HERMAN VAN PAPENDORP: Switching funds when markets fall costs investors

Financial markets have had a tough time so far this year, with significant falls  and volatility the norm across the major asset classes amid a global policy transition from stimulus to tightening.

Global bonds have sold off meaningfully in 2022, and SA bonds were not spared. Equity markets worldwide also experienced meaningful drops. The S&P 500 reached its peak in January and fell almost 19% to its weakest point so far on May 19. Though the JSE all share index (Alsi) held up well in the initial months of the year when strong commodity prices provided support, it has fallen almost 14% between its historical high reached on March 2 and its recent low of May 9.

As SA investors with a diversified portfolio of assets will have the biggest exposure to the SA equity asset class, it is important to note that even at the recent (May 9) low point of the Alsi (when it was 14% lower than its record high of March 2), it was:

• Still 9% up on its previous, September 20 2021 trough.
• Only 3% down over one year.
• A total 29% up on its October 30 2020 interim trough.
• A hefty 76% up on its March 19 2020 Covid-19 bottom.
• A total 8% up on its pre-Covid peak of January 25 2018.

It remains uncertain how much global policy tightening will be needed to quell price pressures and force inflation down closer to central bank target levels, and how severe the effect of this required tightening will be on economic growth and corporate profits. Apart from the unknown unknowns, there are several known unknowns that could place further downward pressure on equity markets.

Corporate profit momentum is still to reflect the prospective economic growth slowdown worldwide. Not only are companies experiencing margin compression from rising input costs, they also have to deal with excessive inventory levels, turnover pressure from supply chain delays, as well as faltering consumer spending as disposable incomes are eroded by higher inflation.

Further setbacks

Frequent lockdowns of the Chinese economy related to its zero-Covid-19 policy could further add to global growth fears and cause instability in financial markets. Any escalation in the intensity or geographical reach of the Russia-Ukraine war will also add to market volatility and more potential downside.

As the US equity market already seems to discount a decent likelihood that a recession will be forthcoming, it should be less of a surprise should a recession come to fruition, in turn somewhat limiting the magnitude of further market declines when a recession becomes fully discounted at such time.

With global equity market declines not far from the 20% falls from peaks widely regarded as the technical definition of a bear market, we should expect the phrase “bear market” to feature regularly in headlines in coming months. Such emotive headlines often lead to harmful investor behaviour by enticing some investors to change their portfolios at the wrong times. In this regard, our research shows that clients on the Momentum Wealth platform destroyed 6.5% and 3.5% of their investment returns in 2020 and 2021 respectively, predominantly due to incorrect switching between funds.

This real-life sample of actual investor behaviour aptly illustrates how paramount it is to investors’ financial wealth to vigorously guard against destroying portfolio returns by reacting emotionally to equity market drops and volatility. As long as investors remain comfortable that their financial goals are unchanged, there should be no need to make changes to portfolios that have been carefully and methodically constructed by their financial advisers to attain these objectives.

Interim periods

That equity markets decline from time to time should not make investors feel obliged to react to these declines. Historical evidence shows it is far better for portfolio returns to rather be too passive than too active in adjusting portfolios in reaction to previous market movements.

Equity markets go up over time as rising corporate profits are reflected in higher share prices. But there are interim periods when poor operating environments cause profits to fall for most companies, driving share prices and hence overall market indices lower.

An appropriate response by investors during such short-lived periods of market weakness is to focus on the investment rationality of long-termism. By concentrating on the reality that equity markets historically provided strong returns in the longer term, investors will be able to push back against their inherent cognitive recency biases to overplay short-term market declines and thus refrain from making unnecessary damaging changes to their portfolios.

It is fittingly revealing that the most recent 2020 Covid-19 bear market does not even reflect on long-term annual equity graphs. Let this be a lesson to us all when dealing with the inevitability of market declines from time to time.

• Van Papendorp is head of investment research & asset allocation at Momentum Investments.