Weathering Uncertain Markets Key principles for lifetime investing
Introduction Managing an investment portfolio for the long term is partly a test of willpower. Your emotions and instincts will be urging you to react to short-term news and market movements, even though your investment goals might have a longer time horizon. Discipline is vital to weathering uncertainty, but it is easier said than done. It helps to understand what s happened before and how short-term thinking could undercut your investment returns. By following some simple rules you can train yourself to prepare for whatever the future throws at you. These kinds of rules can be applied regardless of current market conditions. Globally we are in a period of relative calm, with volatility by some measures at 24-year lows. 1 This still has room to run and doesn t mean sharp market movements are inevitable. But being calm should not mean being complacent: 2018 might bring market and macroeconomic shocks that could test your resolve. Sticking with a long-term strategy and following the principles below will position your portfolio to weather uncertain markets. 1. As measured by VIX Index of implied volatility on the US S&P 500 stock index Source: Bloomberg, September 2017 2 WEATHERING UNCERTAIN MARKETS
Key points Act on insight, not instinct Your loss aversion instincts might tell you to sell in times of market stress, but you could miss value opportunities You can t see the future, but you can plan for it Sticking to a long-term strategy and staying invested is less risky than trying to time market ups and downs Diversify to manage risk Correlations tend to rise in times of market stress so make sure you are invested across traditional and alternative assets Invest with discipline Investing a fixed sum at regular intervals offers several advantages over putting in lump sums every now and then Consider the true cost of cash Holding cash might seem safe but inflation can have a dramatic impact on purchasing power over time BLACKROCK 3
Act on insight, not instinct Savvy investors have long realised that markets do not necessarily react to events in a rational manner: boom and bust cycles, together with asset bubbles and crashes, have been a feature of investing as long as markets have existed. The reason is obvious: investors are human beings, and their decisions are often driven by emotional biases rather than careful thinking. While most investors understand the theory of buying low, selling high, many people don t put it into practice and tend to fear losses more than missing out on potential gains, even if the end return would be the same. This thinking might lead you to get out of the market at the bottom of a downturn, to avoid the possibility of further losses. But if you do this you run the risk of selling low and missing out on some of the best value opportunities. The lesson is to act on insight, not instinct, and stick to your long-term strategy. Trust insight, not instinct Growth of $100,000 in MSCI Asia ex-japan, 1988-2017 $600000 500000 400000 300000 200000 100000 0 Loss aversion instinct to sell greatest here, but so are potential gains missed 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2017 Source: Bloomberg, September 2017. All figures represented in USD. 4 WEATHERING UNCERTAIN MARKETS
You can t see the future, but you can plan for it Even if knowledgeable investors are aware of their biases and can curb their lossaversion instincts, they might put too much faith in their investment skills. No matter how much information you have, it is virtually impossible to predict for any length of time exactly when markets will rise or fall. This is problematic since only a few good days can account for a large part of market s long-term total return. So one of the best ways of planning for an uncertain future is to stick to a long-term strategy and stay invested. If you miss just a few of the best days it can have a massive impact. As the following chart shows, if you made a $100,000 investment that tracked the MSCI Asia ex-japan Index and missed only the top 5 days of the past 30 years, your portfolio would now be worth $167,754 less than if you d stayed invested the whole time. The more good days you missed, the worse your performance would be. Why it pays to stay invested Hypothetical investment of US$100,000 in MSCI Asia ex-japan Index, 1 Jan 1988-8 Sept 2017 $600000 $533,824 500000 400000 $366,070 300000 $270,100 $209,336 200000 $164,365 100000 0 Stayed in Missed top 5 days Missed top 10 days Missed top 15 days Missed top 20 days Source: Bloomberg, September 2017 BLACKROCK 5
Diversify to manage risk Don t put all your eggs in one basket is equally good risk management advice for grocery shopping and investing. Not every asset class will be increasing (or decreasing) in value at the same time, so investing across a wide variety of assets should help smooth returns over time. It used to be the case that splitting investments between stocks and bonds meant you had a sufficiently diversified portfolio, because when stock markets went up typically bond markets went down and vice versa. But after the financial crisis even these assets sometimes moved in the same direction. Annual performance of selected asset classes (in USD) 2009 2010 2011 2012 79 % 19 % 17 % 19 % 32 % 15 % 8 % 18 % 28 % 12 % 5 % 17 % 26 % 9 % 2 % 16 % 13 % 8 % -1 % 4 % 4 % 8 % -12 % 2 % -10 % 5 % -18 % 0 % Emerging Market Stocks Developed Stocks ex-us Emerging Market Bonds US Equities Commodities Developed Gov't Bonds ex-us US 10 Year Treasuries 6 WEATHERING UNCERTAIN MARKETS
