Financial Storm Warning - A Survival Guide

August 2011

World financial markets are in turmoil again as fund managers and investors lose confidence and sell off billions of dollars worth of shares.

Australian share prices have fallen by more than 7% in the past three days with a staggering 4% being wiped off share prices in Friday 5 August's morning trading alone.

The positive market trends are over for the time being leaving the majority of people with depleted superannuation savings and a dazed and duped feeling.

The closest most of us come to experiencing the impact of these types of events is via our investment in superannuation.  Superannuation funds invest in a variety of asset classes with shares – both local and international, being just one of several common options.  The others can include cash, fixed interest, bonds, and property and infrastructure projects.

This sell-off is so widespread that no matter which shares a superannuation fund holds, current events will have a negative impact on short-term performance.

So, what should we do?

Firstly, don’t despair. Take a deep breath but waste no time. Read the following insights and afterwards if you need some further reassurance we recommend you not speak with the average man or women in the street. Chances are good they’ll offer you sympathy and a sorry tale but little wisdom.

How to Survive The Storm

Like others before it, this financial storm will soon be over and unfortunately for some people the opportunity will be squandered.  It’s when we have financial market turmoil based on such widespread fear that disproportionate wealth can be created.

To understand the real opportunity we’re now presented with, we must look at investing differently from how the general population (‘the masses’) see it.

We must behave as smart investors.

Smart Investor Behaviour

Smart investors are those with an understanding of how the current market chaos aligns with long-term trends.  Sharemarkets are volatile. Since the early 1980’s the asset class has lost at least 10% of its value every two to six years.  On four of those eight occasions it lost more than 20% of its value.  So why invest in shares? Over the same period shares have grown by an average of 12% per annum.

Smart Investors understand that getting out of the share-market isn’t what’s difficult, it’s knowing when to get back in.  When sharemarkets begin to tumble, people often kick themselves for not cashing in earlier.  Just as no one ever sounds the bell when it’s time to sell at the top of the market, likewise, no one calls to tell you when it’s safe to get back in.  Smart investors understand that when markets rebound, they can do so very quickly.  It’s not uncommon for the first few weeks of a rebound rally to see share prices increase by eight to twelve percent.

A ‘get out’ and ‘get back in’ approach has other less obvious consequences.  In public offer superannuation funds such as industry super funds, fees called buy / sell fees are incurred when we buy or sell our share fund.  These reflect the brokerage and transaction costs incurred by the fund’s managers and they are passed on to the member.  If the shares have grown in value then the fund may also have to pay capital gains tax.  These costs often make the decision to get out and get back in less appealing.

Rule One of Investing:  Our attitude to investment risk and our need for investment returns should determine our asset allocation.  Determining our asset allocation means deciding how much (in percentage terms) of our money will be invested in shares versus other asset classes such as cash, fixed interest, property and infrastructure projects.

Rule Two of Investing:  Our asset allocation will largely determine the long-term behaviour of our investment. Smart investors know and understand the importance of having and maintaining an asset allocation strategy that’s right for them.  This provides them with a very clear set of rules by which to invest.  In being true to this approach, it’s common for smart investors to be buying additional shares when sharemarket turmoil is present.  The reason is that as share prices drop, the percentage shares represent of the investor’s overall portfolio reduces.  To return the portfolio to its long-term strategic asset allocation, shareholdings need to be topped up.

Although it may seem strange, investors and fund managers often want different things when it comes to investing.  Investors want great long-term returns, fund managers want good short-term performance and to remain employed.
If people do not manage their own superannuation fund or haven’t engaged WealthSpan to provide them with direct share advice through an industry fund, they most probably have a fund manager making the investment decisions for them.
Fund manager’s reputations and careers can be made or lost during times like this.
The reason is that fund manager performance (read bonus and job security) is measured over very short periods of time.  Six to twelve months is common.  Fund managers therefore do not have the luxury of buying an Australian company at a bargain price and waiting two years for it to produce excellent results.  This short term motivation misaligns most fund managers with one of the most successful long term investment approaches; buying quality shares when prices are low and holding them indefinitely.

Smart investor’s will where practical and cost effective; hold Australian blue chip shares directly rather than via a fund manager.  This may be inside or outside a superannuation fund.  This enables them to limit share turnover (buys and sells), reduce transaction costs and tax, and to take a long-term approach to investing.
New Year Sale:  It’s easy to spot a bargain at Myers or at a car dealership.  Comparing prices of the same or similar products isn’t too difficult.  Believe it or not, identifying a bargain on the share market is very similar.
With training and experience identifying quality businesses that are for sale on the sharemarket at a bargain prices is not too difficult.  What is more difficult is predicting how long they will take to return to their true and proper value.
For investors with time on their side – six, twelve or eighteen months is not too long to wait for an outstanding business to return to form.

Today we are spoiled for choice.  Many of Australia’s leading businesses are currently selling for prices 25 to 40% less than we believe they are worth.  Throughout the global financial challenge, most of these blue chip firms increased profits and grew in size, yet their values haven’t changed much.

The recent market turmoil has caused major concern for many investors.  While the world certainly has many macroeconomic issues to attend to, the Australian economy remains very robust.   Our markets have been caught up in the chaos that is Greece, the USA and Europe.  Some of it makes sense, most doesn’t.

A Final Thought

It’s uncommon to be brave while others are fearful and yet that’s exactly what smart investing is based upon.  I’m confident that Westpac, BHP and Woolworths among many others, will all be around in twenty years time, more profitable and more valuable than they are today.

The sharemarket is not a means unto itself; it’s a convenient way to buy shares in quality businesses.

For some strange reason, fund managers, the media and the masses have momentarily forgotten this.

Make hay, we suspect the stupidity want last for long.

Subsequent Note: Since this piece was written the market hit a low of 4056 on 8 August. On 2 September it was trading 6.5% higher at 4321 points. If you did move to cash when the panick was on, it will take over 18 months for your funds to increase by 6.5%.