Investment legends – facts not fiction

20 August 2021
Investment legends have been around for decades. In fact, you can probably trace these ‘legends’ right back to the 18th Century and the creation of the London Stock Exchange.

Whether it's accepted practices like diversification and comparing like for like or going against the plan and hitting the panic button and trying to time the market - collectively, these all form a template of considerations that investors are aware of and are adopted within various processes.

The problem is that during a crisis, we can all be guilty of forgetting these accepted practices. We’ve been through many different crisis’ before but one thing we have never collectively experienced is a global pandemic on this scale. Perhaps if the last 18 months had just been another investment crisis and not a pandemic, we would have seen calmer behaviour right across the market.

So why do these legends exist and what learnings can we take from them to add value to client conversations and investment processes?

On the face of it, we all know the benefits of diversification and why you should refrain from putting all of your eggs in one basket. It’s engraved in investing 101 and for very good reason too.

Roger Ibbotson and Paul Kaplan were responsible for an integral piece of work in 2000 'Does Asset allocation policy explain 40, 90 or 100 percent of performance?'. The study detailed how asset allocation accounts for 90% of performance. Clearly, diversifying means you have a wider exposure to different investment strategies and that can help generate returns in a wider variety of market conditions and help minimise the impact of large market drawdowns.

You’re probably familiar with the investment patchwork quilt. It’s ranking the best performing asset classes over the last three calendar years and year to date. Each coloured box ranks the performance of a particular class of asset. If you look at the pattern of where any one of the colours fits on the chart it clearly shows how difficult it is to pick an overall winner.

2020 wasn’t a great year for UK equities. The winners were clearly global stocks and fixed income driven by a highly valued US market and bond yields hitting unprecedented lows. The tables, however, have turned in 2021(up to the end of July) and along with commodities, the UK’s sector exposure and ‘value’ orientation has provided a greater resilience to this inflationary backdrop relative to overseas markets.

Source: Lipper, Royal London, as at 31/07/21

Instead of picking a winner, the smart answer could be to diversify. If you blend different investments together, you’ll never come top but you’ll also never come bottom as you can see with the black box. Effective diversification also means you are always going to be holding at least one asset that is underperforming but I’d argue that this is very much a success of the design and not a failure.

As the turbulence over 2020/21 has shown us, that design can not only be an effective path to maximising risk-adjusted returns but also serve as a defence against rising inflation through exposure to different investments, particularly commodities. 

I do appreciate that this is much easier said than done, especially when you’re in the midst of a global killer virus! Everyone knows not to panic when markets fall but that is exactly what tends to happen and rational behaviour tends to go out the window when faced with a crisis. It’s happened plenty of times before and it’ll happen plenty of times again. This is despite knowing that downturns tend to be followed by strong upturns.

If you’ve glanced over the Investment Association’s fund flow data for 2020, you’ll be aware that it identifies a strong trend of panicking with both advised and non-advised investors moving significant volumes of assets around. In March 2020, fixed income suffered outflows of £7.5bn. The problem is of course that fixed income went on to become one of the best performing assets over the course of the year.

Over the second half of 2020, money flooded out of UK equities before flooding back in at the turn of the year off the back of improved performance. But how many investors who previously panicked subsequently missed out on this recovery? It’s a similar pattern to the fixed income trend at the start of global lockdowns; significant redemptions followed by strong performance.

Many pensions clients will have an investment horizon of years, if not decades. It's a simple statement, but one that can be forgotten during market shocks.

We would all deny that we are susceptible in allowing heightened emotions to dictate our investment decisions. But we see this type of behaviour time and time again. We saw it in 2020 when feelings of panic, agony and depression resulted in a rush out of quality diversified assets. We’re seeing it at the moment with general feelings of optimism that will surely turn to euphoria at some point.

A rational and disciplined investor will not be distracted by the noise and will stay focused on the long term instead of panicking and allowing emotion to dictate decisions.