Though correlations have come down again in recent months, it is a fact that they tend to rise during periods of market stress, in part owing to a common instinctual urge to sell to avoid further losses. So a crucial part of weathering market stress is ensuring you have exposure to a mix of assets, including alternatives such as commodities, real estate and non-traditional investment funds. While diversification cannot guarantee profits or insure against all losses, it should mean a better risk-adjusted return overall. 2013 2014 2015 2016 32 % 14 % 1 % 12 % 23 % 11 % 1 % 11 % -1 % 6 % 1 % 11 % -3 % -2 % -1 % 10 % -5 % -3 % -6 % 2 % -7 % -5 % -15 % 2 % -8 % -33 % -33 % 0 % Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. As of 31 December 2016. Source: Bloomberg, Morningstar. U.S. stocks represented by the S&P 500 Index, developed stocks ex-u.s. by the MSCI EAFE Index, emerging market stocks by the MSCI Emerging Markets Index, U.S. bonds by the BofA/ML Current 10-Year U.S. Treasury Index, non-u.s. bonds by the Citigroup Non-USD World Government Bond Index, emerging market bonds by the JP Morgan Emerging Market Bond Index, commodities by the S&P Goldman Sachs Commodity Index. Returns in USD and include reinvestment of dividends and capital gains. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Hypothetical strategies assume 100% investment in prior year s best/worst performer on January 1 of each year. Reference to specific asset classes in this communication is for illustrative purposes only and does not constitute an offer or invitation to invest in any of the asset classes mentioned above. BLACKROCK 7
Invest with discipline One way to conquer your emotions and remove the temptation to jump in and out of the market is to set aside a defined sum to invest at regular intervals, usually once a month. This has several benefits. One is that it allows you to budget effectively. Another is that it divorces your investment plans from short-term market news, since the amount you are committing to invest doesn t change, regardless of what s happening. Finally it can actually smooth the impact of price volatility, since you will buy more shares or fund units when prices are low and fewer when prices are high. This means returns are likely to be better compared to jumping in and out or investing lump sums on an ad-hoc basis, especially since this approach also reduces the risks of mistiming investments. The benefits of this dollar cost averaging technique can be seen in the following hypothetical example. Using Illustrative strategy 2, investing a lump sum at the beginning of the year means the investor was locked into the initial price of $25 per share. The investor who committed a smaller sum each month benefitted when the share price declined, making the average cost per share lower (even though the shares still ended the year worth more than at the beginning). 8 WEATHERING UNCERTAIN MARKETS
Why dollar cost averaging works Illustrative strategy 1: Systematically invest $1,000 per month every month for a year regardless of share price Total shares purchased 617.3 $ 19.44 Average cost per share $30 25 $25 $25 $25 $27 20 $20 $20 $18 $16 $15 $15 $17 $20 15 10 5 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Shares 40 40 50 50 56 62 67 67 59 50 40 37 Illustrative strategy 2: Invest $12,000 as a lump sum at the beginning of the year 480 Total shares purchased $ 25.00 Average cost per share $30 25 $25 $25 $25 $27 20 $20 $20 $18 $16 $15 $15 $17 $20 15 10 5 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec The information provided is for illustrative purpose only and is not meant to represent the performance of any particular investment. Systematic investing does not guarantee a profit and does not protect against loss in declining markets. Systematic investing involves continuous investing so investors should consider their ability to make periodic payments in all market environments. Investing involve risk, including the possible loss of your entire principal. All figures are represented in USD. BLACKROCK 9
Consider the true cost of cash In times of uncertainty your instinct might be to convert your investments into cash. Of course, having some cash on hand for emergencies is vital, and it makes sense to have a float you can spend immediately if needed. But consider that the longer you hold cash, the less it can actually buy when inflation is taken into account (not to mention the fact that in some countries, cashing out investments might incur taxes on the realised gains). Compare, for example, the implications of holding onto sums in cash over the past 10 years (in this case, Australian, Hong Kong, Singapore or Taiwan dollars). As consumer prices have continued to rise, the purchasing power of each dollar has fallen. If you decided to hold onto HK$100,000 in cash in 2007, for example, by the end of 2016 it would only buy you around 73% of the same goods and services as it did when you started, despite having the same face value. Of course, returns on investments in other assets have to take inflation into account as well, but they offer a better chance of compensating for the loss in purchasing power of cash holdings. Cashing in or out? Implied purchasing power of 100,000 held in cash in specified currency in 2007 terms, 2007-2016 $100000 90000 80000 70000 60000 50000 40000 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 HKD AUD SGD TWD Source: CPI data from respective government statistics agencies, September 2017. NB: Figures charted are year-end values. Figures take LCU100,000 equivalent and compound annually using year-on-year percentage changes in CPI (where value for year x = (value for x-1)/(1+cpi for x)). 10 WEATHERING UNCERTAIN MARKETS
Conclusion: How to weather uncertain markets Uncertainty is a fact of life and volatility can test the resolve of even the most experienced investor. Understanding how your emotions and instincts might tempt you to make short-term decisions, as well as following the points in this guide, will help you prepare for the future whatever happens. Investors don t invest for the sake of it, of course: having clear goals and timeframes is the first step to disciplined investing. To establish these, it helps to talk with investment professionals who can review your goals and suggest strategies for how to achieve them. They can also develop an asset allocation strategy tailored to your needs and risk profile, and review your portfolio periodically to make sure it is on track. Investment professionals also have the experience to advise the best course of action in times of volatility and uncertainty. Whatever transpires, BlackRock has the expertise, insight and risk management capabilities to help you achieve your goals in any market. Ask your investment professional about BlackRock s investment management solutions. BLACKROCK 11
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