spread over an average period of just over two years and taking four years to recover.

In the thick of a crisis investors may ask themselves: ‘if we act quickly, can we sell stocks before they lose too much of their value?’

Unfortunately successful market timing is notoriously challenging and this paper explains more fully the pitfalls involved in attempting to do so. There are two decisions involved: when to sell out and when to buy back in. More often than not the largest rebound comes after the biggest fall; an investor would have to be uncommonly nimble to time both decisions correctly. The evidence shows just how difficult this is to execute with any consistency. 

Human psychology inclines us to make poor investment decisions

Quantitative analysis about investment positioning and performance tends to take centre stage at board meetings.

However, the behavioural aspect of investing can be crucial when faced with a crisis.

In essence, stock market crises are social phenomena, where external economic events combine with crowd behaviour (“herding”) and instinctive fear. Selling by some market participants drives more market participants to sell, leading to a downward spiral in price – and a significant loss of paper wealth. Investors anticipate further losses as pessimism and selling increases, and the market’s downward spiral becomes self-fulfilling.

Our instinct says: “we need to stop losing money…acting in unison gives us comfort…we must do something.”

Our logical mind says: “stay the course; we know that markets recover…we are long-term investors…volatility is expected.”

Much has changed in recent decades including a proliferation of data and algorithmic trading. One thing that has not changed is human nature. Under stress, the short-term is a lure.

How can we shield ourselves from the urge to capitulate?

Preparation

For trustees, we recommend drawing up a crisis plan, using quantitative questions to establish what a crisis would look like for your charity. Ask questions such as:

• Do you have sufficient liquidity and is your cash spread across numerous counterparties?
• Are your investments adequately diversified?
• Is your revenue stream diverse and dependable?

In addition, examine spend in light of the charity’s overall finances and stress-test under various scenarios, mapping out your short- medium- and long-term liabilities and the likely impact that a broad market sell-off or recession might have on your ability to meet those needs.

A proven way to ward off negative behaviour is to agree a policy that focuses on the charity’s overarching goals and is not dependent on short-term market conditions. To this end, we discuss how best to establish and enshrine a long-term financial strategy for your charity. Implement processes to ensure that trustees do not succumb to the allure of short-termism. Filter your news. Most financial news is entertainment, written in isolation and designed to target our emotions. Be mindful of journalists’ agendas.

In summary

• Investors are rewarded for taking risk. Avoiding risk means avoiding returns.
• Behavioural biases can exacerbate the draw of short-term thinking in a crisis – take care to avoid them.
• You have a multi-generational timeframe and an investment policy to match. Shorter-term assets are identified and positioned appropriately.
• You have processes in place to deal with disputes, a diverse and experienced board, a watertight policy, and a strategy designed to fit.

Market falls are regular and periodically turn into a crisis, but history proves that resisting the urge to rush for the exit can reap long-term rewards. Along with your colleagues and other stakeholders you can implement the advice we provide and build the defences to shield your charity from crises of the future.

These ideas are explored in full in the attached research paper, which you can download below