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May 29, 2019

Investing: Do You Have The Right Temperament?

by David Ensor

David EnsorIt is an unfortunate truism that far too many investors “buy high” and “sell low”. Given how counter-productive and demonstrably irrational that is, we have to ask: “Why?”

Let us say that you (with or without the help of a financial advisor) have decided how you wish to allocate the capital which you have set aside for investment (as opposed to the emergency fund which you should also have in cash or the equivalent.)For most individual investors, this is done across three main available asset classes: cash, bonds and publicly-quoted equities.

What process did you follow?

No doubt you examined the historical performance over time of your chosen investments, and perhaps read research on expected future returns, both in nominal and real terms.

Perhaps, as you should do, you looked at the costs of making and holding the investments and at the track record and reputation of the investment manager (if investing through some form of collective investment vehicle such as a mutual find or Exchange Traded Fund (ETF).

However, did you perform a self-analysis on your risk appetite and tolerance, as well as to consider how impulsive you are? Any investment broker or advisor will have some form of template for supposedly assessing this. However, these tend to be rather “broad brush” and more of a box-ticking exercise than anything else, because they often have very different incentives from you; generating fees. After all, it is your money, not theirs; and, if you lose it, absent fraud or gross negligence, the worst that can happen to them is that they lose future revenue from whatever management fees they charged.

All the above is what you might call “standard stuff”. Yet, you are not “standard”; you are an individual, and this is where a much deeper understanding is required if you are to avoid the “standard”, often bad, outcomes.

You may have heard and read about “drawdown” risk. In essence, it means the risk that the realizable value of a particular investment or index will experience a significant decline from the price at which you purchased it over a given period of time. Another way to think about it is as “negative volatility”. Of the three asset classes mentioned above, it is most obvious in publicly-quoted equities.

While the historical record does not predict the future, it is instructive. What happened can be examined in the context in which it occurred and an investor can try to see if there are any signals or patterns.

Canada’s public equity markets are unusually concentrated in certain sectors: at time of writing 36% of the S&P/TSX 60 Index is comprised of Financials and almost 20% in Energy, so it is unusually vulnerable and a prime example of why one should diversify outside Canada.

Looking more broadly over time, could you have coped with an annual real return of -38.6% (US, 1931) or – 47.5% (Europe, 2008), or even more extreme moves over shorter timeframes? Or would you have felt the need or been compelled to sell and realize that loss? If the answer is “yes” in either case, then perhaps you need to re-think your risk appetite and tolerance, because over time volatility in the public equity markets tend to work in both directions. +55.8% (US, 1933) and +75.2% (Europe, 1933) sounds much better, and you need only look at any of the major equity indices over time to see the cumulative effect of that pattern.

So, what is the point of all this? It is to ask you to consider whether you not only have the financial capacity, but also the temperament (the “stomach”, if you will) to deal with the level of drawdowns mentioned above.

Over time, particularly in equity markets, the existence of “positive skew” (a topic on which we have written before) means that even steep market-level declines tend to be retraced and then reversed into a positive return. This is not always a quick process (although it can be,) which means that investors still needs the capacity and “stomach” to endure it. For example, in December 2018 the U.S. equity markets experienced their worst monthly performance since the Great Depression, with the S&P 500 returning -9.18% (having also fallen almost 7% in October). How did you react?

No doubt you were as shocked as the “experts” were. Did you panic and sell, or decide to wait? That short correction is instructive as a simple test of your temperament, because in the first quarter of 2019, the S&P 500 was up 13.6%, and the S&P/TSX 60 up 13.4%.

I would emphasize that, as the blurbs say, “past performance is no guarantee of future returns”. However, market volatility is a feature. It pays to study market history. Understanding the nature of volatility should provide some help in assessing how much of it you can tolerate emotionally as well as in terms of your actual ability to avoid being forced to sell.

As the ancient Greek maxim goes: Know Thyself. It applies in investing, as much as elsewhere.


David Ensor/Risk Management Consultant