We are currently living through an interesting environment marked by rising mortgage costs and escalating costs of living due to inflation. In response to these economic challenges, there is a growing need to make your capital work for you. Many investors have chosen to achieve this by embracing growth assets within their portfolios. However, when the market encounters significant downturns, as demonstrated by the COVID-19 crisis, it’s human nature to succumb to fear, leading to investors shifting their investments towards defensive assets or cash. This risk-averting behaviour is particularly common amongst retirees and pre-retirees, who tend to fear losses far more than they value gains, and rightly so, given their heightened exposure to sequencing risk.
Unfortunately, this de-risking trade can prove detrimental to investors when markets eventually bounce back. In this discussion, we will explore the importance of staying invested during times of crisis.
Consider two investors, both initially investing $100,000 into a standard 70/301 growth portfolio at the beginning of 2008. Investor A chooses to remain invested in the growth portfolio for the entire period, throughout market crises, such as the global financial crisis (GFC) and COVID-19 pandemic, and subsequent market recoveries.
On the other hand, a hypothetical Investor B is more risk-averse, has a tendency to become increasingly nervous during market downturns and is more prone to de-risk their investment portfolio. For simplicity, let’s assume this investor is also in the 70/30 growth portfolio, but switches out of equities into cash for three months each time they experience a 15% fall in their portfolio.
The chart in Figure 1 offers a visual representation of the cumulative performance of the two investors spanning from January 2008 to June 2023. The data unequivocally demonstrates the contrasting outcomes for Investor A and Investor B.
Figure 1: Investors A and B, cumulative performance, January 2008 to June 2023
Investor A’s portfolio has exhibited strong growth over the past 15+ years, from an initial amount of $100,000 to $257,000. On the other hand, Investor B’s portfolio, though respectable at $213,000 during the same period, falls short by approximately 17% (or 1.1% annualised) when compared to the wealth amassed by Investor A.
This divergence in performance can be attributed to Investor B’s inclination to de-risk their portfolio during market turbulence, driven by understandable nervousness. Unfortunately, this resulted in crystallised losses and missed opportunities for subsequent market recoveries, ultimately leading to a less favourable financial outcome in the long-term.
It is important to recognise that this innate fear and flight to safety response during market crisis events is just human nature and is particularly tempting for those approaching retirement or in retirement. This is precisely where risk management strategies can be utilised to reduce the impact of large market drawdowns, giving investors more confidence to stay invested.
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1 A 70/30 growth portfolio consists of 35% ASX200 Total Return Index, 35% MSCI World ex Australia Net Total Return Index (AUD Unhedged), 14% Bloomberg AusBond Composite 0+ Yr Index, 14% Bloomberg Barclays Global-Aggregate Total Return Index (AUD Hedged) and 2% Bloomberg AusBond Bank Bill Index.