Being Defensive Makes Sense in a World Where So Many Things Can Go Wrong?

10 Mar

We are all more fearful of the pain of losses than the pleasure of gains, that is “behavioral finance”.

One of the reasons so many worry is 2011 was such a volatile year – actually one of the most volatile on record. Within the first quarter saw the FTSE 100 drop almost 10%, followed by the markets rallying back and then again in the third quarter another drop of over 18%, followed by a rally of over 12%, leaving the FTSE100 down on the year by about 5.5% but what a roller-coaster.

There were and are concerns that Greece would default on its debt, efforts by China to slow the growth of bank loans, and persistently high U.S. unemployment.The stock market is up 62% since the March 2009 low, and there clearly is still a mood of pessimism and we’re still in redemption territory for equity funds, with a high amount of cash not invested even with cash returns (net of tax) typically between 0% – 2% and inflation in the UK at 3.6%.

So what happens if inflation is higher than the rate of interest accrued, in this scenario, you make a loss in real terms.

Some believe that stocks’ relatively low valuations reflects a rational assessment of their prospects. Profit margins for companies have risen since the March 2009 lows. Profit margins could have peaked and will begin contracting in coming years. So, why pay a premium for earnings which are clearly uncertain?

Others see low valuations as normal market overreaction, so stocks are now cheap. The point is we have over-worried. China was going to have a hard landing but didn’t happen. US, UK and the developed economies was going to have a double dip recession but that again hasn’t happened. Europe was going to disintegrate under internal debt crises but, and again, that just didn’t happen. So, have the worst risks passed?Even if this is true, are investors just suffering from fatigue from the investment roller-coaster ride?

While the latest rally has helped recoup a large proportion of the losses in the latter stages of 2011, it was a particularly punishing setback. I believe it is the severity and the quickness of the fall and how long it then takes to recover, which adds the levels of fear and anxiety investors have suffered.

Over time, if things continue to progress on a step-by-step basis, people will come back to stocks. When investors do, their buying power I believe will lead the market to new highs. In the mean time, I have a foot in both camps which has led to profits in both halves of the cycle. We are poised for the next market correction (this will add additional profits). Also, this stance and asset allocation in my experience leads to profits in most market conditions, so we are well placed to take advantage of market over-reaction (to the good and to the bad).  

The bottom line is – it is very unclear what 2012 will hold but it is expected to be a roller-coast ride.

I am always shocked when I meet new clients who live in fear of the roller-coaster ride (especially the down side – losses) but either stay fully invested whatever, in the hope one day it will get better; or spend too much time trying to time the market, which is impossible.

Any questions –

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