How to plan for a market disaster

Last week one of our readers asked for some more tangible and we presume actionable advice on how to weather the current market ‘storm’. Our observation had been that so far what we had seen was more of a blip compared to what could happen if things really went wrong.

Giving ‘actionable’ advice creates a problem in that we don’t think anyone (ourselves very much included) can really tell you with any credibility what will happen in markets for the rest of the year. However, we think it is a fair question and so in this article we will consider a worst-case scenario, and how to prepare for it, versus the potential upside over the next few years described by two more likely scenarios.

RED DOOR, BLUE DOOR, GREEN DOOR

To make sense of it all, we have put these observations in the context of InvestSMART’s Diversified Portfolios, their objectives (cash plus 1% for the Conservative portfolio, cash plus 2% for the Balanced portfolio, cash plus 3% for Growth and cash plus 4% for High Growth) and the time horizons that might be suitable for each of these portfolios (three, five, seven and 10 years). We have reconfigured our Valuation Dashboard into a forward-looking scenario analysis tool that will give you an insight into potential scenarios for each of the Diversified Portfolios: best case, worst case and our current base case.

• The red line shows what might happen in a ‘GFC Mk 2 or worse’ scenario, but one in which bonds fall in value (quite the opposite happened in the GFC). In this context, the 2% or so drop for the Conservative Portfolio so far this year is really not such a big deal (that’s the little squiggle at the start of the chart on the left). Here, the ‘worst case’ scenario really is quite pessimistic in that it describes a situation where interest rates start rising not for the traditional reason (that the economy is doing well), but because inflation is rising despite recessionary conditions and many hard-pressed companies can’t borrow (think of the 1970s or Brazil now).
  There is little expectation that this will happen as we have become accustomed to being bailed out and that is exactly why it represents the worst-case scenario (markets would be very unpleasantly surprised indeed if inflation and low growth occur simultaneously). It is worth noting that even in this dire scenario an investor in the lowest risk option probably wouldn’t have done much better in cash after about three years.
• The base case is a relatively stable ‘lower for longer’ scenario where interest rates are constant or rising gently and equity markets keep their cool (generating returns of 7-9% per annum on average). In this scenario we think the base case is quite achievable but we would also hope to improve on this outcome quite considerably by making asset allocation changes on the way through (we obviously can’t show that line as we don’t know what those changes will be yet).
• The green line would certainly be very welcome and would most likely be considered a success by the central banks. This might involve some more assertive intervention by both central banks and governments in the short term followed by a rise in economic productivity in a few years. It feels unlikely right now but again maybe that’s the point.

As bond yields loom low and equities still offer OK yields, the prognosis for the buy-and-hold investor steadily improves as you move out of the risk spectrum and allow yourself time to recover. The charts show the three scenarios over five, seven and 10 years compared with alternatives of cash plus 2%, 3% and 4%.

By the time we get to seven years and 10 years out respectively for the Growth and High Growth portfolios we think there is a fairly high probability the portfolios will exceed their objectives. Even better, the worst-case scenario does not leave you materially worse off as long as you stick to your guns and don’t crystallise those losses by bailing out at the bottom of the market if the worst happens.

THE HUMAN ELEMENT

In all the scenarios we’ve shown investors will at least do OK if they stick to their guns — but there is an even worse scenario! That is the one where an investor thinks they are OK with the risk shown here until they experience it.

There is great danger when investors follow markets down and then somewhere near the bottom they switch to cash and thus miss out on the upswing on the other side. That is why we think it is a good idea to consider the risks involved ahead of time and in a future article we will talk a little more about the psychological challenges the investor will face in those scenarios.

This may all sound like the usual ‘invest for the long term and she’ll be right’ mantra that we heard prior to the GFC and which doesn’t sound so credible these days. Not so. As we showed last week, the world looks very different right now: expected risk premiums for equities were not so favourable back in 2007 while bond investors literally couldn’t fail to outperform cash by several percentage points (given relatively high government bond yields).

REMEMBER THE LONG GAME