Markets in disarray are where long-term investors make their money. Investing countercyclically – when many others without long-term liquidity are selling – is a clear advantage for long-term investors. Investors that perform the best over the long term will have taken calculated and deliberate risks and put money to work during crises like this one.
But how? While we didn’t predict a pandemic, FCLTGlobal had market events like this one in mind when we published Balancing Act: Managing Risk for Multiple Time Horizons, and that research provides tools that long-term investors can use right now.
Rebalancing consistently with your fund’s policy is one such tool.
Take for example a message that one of us sent last week in the capacity of an endowment trustee advising the full board: “Panic is contributing to the market crash and, when we see opportunities to buy fundamentally-strong assets at a discount, we will. This may create the short-term appearance of compounding our losses, but the long-term effect of buying low will be an opportunity to sell high in the future, add real value to our fund, and increase grant-making.”
Research associated with Balancing Act discusses why each part of this message is important. It explains the investment tactics in terms of the organization’s purpose: whether that is grant-making, building retirement savings, or funding liabilities. It sets expectations honestly: our tactics are going to make things seem worse before they seem better, but it’s worth it for fulfilling our purpose. And it defines the tactic – rebalancing consistently with policy – in terms that will be familiar to a range of stakeholders, not just the finance people: buying fundamentally strong assets at a discount.
Behavioral scientists note the importance of the framing effect, particularly as we react more strongly to losses that we do to gains. Rather than framing the conversation around peak to trough losses, investors that track how they are progressing towards their long-term goals – even if they may have taken steps back from their goals through this time – are more likely to be confident in their decision to proceed with rebalancing in down equity markets.
Drawing on set-aside funds is another tool that long-term investors can use right now. The way to permanently impair capital in a down market is to sell positions, realize losses and remove the ability to bounce back. Crises like this are why set-asides exist. Using the set-aside money for liquidity spares organizations from having to realize losses in the core portfolio.
We all recognize this “mental-accounting” behavior. This same endowment uses exactly this sort of set-aside account to shelter eighteen months’ worth of grantmaking and operational costs from market risk. Having that resource adds to the organization’s liquidity and the board’s confidence in a way that makes rebalancing possible.
True impairment means becoming unable to do the organization’s work or fulfill its purpose. This set-aside, or rainy-day fund, provides the staying power to continue the work long enough for markets to rebound. Furthermore, because the organization has the set-aside as a source of funding during down markets, there is more patience with performance in the core investment account – even to the level of being willing to rebalance into highly-volatile markets.
All of these mechanisms reflect plans put in place long before the crisis. Ideally, investors have planned strategically and calmly as portfolio and investment allocations are made, rather than allocating capital based on the emotions of a particular day’s or week’s disturbances.
Every investor will be in different positions of planning, using set-asides, and rebalancing. The key long-term behavior is not arriving at a single right answer, but having these tools come together in a strategic and internally coherent way with respect to each investor’s purpose.
Risk models or historical statistics will not provide a definitive answer about how to invest in markets like these. We typically think in terms of probabilities over an investment time period. However, the most common projections of risk – probability of loss and value-at-risk – pertain only to the end point of the investment, not to the pathway. What is important is to account for multiple time horizons within risk models with such statistics such as “first-passage” or “within-horizon” probability of loss and value-at-risk.
Let’s take for example a $100m allocation with a value-at-risk of $10m according to a 95% confidence interval. In more common language, this means that the investment will have an ending value of $90m or more in all but five cases out of a hundred. What the statistic does not mean, though, is that the valuation of this investment will remain above $90m throughout the investment horizon in all but five cases out of a hundred. Quite the contrary: it is a statistical truism that the likelihood of a temporary dip in valuation below $90m is much higher. Statistical inference allows us to compute the maximum drawdown that the same investment may experience within its horizon with equal probability. Just for the sake of illustration, the within-horizon value-at-risk of this same investment could be $30m. And, of course, these value-at-risk models do not tell us at what happens in those five cases out of a hundred when the outcome is beyond the band.
Additionally, the benefit of estimating risk across multiple time horizons is not just mathematical. Having interim and final figures provides a frame to everyone involved, both for risk professionals and others, like board directors, so that they expect the pathway to be bumpy even if they are headed to the right destination. Managing expectations to be realistic is an essential long-term behavior: it reduces surprises, which in turn reduces short-term reactions.
The COVID-19 pandemic presents an extremely difficult short-term crisis, but nearly all long-term investors will have an investment horizon beyond this pandemic. Focusing on that horizon will help us use our risk models better; and will ultimately help us perform better too.
Yet, even with these improvements in how we use risk statistics, human behavior underlies financial markets, and no unified set of statistical assumptions encompasses these behaviors, much less the ways that they interact, particularly in times of crisis.
In these times, a long-term investor will understand that the world has moved outside of statistical probability and that human behavior will affect both our response to the pandemic and the risk and return that financial markets produce. Long-term investors recognize that this crisis presents a leadership opportunity to contribute to outcomes that fulfill our organizations’ purposes.
Sarah K. Williamson and Matthew Leatherman are CEO and Research Director at FCLTGlobal, respectively. FCLTGlobal is a non-profit organization that develops research and tools that encourage long-term investing. Its membership is comprised of global asset owners, asset managers, and companies that play a leading role in rebalancing capital markets for sustainable growth. Further research and practical toolkits are available at www.fcltglobal.org.