Market Volatility: ‘It Pays to Take a Step Back’
Christopher Johnson: Welcome to Morningstar. Today I’m joined in the studio by Mike Coop, the CIO EMEA of Morningstar Investment Management. Mike, thank you so much for being here with me.
Mike Coop: Chris, my pleasure.
CJ: So, we’re here to talk about the market sell-off. So, what drove it, in your opinion?
MC: Well, it’s normal to have bouts of volatility, especially in markets that have risen sharply and become very popular. And you can see that this year, AI-themed investments fall into that. So, in some ways it’s hardly a surprise that at some point after lofty expectations, we’d always realize that you saw some rotation. And so some of those stocks have fallen pretty heavily. So that’s one of the factors. We have had quite a bit of volatility in Japan, which has some of those same features that became quite popular. And at the same time, we’ve had some shifts in interest rates. So, we’ve had interest rates that were cut in the UK, in Europe, and in Japan they’ve gone the other way. And the central bank, I did think it caught some of us off-guard with that. So those were some of the factors behind it, but it’s not really all that abnormal what happened. You do get bouts of volatility and so it’s been a while since we’ve seen one.
CJ: So, there was a lot of panic in the market. So how should investors act when dealing with such acute volatility? What would you say to them?
MC: So, it pays just to take a step back and remember why people are investing. They’re investing to meet their personal goals, whether it’s saving for retirement or to fund their accommodation, or maybe their education, or even something like a car or a holiday, whatever it is. So, the goal is to achieve a certain amount and so when markets go up or down, it doesn’t change the need you have to have money and the goals that you have. So, it’s better to really focus on how you are tracking compared to your goals rather than just the ups and downs of markets, which will do their thing, but that’s factored into your long-term investment strategy that’s been designed to help you reach this goal. So, sticking to your strategy is what matters and accepting that volatility is part of the investing journey. If you’re going to get a return that’s higher than cash, then you’re going to have to accept some variability and return in the short term.
CJ: And what are the behavioral traps that crop up when there is this panic that enters the market, do you say?
MC: So, these things all occur because we’re dealing with the future and the future is uncertain and so we can quickly find ourselves changing our minds about what the future might look like. This is what makes investing different from going and buying a hamburger. When you buy a hamburger you know exactly what you’re getting there it is in front of you, you eat it, you’re going to endure that experience. Whereas when you’re buying investments it’s about what might happen in the future and the less certainty around that. So, we have a couple of behavioral traits that come to the fore here. One of those is as we think about the future, we tend to over emphasize what’s just happened recently to us. In the jargon this is referred to as confirmation bias and so if we’ve been through a particularly memorable experience or an economic situation or a market situation we act as if that’s highly likely to continue and we over emphasize a likelihood of it. So, we tend to expect extremes to continue when we know that by their nature extremes don’t continue. So, we tend to get caught up in the moment and become too optimistic or too pessimistic. So those attributes plus we tend to seek information that validates our existing view. There’s confirmation bias and of course this is exaggerated with social media where we tend to be grouped with others of a like mind. So, we tend to be overconfident in our view about what might happen and be less aware of other perspectives and so that tends to mean that we make bad decisions when you get these more extreme shifts in markets and conditions and this is borne out by Morningstar’s own research on study of the impact of those timing decisions. So, mind the gap research which shows that your returns are lower when you take into account people’s timing decisions then you’d otherwise get just by staying put. So that tends to be what happens. Those are the traps that you can easily fall into.
CJ: And to what extent does a herd mentality impact investment behavior and can it be a good thing?
MC: So, I think in these situations, and this is where investing is a bit different from other forms of human activity and choice. So, if you want to find a good restaurant walking down the road seeing the ones that lots of people are in is often a pretty reliable sign that there must be something good going on there, relative to the ones where there’s nobody there at all. But with investing the things become very popular. What happens is people are forming these expectations and they’re buying and pushing up the price based on these very optimistic expectations. And whilst those optimistic expectations could occur more often than not if they get too optimistic it’s quite hard to meet them. So, you end up with disappointment and when you end up with disappointment and people are already owning a lot of something then that tends to lead to a sharp fall in the price of those assets as they decide to own less, and they adjust their expectations downwards. So, our whole investment approach for our clients is to do the fundamental research, identify how much you would pay in most circumstances to own an asset, understand whether assumptions that investors are making it too optimistic or pessimistic and those create opportunities that you can exploit.
So, it goes back to the start of this conversation which is having a long-term investment plan sticking to it. What you can as an investor do is at the very least rebalance your portfolio back to target when market movements are big. Over time that adds value because typically you’ll be buying things that have sold off too much and you’ll be selling things that have probably gone up too much. So that’s typically how we operate as well as making sure that you are not falling into this trap of getting carried away with things when they’ve gone up a lot and people are very optimistic. So, while valuation driven approach is designed to alert us to those situations. You still got to do your homework and if you’re not able to do it then people like Morningstar can help do that for you and create the portfolios but that’s the key really is having that foundation, the discipline of rebalancing and sticking to your investment strategy and not succumbing to a lemming like behavior when you’re seeing extreme headlines because that’s just the ups and downs of markets are a feature of investing and it’s a little bit like what used to be the case when you’d have a once or twice a year sale in department stores and shops.
And so investment markets give you that similar opportunity when people start to panic and assume the worst is here and that often by keeping a cool head you get the opportunity to buy things at a much better price than you’d normally be able to do it. So, these things are actually great opportunities. It’s that analogy that you hear Warren Buffett reference to and Ben Graham, Mr. Market and getting excessively optimistic or pessimistic because those are opportunities that can present themselves to pick things up from time to time. But the main thing is to stick with your investment strategy and not be knocked off course because it’s very hard to add value with any kind of market timing. You’re better off just sticking to your investment strategy.
CJ: Mike, thank you so much for taking the time out to speak to me.
MC: Thank you, Christopher.
CJ: This is Christopher Johnson from Morningstar UK.
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