Those individuals who do try to time the market, can often end up buying high and selling low. It very rarely pays off and when it is successful, it’s usually more down to luck than skill and highlights that time in the market is perhaps more important than timing the market.

Let’s expand on this theme a little further. The performance here is based on our Governed Portfolio 4 from January 2009 to the end of March 2021. We’re assuming an initial investment equalling £100,000 and the figures are shown net of a 1% charge.

Source: Royal London, 31/03/21

It needs to pointed out that the figures are for illustration purposes only, and are to demonstrate the possible effects of mis-timing the market. It's not intended to highlight the relative performance of any one fund or sector

The first column shows an annualised return of 8.12% over this period generating a pot of £269,387. The second column shows what the impact would be on the annualised return and what the amount in the pot would be if you missed the top five days over this period. The pot size has now reduced to just over £228,000.

The third column takes the top 10 performing days out of the equation but it’s the final column which really underscores the significance of time in the market. This column shows the impact if you remove the top 20 days and if you compare this directly to the first column where you are fully invested – the annualised return has shrunk from 8.12% to 3.93% and the pot size has reduced by over £106,000.

Markets don’t usually require investors to sit tight for too long and yesterday’s losers can often turn around dramatically during the early stages of a recovery. You only have to look at the difference in the performance of UK equities over 2020 and then YTD in 2021 for proof of that.

The actual experience, however, highlights that we can be far too quick to dismiss poorly performing sectors or asset classes that are going through a phase of poor performance and into those that have performed well and potentially past their peak. 

The flip side of this could also be true. It may be possible to time the market so that you miss the bottom 20 days, which would limit your downside but is it worth taking the risk?

This ‘legend’ is perhaps less of a rule because current processes may dictate that you have to compare a specific investment against a specific sector average for example but it’s one that should at least be  taken into consideration particularly when comparing against mixed investment sector averages.

If we take the ABI mixed investment 40-85% shares sector as an example - we know funds in this sector can hold up to 85% in equities. That’s quite high for your typical ‘balanced’ investor but that’s an argument for another day.

What I really want to focus on is the composition of this sector and the huge amount of variance which exists amongst the constituent parts. The following chart shows the range of minimum and maximum allocations with thin the sector as well as the average.

Source: Lipper, 31/03/21

The fact that you could have one fund with a 19% exposure to UK equities being compared to another fund with almost 60% exposure doesn’t really feel right. If you were to put those two funds side by side, it’d be unlikely that you’d want to compare them on an individual basis so why would you compare against a sector average?

Well as I said earlier, it may be something which is a constrained part of your process but it’s important to consider what’s in the box when you’re comparing against a sector as well as what comes out of the box in terms of the range of returns. Multi-asset solutions aren’t designed to beat other multi-asset solutions over every time-period. That is practically impossible because there is such a variation in how they are structured and what they are exposed to.

Failing to take this into consideration can paint a very distorted and misleading picture when talking to your clients about their relative performance.

In summary

These ‘legends’ aren’t new; they’ve been around for decades and for very good reason too. We don’t consciously decide to ignore them but emotions can dictate decisions particularly in the midst of a crisis.

So stay rational and disciplined, don’t be distracted by the noise and continue to focus on the long term and continue to focus on the long term for your clients who will be invested long term. Always keep these legends front and centre.

About the author

Ryan Medlock

Senior Investment Development & Technical Manager

Ryan’s journey with Royal London began back in 2008 after starting his career in compliance with Norwich Union. As an Investment Proposition Manager, Ryan contributed to the growth and development of Royal London’s Governed Range before moving to Aberdeen Standard Investments for a stint in the Strategic Client’s relationship team. Ryan returned to Royal London in 2018 with a focus on exploring adviser angles amongst complex regulation and investment themes. Ryan is involved in developing adviser facing content, presenting, writing articles and commenting for the press. Ryan holds the IMC qualification. Ryan is particularly proud of the fact that he finished 952nd in the 2008/09 edition of Fantasy Premier League.

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