Apply logic when markets begin to wobble

It can be tempting to switch from equities to cash when markets start to look shaky, but history tells us that fortune favours those who hold their nerve.

Inflation surge

Inflation is the biggest current economic talking point, with current and projected figures spooking both markets and investors. The headline figure of the UK’s preferred measure of inflation, the  consumer prices index, vaulted 5.4% during December 2021, its highest level for 30 years. Across the Atlantic, US inflation has surged to a 39-year high of 7%.

The long-anticipated return to rising inflation is proving a dilemma for Central Banks. On one hand, corrective action is needed to prevent inflation from spiralling out of control. On the other hand, raising interest rates too aggressively in a bid to stem further inflation will hit the purse strings of consumers. This comes at a time when many individuals and families are still in the process of restabilising their finances after seeing businesses and livelihoods hit hard by the pandemic.

Markets have reacted to inflation concerns by showing signs of fragility. The US equity market has dropped almost 10% since the start of the year. This volatility is spilling over into other global markets, the global equity index has fallen 7.5% over the same period.

Reacting with logic

Watching a portfolio lose value over a short period of time can provoke an understandable urgency to take corrective action to protect wealth in the event of uncertain markets. This is a natural and primitive response, which in psychology theory is termed loss aversion. 

The theory asserts that humans have a cognitive bias where the pain of losing is psychologically more powerful than the pleasure of gaining. The despair of losing an entire investment portfolio is, therefore, likely to endure for longer than the joy of crystallising a sizeable gain.

The key, however, is to apply logic. The way markets plummeted during the 2008 global financial crisis offers a case in point of what can happen when economic conditions become severe.  Indeed, the crisis left a bitter taste in many investors’ mouths, but the way markets have rebounded in the decade since emphasises that making rash, short-term investment decisions – such as moving from equities into cash – can cause lasting damage to portfolios’ performance.

Recent history delivers another powerful lesson on the benefits of blocking out short-term noise and retaining focus on long-term goals. At the beginning of 2020, as the severity of the pandemic began to be understood, the UK equity, market began a fall of 35%, from its peak in mid-January to the trough on 23 March 2020, for the first time in more than a decade. Yet fast forward just a few months to the end of June, the UK market had rebounded 24%, steadying to see out 2020 12% lower than at the start of the year. During 2021, despite the effects of the pandemic still being felt, the UK equity market climbed 18.7% – its highest annual rise since 2016.

Timing error

Switching from equities to cash when markets are bearish is based on the premise that markets can be timed. The most lucrative way to invest is selling stocks when they are high and buying them when they are low, or ‘buy the dip’ as it’s commonly known.

The difficulties of timing the market were identified more than a century ago by French mathematician, Louis Bachelier. In his PhD hypothesis, entitled ‘The Theory of Speculation’, published in 1900, Bachelier posited that market movements are inherently random, and even with the best will in the world cannot be predicted with any true accuracy. This known as the random-walk theory.

There are real risks to being overweight in cash. Given that interest rates, despite starting to rise in both sides of the Atlantic in a bid to curb inflation, remain close to historic lows, any money held in cash will see its buying power eroding in real terms. The US Federal Reserve is poised to implement several rate rises during the course of 2022, but interest rates will almost certainly continue to lag inflation.

Investors should resist being influenced by market behaviour and revisit their initial and ongoing objectives. Prudent investment planning is not about buying and selling to capitalise on each and every transient market event. Instead, portfolios should be tailored to each investor’s specific investment objectives, investment time horizon, appetite for risk, and capacity to bear financial losses. Portfolios should be regularly monitored and reviewed – at least annually – against investors’ goals. But, as stressed above, churning equities for cash to protect portfolio assets from potential dips could result in missing out on any potential upswing once markets rebound.

Investing would be a far easier pursuit if markets moved in a linear upwards trajectory, but we know from experience this is not the case. It would also be easier if cash deposit rates outstripped inflation, but this is also not the reality and is unlikely to be for some time. It can be tempting, and indeed reassuring to exit the market when it begins to wobble, but history tells us that holding one’s nerve is not only the best course of action, but often the safest.