A few weeks ago, I was packing for an overseas business trip. As I needed to visit the United States, its stringent carry-on rules for personal luggage required that I buy quart-sized Ziploc bags so that the security personnel at American airports could see my lipstick more clearly.
I wondered if Ziploc sales have soared since the security measures were introduced in the wake of the September 11, 2001 attacks. This multi-billion-dollar company, I found, is family owned and is not listed - so we long-suffering travellers cannot benefit from their good sales and buy a few shares in Ziploc. I guess there are a few trust fund babies in the Johnson family who don't have to worry about planning for retirement.
Millions of travellers use these quart-size plastic bags to carry in plain sight the personal things they feel they cannot be without during their flights.
That they have to do so is, of course, the result of a tragic event. And such events seem to happen at random and are very hard to predict.
With markets continuing to defy gravity and concerns mounting over the shrinking risk premium and the seemingly inevitable pullback in equity markets after a long bull run, it is perhaps time to look at extreme events and their impact on your investment thinking.
Perhaps you know someone who has a doomsday philosophy when it comes to investments. It has been a while since these doomsayers have had it their way, with global equity markets not only experiencing these shocks (such as September 11, terrorist attacks and emerging market events) more frequently, but shrugging them off with remarkable resilience.
Do you even remember the Chinese scare in February or have you also moved on from that event?
European central bank research
There are numerous research papers on the propagation of these shocks and the reasons for the increased resilience of world markets. (The notable one is the assertive use of monetary policy to improve liquidity in response to shocks. For example, the US has tended to cut interest rates aggressively to compensate.)
The European Central Bank revealed in a paper (see: www.ecb.int/pub/pdf/scpwps/ecbwp724.pdf) that there have been fewer emerging market shocks since 1998, and it also found the following:
- The impact of emerging market shocks on global equity markets are quite significant on a daily basis - this appears to be when the largest impact takes place. So practically (bear this in mind when you are tempted to panic sell after the event) the biggest move has tended to take place on the day of the shock.
- The impact of emerging market shocks is quite persistent, highlighting their increased importance to the world.
We tend to view these shocks as negative events, but it is important to realise that global markets have reacted as strongly to positive news from emerging markets. And with the acceleration in economic growth in emerging markets, there has been more good news than bad in recent years.
Perhaps this highlights a big potential threat to equity markets - a slower rate of growth from emerging markets. This is likely to happen in a series of smaller shocks and indications over time, and it will be hard to find a single trigger to sell.
What to do
So what do you do about market shocks? Firstly, realise that they do come around with more frequency than we'd like. Secondly, your chances of predicting when they will happen are pretty low.
If you are concerned about the potential for negative market shocks to impact on your portfolio, there are a few approaches to consider:
- You can stick with your long-term plan and do nothing. You can rely on time in the market to help you out in the long run. In other words, roll with the punches and consider applying a little extra cash to your portfolio when there is a nasty shock that causes a market dip.
- You can run scared. Put everything in cash, which will make you feel more comfortable now, but, in fact, if you have a long-time horizon you are more likely to sleep well now but not in your retirement as you will miss out on market growth over the next 20 to 30 years.
- You can maintain your target equity exposure as a percentage of your overall portfolio. In other words, as it creeps a certain percentage above your target, you sell a few shares, and as it dips below, you buy more. This is not a bad approach, but you do risk trading more, leading to more capital gains tax events and possibly being seen as a trader by the taxman. If your target is 60 percent, it helps to limit trading activity if you act only at 10 percent triggers on either side (so you only sell back a few percent when it goes over 70 percent and buy in at 50 percent exposure).
This approach can be called top-slicing and forces disciplined participation in dips and runs in the market.
If you have a tax-efficient vehicle within which to do this, it can work. But you may also give up some returns when there is a sustained bull market such as we've seen over the past few years.
You can also buy an aggressively managed flexible fund, which leaves market timing to the professionals. But even they do not always get it right; many tend to be conservatively positioned in equities and many can be prone to panic selling after the fact.
- A final, more sophisticated add-on is to use some of your top-slicing profits to buy some portfolio insurance in the form of options that will pay out only if the market really drops. This is not always practical, and you will have to live with the fact that more often than not you will lose the premium you pay for the option while you wait for the big payout in the case of disaster - exactly like a short-term insurance policy. You will also have to manage this actively. If this appeals to you but you do not want to take on this responsibility yourself, an alternative is to look for a fund manager that takes this approach in its flexible fund.
Trying to cater for market shocks is very tricky and the cost of not being in the market can be very high indeed, especially over the long run. Time spent assessing your needs and your risk profile upfront is likely to lead to less panic and more sanity when these shocks do come around.