Friday 13 March, 2020
Article written by Bernard Hickey first published by Newsroom
Bernard Hickey asks for a friend if he should pull his money out of the markets and buy baked beans because of the Covid-19 virus. Kiwi Wealth's Chief Investment Officer Simon O'Grady explains why his 'friend' should step away from the baked beans and hold tight.
Bernard Hickey: I've got a friend who says he's heard the market is collapsing and wants to pull his money out. What should I tell him?
Simon O'Grady: The answer is no. It would not be a great thing to do. Markets do this all the time. If you're in equity markets, the reason you get paid an extra return above cash is because of these types of events and movements, and it's very difficult to time these.
You should keep your risk budget and approach in your financial plan that's right for you, invest accordingly and wait out these types of events. A lot of money has been lost buying at the highs and selling out at the lows. It's one of the worst things you could do.
Bernard Hickey: But I'm told the way to make money is to sell high and buy low. And if I sell now, when the markets near their highs, and wait for it to bottom out, and then I jump in and buy again, aren't I gonna get rich?
Simon O'Grady: In theory, if you could pick the tops and pick the bottoms and buy at them, then you could do very well. But in practice, it's extremely difficult. Even the professionals find that very difficult to implement and fail most of the time, and a lot of money has been lost trying to do that, both by professionals and by individuals.
And you've got to always remember that if you're buying and selling, somebody is on the other side of that and it's most likely to be professionals who do this for a living all the time. You've got to ask yourself the question: why do I think I'm better than those who do this for a living?
Bernard Hickey: But isn't this time different? Some say it's a zombie apocalypse type event and you'll need cash to buy baked beans and a semi automatic weapon. So take your money out now...
Simon O'Grady: That's a fear-driven statement. Some people are concerned: is this the apocalypse? Is this going to wipe out a substantial part of the population and be the epidemic and pestilence that everybody has been forecasting since the Black Plague? But the answer is 'very unlikely'. We've seen episodes such as SARs in the past and this, while it might appear to be a bit more virulent, is certainly not as dangerous.
Governments are taking actions, and drastic actions as we've seen by China, which has appeared to have contained it. And Italy. But even so, these have come and gone in the past. We would expect this to be the same thing.
It pays to keep in mind that a virus spreading around the world is not an economic or financial problem per se. It's really one that will impact economies and investment through demand and supply, and all indications is that this will run its course -- whether it's months or whether it's six months. But eventually things will become normal.
Bernard Hickey: Really? Over the last 20-30 years the global economy has become much more globalised and you've got just-in-time supply chains and everyone's going on overseas holidays and buying things online from overseas. Doesn't this shock to just-in-time globalised supply networks and travel industries actually mean it isn't going to pass in just a six to 12 month period? And that after it there could be a substantial change in the way we run society and think about globalisation?
SImon O'Grady: As globalisation occurs and supply chains become integrated, this sort of event, which affect the networking that we have across economies and production chains, is going to be impactful. But if you look back through history, human beings have this remarkable ability to learn, funnily enough, and improve processes. So there's no doubt the system and the supply chain framework to come out of this will be more robust and better for the experience.
But that certainly doesn't mean we're not going to get some severe impacts. You only have to look at the forestry industry where the demand literally turned off from China and has had an enormous impact on small businesses in those supply chains, but certainly you don't want to underplay or underestimate the huge impact it's having on all those value chains. This is something that will cause damage, but it's not going to create a structural break to economies. They'll continue to evolve.
Bernard Hickey: This isn't the first crisis we've had and it's not the first time people have said 'hold your nerve.' But it seems every time it happens, everyone runs for the exits. What's going on in people's brains? What's the behavioral economics or psychology behind people panicking and selling like this?
SImon O'Grady: That's a really good question, because clearly this is the quintessential animal spirits that Keynes referred to way back in the 1930s. One of the pre-eminent proponents of behavioral finance in San Francisco breaks it down into three key drivers that sit underneath people's fears. The first one is what he calls 'utility.' So when people are confronted by this, they ask: 'Will I be able to buy the stuff that I need to buy' and are fearful because of that.
Then there's a behavioral bias, which is around status and perception, which is: 'I'm going to feel like an idiot if I don't get out of this.' And the third area that he refers to is an emotional sort of drive. There's a lack of objective information that people make decisions on. That information gap is something that's fearful and scary.
