Last December I took it upon myself to extol the virtues of delayed gratification by insisting my younger colleagues did not open their advent calendar windows all at once to devour the chocolates. Temptations like this are hard to resist and the merits of delayed gratification go out of the window for the short-term sugar rush.
Much could be said about the stock market at present. Charlie Munger, legendary investor Warren Buffett’s business partner, succinctly put it when he explained that, “It's waiting that helps you as an investor, and a lot of people just can't stand to wait. If you didn't get the deferred-gratification gene, you've got to work very hard to overcome that.”
We know patience is a virtue but with investing you need it by the bucket-load.
Of coyotes and bears
Firstly, patience in investing is needed to see your money build up, especially for performance to compound up to produce returns.
Equally, however, patience is needed when valuations are high and it is right to stand away from paying up. Yes, markets can continue to rise, fuelled by momentum and animal spirits*. But like the cartoon Coyote, they are simply running on air after overshooting the cliff and set for a fall. Waiting for the momentum to falter and to invest after the fall is the art.
Let’s take a quick look at a classic Coyote moment.
As you can see from the FTSE 100 Index chart below, from the start of 1999 to the top of the market the following year, markets continued to forge higher and rose by 20% by the start of September 2000. Thin air.
Famously, a particularly bearish City of London pension fund manager called Tony Dye at Phillips & Drew (now part of UBS) was sacked in March 2000 because he was thought to be plain wrong and investors were pulling their money out of his fund in droves because they disagreed with his negative outlook. He was given the moniker of ‘Dr Doom’.
Over the following three years, the stock market halved.
Of course, it is one thing to say a market is overvalued but another to start selling in anticipation of a fall in the market. As evidence-based investors, we tend to look at the facts as they are and make reasoned investment decisions. So, what is the evidence?
- The UK stock market currently trades at a high valuation multiple of 20x price to historic earnings.
- Over the last 30 years, when the stock market has been at the current valuation, the average annual returns in the subsequent 10 years have been 6% per annum.
- If you can wait until the market trades on 15x, the average subsequent returns have been 12% per annum - twice the annual return expected at the current level.
- On average, the UK stock market has an intra-year fall of 15.8% every year.
- Generally, stock markets have declines of 20% or more every 4.5 years.
- It is over 8 years since the UK stock market had a fall of over 20%.
Let’s get this straight, we are not saying the market cannot go up. Sure, it can.
But, and this is the crucial bit, you should invest when the odds are in your favour and the asymmetry at the moment, where the probability of low returns are high (and vice versa), are conditions when you want to start reducing holdings, especially as there are rising risks of loss.
At present, we are in the process of rebalancing those risks for our clients. Of course we continue to hold equities but at the start of the year our portfolios held 32% in equities which is an underweight position relative to our strategic weighting of 38%.
However, last week we reduced the equity weighting by a further 3% and switched into a structured product from Morgan Stanley that will potentially give a return of 11.55% per annum and serve to protect capital if markets fall, realigning the odds back to our client’s favour. Over the life of the product, the US or UK equity market would have to be 40% or more lower than the current level in six years’ time before there is any risk to capital from market movements (although credit risk applies). For more information on these products, please see our blog from November 2016 ‘Defining Portfolios’, or if you are an Equilibrium client ask your client manager for further details.
The truth is that delayed gratification is not much fun; human behaviour is inclined to want all the goodies here and now. Our job today is to sacrifice some of this short-term sugar rush for even sweeter longer-term returns.
*Economist John Maynard Keynes described ‘animal spirits’ as, “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities” in The General Theory of Employment, Interest and Money (1936). In other words, a tendency towards instant gratification.