How to handle the global market contagion

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Just as social isolation is being used to slow the halt of the virus, distancing yourself from share market panic is the best way to protect your wealth. But nobody said it was easy.

Behavioural economics has taught us that people fear losses twice as much as they value gains. And fear makes us behave irrationally, from panic buying of toilet paper to panic selling of shares.

Share market rollercoaster

Australian shares have fallen over 30% since the record peak in February. US and European shares have suffered similar falls, while Asian markets are slightly ahead on the coronavirus curve and hence have posted slightly lower falls over the past month.

Along the way the market has whiplashed between record daily falls and record daily gains, only to plunge again.

This is a sure sign of a market gripped by fear and uncertainty and this is likely to continue until the peak of the coronavirus pandemic passes and there is more clarity about its impact on the domestic and global economy.

At this point in the market sell-off, it’s worth remembering that your losses are on paper only unless you sell and make them real.

It’s also important to understand that shares are only part of the investment mix. Most super fund members are in a diversified investment option with a mix of growth assets (mostly shares and listed property) and defensive assets (cash and bonds).

Even so, the temptation is to act now to avoid the pain of even more losses. However, history teaches us that it is near impossible to time the markets.

The perils of trying to time the market

Trying to time your entry and exit points while the market is gripped by panic rarely ends well. You may avoid some of the losses, but you also risk missing the inevitable recovery. 

As market wisdom states, it’s time in the market that counts, not timing the market.

Experienced investors are likely to have a process in place where they periodically rebalance their portfolios, taking profits in a rising market and shifting money to cash and conservative investments in anticipation of a downturn.

With the wisdom of hindsight, the time to rebalance and de-risk has passed for the moment. It may seem counter-intuitive, but the best thing to do in a crisis is often nothing.

The lessons of history

During the GFC, many retirees sold shares and moved to cash. At the time, term deposit rates were around 7-8% and came with a government guarantee, while the dividend yield on shares was around 4%.

Fast forward a little over 10 years and dividend yields are still around 4% but term deposit rates are less than half that and falling.

In the long run, many investors would have been better staying the course.

Dr Shane Oliver, head of investment strategy and chief economist at AMP Capital points out that someone who remained fully invested in shares over the past 25 years would have enjoyed an average annual return of 8% a year. Avoiding the 10 worst days over that period would have boosted your return to 11% a year. But if you missed the 10 best days, your return would drop to 6.1% a year.

Missing the best days and the worst days

Return on Australian shares, % per year (All Ords Accumulation Index, 1995-2020)

Source: AMP Capital

According to Chant West, the median growth superannuation fund (where most Australians are invested) returned 7.9% a year in the 10 years to February 2020 and 6.9% a year over 15 years. Pension fund returns are slightly higher due to their tax-free status.

What does this mean for my super?

By its very nature, superannuation is an investment measured in decades not days, so it pays to think long-term and avoid any knee-jerk reactions to short-term market fluctuations.

Rather than hit the eject button, now is the time to plan your long-term strategy if you haven’t already done so.  Your strategy will be determined by your age and stage of life and your risk tolerance.

Younger super members

If retirement is still a way off, then time is on your side. Younger super fund members can afford to have their money in a growth option in the knowledge that the trade-off for higher risk is higher returns in the long run.

However, the current market sell-off is the first major downturn many younger super fund members have experienced. It is also likely to coincide with the first recession in Australia for almost 30 years.

That makes this a perfect time for younger super members to reassess their risk tolerance in a real-world scenario rather than in theory.

If you find a big market fall keeps you awake at night, then you might consider switching from a high growth or growth option to a more balanced investment mix. But not until the crisis has passed and you are able to consider your options in a calmer state of mind.

Close to or recently retired

The timing of a market downturn is most challenging for people who are on the verge of retirement or recently retired. This is what some researchers refer to as the ‘risk zone’.

For members shifting their super savings into a pension account, a market fall while they are in the risk zone will reduce the pool of savings they have to draw down on. This is known as sequencing risk.

Simply shifting your super into a pension account will not require the sale of assets, or the crystallisation of losses, provided you remain in the same risk category. For example, if you move from your fund’s balanced option into its pension account balanced option, then there is no buying or selling of assets required. However, if you shift from a balanced to a conservative option, for example, there will be some selling of growth assets.

Even so, there’s no getting around the requirement to make minimum pension withdrawals each year, between 4% and 14% of your pension account balance depending on your age.

In the aftermath of the GFC, the government reduced the minimum drawdown amounts to protect retirees from having to crystallise losses and unnecessarily eat into their savings. It is likely that the severity of the current downturn will prompt a similar move, so stay tuned.

See also: What to do if the market tanks and you’re retired, or close to it

Managing sequencing risk

One way to avoid sequencing risk is to make your minimum pension withdrawals from the cash component of your pension fund

Most advisers recommend having enough cash to cover your living expenses for two to three years. That allows you to hold the rest of your savings in a diversified investment option to capture future market growth for your longer-term income needs.

If you haven’t retired yet, you might consider working a little longer to build up your savings and allow the market to stabilise.

Many new retirees plan to make a lump sum withdrawal from their super on retirement to pay for a caravan, an extended overseas trip, home renovations or to pay off the mortgage. If possible, consider delaying or adjusting your plans to avoid a major drawdown of funds during the market sell-off.

Older retirees

Older retirees have enjoyed some excellent market conditions during their early retirement years, so sequencing risk is not such an issue. However, many will be understandably worried about the risk that their money may run out sooner rather than later.

While tempting, older retirees should also avoid cashing in their shares after big market falls. Provided you have enough cash to tide you over, local and international shares will provide the best returns in the long run.

Given that many retirees can expect to live into their 90s, even someone in their early 80s stands to benefit from the inevitable market recovery. In the meantime, you will still receive franked dividends from your shares to help meet your income needs.

Whereas, if an older retiree were to cash in their super now and put it in the bank, they would not be able to get it back into super if they have a change of heart when the market bounces back. Fear of loss can quickly turn to regret about missed opportunities.

Fortune favours the brave

History tells us that the market will recover, and bargains will emerge, but we’re not there yet.

Just as a rising tide lifts all boats, a receding tide drags down good companies along with the bad. At some point, quality companies that survive this bad patch will present buying opportunities.

Until then, the safest thing to do is to avoid turning your paper losses into real ones. So sit on your hands and ride out the volatility, then enjoy the upswing when it comes.