In my conversations with some clients, I am frequently asked when we will see a large drop in financial markets. It’s typically asked by clients who have patiently been waiting in cash, because they are convinced that when they do invest, the markets will almost immediately sell off significantly. And often those same clients have seen crashes, but considered it too risky to invest “just yet”.

And I can understand these concerns. Bombarded by information about the ongoing uncertainty in life, investors scan daily headlines related to fumbled macroeconomic and company responses to the pandemic. They see the increasing numbers published for inflation and the speculation about whether central banks’ responses will be good enough. And there’s that constant drip of comments highlighting just how expensive equity valuations are, especially in the US, and that prices “have” to collapse soon.

There is good news as well, but it doesn’t sell newspapers and so it’s not visible. It’s the negative that causes us to press pause. It creates a certainty that something must be about to go wrong – perhaps very wrong – and prompts apprehension. These thoughts chime psychologically too – after all, as Daniel Kahneman and Amos Tversky demonstrated in 1992, the fear of loss is deemed to be at least twice as powerful as the exhilaration of an actual gain.

So, given valuations, inflation, the possibility that COVID-19 just doesn’t go away, political tensions, indebtedness (and I can continue) what should you do, particularly if you have been watching the markets, waiting for the ’imminent crash‘? You feel you have to do something given inflation is gradually decreasing the real value of your money and equities are climbing ever higher, but is now really the right time to move?

We cannot predict the future, neither can you, but we can outline your options, which may help give you clarity in these uncertain times:  

  • Option one – remain 100% in cash in the hope that a market correction occurs, with the view of investing at or close to the ‘bottom’. 
  • Option two – explore investing in a more cautious strategy than we would typically recommend in order to achieve your objectives, with the intention of increasing your equity holdings if a market correction occurs (or as you become more comfortable with an increased exposure to global stocks).
  • Option three – invest in the most appropriate strategy to meet your financial goals, but not without having examined how your goals might be compromised if a crash does occur.

Let’s examine the pros and cons for each route.

Option one – remain in cash

The advantage is:

  • If a crash occurs you might be able to take advantage of a better price. We say might as research tells us the opportunity to invest at that better price is usually missed.

The disadvantages are:

  • Your capital would be impacted by inflation and the potential loss of purchasing power.
  • Markets may continue to climb higher, pushing up the eventual cost of the asset purchases even further and making the decision as to when to invest ever more difficult, as well as seeing the opportunity cost for holding back really hit home.
  • Markets could move sideways, which (although this doesn’t sound like it) is a risk given cash is still not generating any income, whereas shares, bonds and property typically would – even if the prices move sideways.

We would emphasise that, even if there is a correction, statistically most investors remain in cash when this occurs. Fear leads to inaction. It takes some nerve to buy when everyone else is selling. Aside from this, add the difficulty in timing the bottom of a correction. It is human nature to want the best outcome possible, which means people end up missing the boat – even if you sense the fall was due and were ‘primed’, despite being told it’s the best time to invest.

Option 2 – exploring a cautious investment strategy

Seen as an interim strategy to an eventual portfolio with a more substantial allocation to equities, this is different to the approach most wealth managers often advocate. Normally, pound cost averaging would be recommended, which sees you dripping funds into the market over time rather than investing all your cash at once. Although the theory sounds plausible, multiple studies have proven that it normally leads to worse outcomes, while only marginally cushioning the ups and downs.

Instead, we would recommend a lower risk option that acts as a stepping stone to your eventual portfolio. This has the following possible advantages:

  • You’re hedging against the possibility that markets could continue to rise by buying some of your equity exposure now, while reserving the right to buy more equity if you are right and markets crash.
  • You follow this trajectory with a ‘positive carry’ from other asset classes, i.e. you benefit from the returns/yields in the bonds, property and alternative investments also held in your portfolio, which could also appreciate in value.

The disadvantages would be:

  • If markets go down, you own some equities that you could have bought at a cheaper price.
  • If markets go up, you could have bought your full allocation to equities at a cheaper price.

Option three – selecting the portfolio best placed to meet your long-term objectives

Before going into the advantages of this option, it is worth stressing that we consider scenarios which envisage a substantial market crash when advising you. We would never encourage you to invest without examining the impact of a selloff on your financial goals. We call this your capacity for loss. We routinely model crashes for our clients, not only to examine the impact it would have on their wealth goals, but also to prepare for this eventuality. The best trading days in markets often follow the worst ones, so the last thing we would want our clients to do is panic and sell out during a downturn.

The advantages to this approach could be:

  • Over the long term, this has the best probability of meeting any financial goals you and your private banker might have identified over your preferred timeline.
  • You invest having considered negative, as well as positive, scenarios.

The disadvantages might be:

  • You might panic and sell out at the wrong time (admittedly this is less likely if we’ve modelled the implications of a crash as part of the planning process to invest).
  • You could wish you had waited – although then we are back to the question “would you have actually invested?”

So what should you do?

Speak to your private banker. Understand the right options for you. Then make an informed choice.

Markets increase in value 80% of the time, although that’s not in a straight line. Meanwhile, if you plan to wait for that 5% dip, this might occur given it has a 74% probability* – quite good odds. However, that means that a quarter of the time (26%), the dip doesn’t happen. In this case, was it worth it for 5% and forgoing the yield some assets could generate?

It is also worth acknowledging that most investors are waiting for a greater sell off than a paltry 5%, often at least in excess of 20%.  The odds if this is what you are waiting for aren’t as great. 20% falls happened only 38% of the time and usually not everything drops in value at the same time. Additionally, we might have profit taken on your behalf, as well as received dividends.

Although, like Chicken Licken, the press runs around shouting that the sky is falling, there are many reasons why markets could continue to rise, which include:

  1. We are in a an expansionary phase, with a benign environment for equities – it’s the supply of goods holding things back, not the demand
  2. We cannot label all markets as “expensive”. Valuations across countries and sectors vary.
  3. There is little to no return available from lower risk investments, therefore equities will remain well supported until governments raise rates. Even if there is a crash, there are many investors waiting on the sidelines for an opportunity to invest, so a crash could be very short lived
  4. If you look at an aggregate of valuations, investor leverage, cash sitting on the side-lines, investor sentiment and the supply of equities, all of which are indicators of speculation present in markets, the sum is still at a very low level. Governments have flooded the financial system with cash and much of it is making its way into the equity markets at a time when equities are in limited supply.

Finally, although I have given you lots of objective reasons why the market might go up or down – there are also behavioural biases to consider: investors want prices to go up, traders want prices to go up, politicians want prices to go up, the Fed wants prices to go up…

Investing necessitates taking risk, which is uncomfortable, but there are ways in which your investment journey can be made smoother as opposed to remaining in cash and accepting the inevitable erosion of your capital.