When you put all of those together and condense them, there's two big drivers: regret -- 'I wish that I had done less. I should have done that. And I'll regret not having gone out.' And that's a fear of that regret.
And the other one is mental accounting. People mentally spend their money as it accumulates and it grows. So we have had a bull market and people were looking at their balances and mentally spending them on the things that were going to buy. And as soon as we get a sell off, that's very real to them, they can't actually buy those things. That feeds back into the behavior. It's partly exacerbated by the headlines that you see across media, which are always scary, with lots of adjectives and terms like crash and carnage that feed into that emotive fear.
Bernard Hickey: So how are you thinking about this fall? What are you doing when you see the markets fall seven percent in a couple of minutes?
SImon O'Grady: I've been in this game for over 30 years. My first financial crisis was in 1987 at the fresh age of 18 years old and I've seen all the ones in between. The first thing to note is that fund managers know this is going to occur. They build portfolios in order to to be robust through them. That's the first port of call. And the way we approach it is we've got highly diversified quality-type portfolios. They're pretty liquid. And we know that they will survive through these types of crises and they thrive in the inevitable upturn afterwards.
We're prepared. We know it's coming and you're objective in your decisions. It's very difficult to time these. It's like trying to catch a falling knife, trying to time your buying in a down moving market.
What it does do is punish good quality bonds and shares just as much as bad ones often. And there's lots of opportunities, particularly for active type strategies to pick up cheaper assets that are good quality through this process and in the aftermath. The other thing you often see after every one of these crises is that assets become relatively cheap. So there is opportunity to extend risk on the credit markets and share markets on the up.
But of course that's off in the future. We're only in the very first stage of a crunch and sell off.
Bernard Hickey Any particular areas so far that looks like they're being oversold or caught up in the collateral damage?
SImon O'Grady: I can point to a bunch of anomalies. The sectors that are hardest hit are energy or oil or gas after Saudi Arabia's actions over the weekend. But when you look through that particular sector, many of those companies are involved in other elements. They might not be primary producers, or they might not have a delta [strong connection] in their earnings towards oil very much at all. And they can be supply chain businesses or be around renewables, etc.
Banking is another one that has just wholesale been hit. We know that some parts of the banking sector are exposed to the oil and gas industry, but a number of banks have been pulled down by both the fall in interest rates and also the unknowns about what their balance sheet qualities are.
The other area is the the long standing value versus growth issue and problems. Typical growth type stocks are those which are growing earnings, but are trading at high PEs [price to earnings multiples] and expect to grow faster in terms of earnings than the average, and have been outperformers in this rising market.
Then there are those that are more high dividend type stocks that aren't growth. They have struggled for quite some years now. Some of these sectors are actually quite good pickings at the moment because they have been hit just as hard.
Bernard Hickey: So in summary, what do I tell my mate who says run and hide and buy baked beans?
SImon O'Grady: I appreciate and understand the sentiment and the fear. It's a very human reaction to uncertainty. When we look at the three core drivers of the sell-off, we were starting to see global economies already beginning to slow. So we were starting to see equities come off reflecting that, albeit off of a pretty high base.
The second element is the virus. The indications are in any objective analysis are that it's like the flu, but with a higher mortality rate. And while we don't diminish the impact that certainly has, it's not of the order of the MERS or SARs mortality rate.
These rapid oil price falls we've seen are actually beneficial at the end of the day for energy or consuming companies and detrimental to those who are supplying them. So it's broadly positive in the long run. But ultimately economies grow because they get out there and create things. The Spanish Flu in 1918 went around the globe and then there was a recovery.
Bernard Hickey: So I'll tell my mate: take a chill pill, things will calm down and come back. And there's a risk if I take all my money out now and put it under the bed, that when I come back I will have lost some money, and I should just look after my friends and family and think more about their health than my finances?
Simon O'Grady: Exactly. The critical thing people need to do is just make sure that the risk level they're taking is objective and matches their temperament and their willingness to take risk. If that's set right, you're good, and you ride through these every single time.
*This is a lightly edited transcript of their conversation this week as countries closed their borders and stock and bond prices fell sharply.
Kiwi Invest is the investment team behind Kiwi Wealth's funds