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Fortune favors the prepared

February 3, 2021

reading time: 5 minutes

by Johannes Oehri, Senior Economist, LGT Capital Partners

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Keeping a cool head when the stock markets are turbulent is often difficult – but it is crucial for long-term investment success. Investors who make preparations when things are calm can weigh up opportunities and risks in a balanced manner and maybe even make calculated acquisitions when the heat is on.

The new decade began with a bang. 2020 has been a year that most people certainly won’t forget so quickly. It has been extremely challenging in many respects – and that includes for investors. It has been a year of extremes and contrasts for the economy and the financial markets, featuring the deepest and fastest global economic nosedive of all time, but also probably the shortest recession. The fastest bear market in history, but also the quickest recovery. This kind of environment offers long-term investors attractive investment opportunities, but unfortunately only a few tend to take advantage of them.

Compared with speculators, who focus on monthly or even daily returns, investors generally measure their financial success over a longer period. As such, the main risk investors face is not volatility, but a permanent loss of capital and the associated threat to their long-term investment goals. However, that is precisely where their advantage lies: they have more staying power and can better tolerate temporary price losses. This basically means that they run less risk of losing their bearings at the height of a general panic and are less likely to sell off long-term investments unless they have to. Instead, they should literally capitalize on their advantage by buying long-term value-adding investments at favorable prices during severe market distortions. It is how one behaves in precisely these occasional stock market turbulences that sets successful investors apart from also-rans over the long term. Napoleon Bonaparte is said to have defined a military genius as “the man who can do the average thing when everyone else around him is losing his mind.” The same is true of successful investing: most long-term success comes from keeping a cool head during occasional periods of market panic.

Irrational aversion to loss

That is of course easier said than done: we are all quick to give credence to the harbingers of doom in the media, who vie for our attention with frightening horror stories and make us forget the long-term view. That is because we humans have a fundamental preference for security and an irrational aversion to loss. For example, experiments done by Daniel Kahneman and Amos Tversky, the founding fathers of behavioral finance, showed that our distress at a financial loss is about twice as great as our happiness about a profit of the same size – the psychological impact is therefore unequal. This cognitive distortion prompts us to make irrational decisions. Because we weigh opportunities and risks differently, we run the risk of selling long-term investments after sharp corrections due to uncertainty and fear of further price losses. But it can then prove difficult to start investing again. Initially, the environment remains uncertain and we want to wait until the fog lifts – but as soon as the haze of uncertainty clears, the stock markets have already priced in the improvement. At that point, we do not want to chase after rising prices and would rather wait again for a more favorable buying opportunity. This means that while the risk reduction may bring short-term emotional relief, it can be painful in the long run – because the compounding effect amplifies even minor missed bull phases, resulting in lower financial returns over the years.

Prepare for sharp corrections
Prepare for sharp corrections

What can investors do to counteract this? Get prepared! Because even if the stock markets rise in the long term, there will inevitably be sharp corrections at some point. We now all carry devices around with us that give us access to global negative headlines anytime, anywhere. As a result, bad news spreads faster than a virus and short-term overreactions are probably even more common than before. If one prepares for this, the psychological effect can be reversed at the decisive moment and, instead of focusing on the risks, increase the awareness of the opportunities arising.

Integrating findings of behavioral finance

As a long-term investor, LGT Capital Partners has also prepared itself accordingly. We have been explicitly incorporating the findings of behavioral finance into our investment processes for many years. In our strategic asset allocation, we use the scenario approach to systematically address negative future paths and their impact on asset prices. And in order to be prepared for strong corrections, such as in March 2020, and to be able to benefit from opportunities as they arise, we have included a countercyclical component in the investment process of the portfolio we manage for the Princely Family of Liechtenstein (Princely Strategy) since 2012. In quiet times, we calmly and carefully set out the conditions for various asset classes – such as valuation levels and investors’ sentiment – at which we consider strategic acquisitions to be opportune for the Princely Strategy amid all the uncertainty and stress of a sharp correction. We focus on questions such as: At what level of credit spreads do high yield bonds price in a default cycle on a historically unprecedented scale? At what level can discounts for listed private equity investments no longer be fundamentally justified, even in a recession? This approach reduces complexity in turbulent times and provides support. The conditions are defined conservatively with the aim of unlocking significant gains in the value of the investments in question over one to two years. Of course, such acquisitions are never made automatically, but are always subject to the critical veto of the experienced investment committee of the Princely Strategy, which takes equal account of opportunities and risks. The acquisitions are sold as soon as market conditions and the valuation metrics under consideration have normalized.

This article has originally been published on the LGT finance blog (German only)

 Pictures: Shutterstock

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