Why risk shouldn’t be reactive

For financial professionals only

After 10 years of loose monetary policy and a record bull run, the recent market correction has come as a shock – even to investors who have seen significant equity movements in the past. As a result, some have hit the panic button, and looked to de-risk their portfolios.

An analogy my mentor gave me when I first trained in investments comes to mind. If you are shopping for something, and it’s half price, you don’t wait until it’s back at full price before you buy. You might even stock up.

Whether that’s groceries or socks, it’s natural behaviour. But when we see a price fall in investments, our instinct is to do the opposite.

While this is understandable (indeed, there is a whole section of behavioural finance devoted to Loss Aversion), there are many pitfalls of turning that instinct into action.

When is a loss not a loss?

From the start of the downturn on 20th February to the trough on Monday 23rd March when the UK lockdown was initiated, the FTSE All Share shed 1422.33 points – around 34.27%.

This loss was not locked in unless investors immediately sold their investments and withdrew the resulting cash from the market.

In doing so, they would have missed the market rebound over 17% in the following 3 weeks, and crystallised a larger loss than if they had remained in the market.

Opportunity knocks

Imagine, instead, that the investor was savvy enough to sell before they suffered the full pain of the market drop and exited the market at the end of February. At that point, the FTSE All Share had fallen just 11.48%. By March 23rd, they might have been feeling quite pleased…but with the market now trending up, what will they do? When do they decide to buy back in?

Conversations with our Active managers show they are broadly very excited about the opportunities now present. They are in no hurry, but there are businesses they have wanted to buy into for some time that now look to be priced attractively. Investors out of the market stand to miss out on significant growth when these businesses bounce back.

Price is what you pay, value is what you get

In recent years, the debate of active versus passive fund management has been lively. A rising tide lifts all ships, so passive vehicles have held their own in a decade-long bull market.

If the tide has turned, now is the time our Active managers will prove their worth. They have the scope to be selective in their exposure across a range of tools: sector, market cap or region for our selected equity managers, and credit, duration, or region in fixed income.

This means they can position themselves to avoid the worst hit areas if we see a recession, or conversely, maximise the benefit when we emerge.

For those who have stayed the course with Active managers and paid their fees for the past few years, selling out of the market just when the benefit of this investment approach stands to pay off seems illogical.

Risk as part of a holistic financial plan

The most important thing to remember in all of this is that risk is an integral part of your clients’ financial plan.

Their Risk Grade is not an arbitrary number, subject to market conditions. It is arrived at through a personal assessment of their risk appetite, their need to take risk to achieve their stated objectives, and their capacity for loss – an objective view of how much loss your client can afford to bear.

This has all been factored in to get them to where they are today – how much money was invested at the outset will have been guided by this, along with their exposure to growth versus defensive assets within those investments. As part of that advice journey, it was agreed that your clients’ investments were suitable for them, over the period of time they have to invest – even encompassing shorter term market falls.

At a time when cost disclosures are more transparent than ever, the value of good advice is becoming clear. Much wartime rhetoric has been used to rally the nation during this unprecedented time – so I shall evoke another. Keep Calm and Carry On.

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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