By Fidelity Editorial
Fear and uncertainty can kill investment returns. And the new Covid-19 coronavirus outbreak, in particular its impact on global equity markets, is a good example of both. US stocks fell more than 4 per cent on Thursday after several sessions of sharp selloffs. Volatility is rising across the spectrum of risk assets on investor concerns the outbreak that began in China is spreading deeper into more countries around the world, and threatens to hurt economic activity. Investors' attention is shifting to the potential dimensions of the fiscal and monetary policy response from those economies impacted by the coronavirus - already, China has lead the way with a proactive stimulus package, and more measures are expected. Policymakers in Europe and United States are likely to follow but how much capacity they have to act and what shape their stimulus approaches will take remains to be seen. The key question now is: how should investors respond to this kind of uncertainty and the volatility it may create?
At times like these, it is worth identifying behavioural biases and adhering to some key investment principles. The most obvious response to this kind of situation is fear, which is hardwired into human behaviour and developed as a way to respond quickly to danger. However, it’s not particularly good at keeping investments out of harm’s way. Such emotions are a product of cognitive bias. A type of bias occurs when investors focus on the most recent news to make decisions (recency bias), rather than looking at historical examples and taking a longer-term view. As Warren Buffett said: “What we learn from history is that people do not learn from history. When investors get either too fearful or too greedy, sometimes they hide behind the notion that this time is different. Usually they regret it.”
Herding bias is also a deep-rooted behaviour that leads people to follow the actions of a larger group, trusting the ‘wisdom’ of the crowd, even when it is irrational. The signal of markets rising or falling spurs others to act and follow the trend. But when markets are volatile this can have an adverse effect. By selling in a falling market, for example, when China onshore stock markets reopened after the New Year holiday, an investor might miss out on a subsequent recovery. Similarly, following an exuberant herd into a bubble can lead to losses over the long term.
Finally, studies have shown that investors are more sensitive to losses than to gains, which produces behaviour aimed at avoiding losses rather than maximising investment returns. This is obviously particularly acute when asset prices are falling.
Adhere to investment principles
As well as being aware of, and managing biases, it is also important to re-examine your portfolio and check it reflects key investment principles. These include being well-diversified; in the current context that could mean adding exposure to some assets that can benefit from a flight to safety as the virus spreads and others that are positioned for any snap-back once conditions return to normal. It is especially important to avoid trying to time the market, which has been shown to hurt long-term returns across a range of asset classes (see chart).
As we have seen, markets can react sharply to potential threats, but they can also quickly stabilise and then eventually recover. Therefore, it is important not to focus too much on short-term swings, however powerful they may seem, and instead invest in quality companies that can continue to deliver sustainable returns over the long term.