Mark Northway: Investors should avoid crisis decision-making by following the rules

Wild moves in markets can present opportunities but investors must refrain from being led astray by cheap prices, writes Mark Northway

Pressure on investors is at its most extreme during market shocks.

Significant price falls can create opportunities but investors must be cautious about snapping up unfamiliar investments just because they are cheap.

Fighting fear

Warren Buffett’s maxim of being greedy when others are fearful rings the most true during times of extreme stress.

The so-called fear index, the CBOE Volatility index, hit its highest level since the depths of the 2008/09 financial crisis on 16 March, highlighting just how nervous investors are.

But money managers must avoid bargains that could throw their strategy off course.

It might seem appealing to buy into a sector or individual stock because it has never been so cheap, or to ramp up equity exposure beyond usual limits because risk has never been so discounted. But this can too often be a mistake.

In most cases, the most sensible approach is for investors simply to adhere to the strategy they employ during less volatile markets.

Stay focused

Every crisis is different and has the capacity to lead to any one of a myriad of potential outcomes.

More importantly, no investor can legitimately claim that their style or process can accurately guide them through this or any other crisis.

The best that clients can hope for is that their investment manager holds true to the risk parameters attached to their fund or portfolio, regardless of the storm blowing in markets.

Deviation from this means that managers are taking active decisions aimed at achieving increasingly illusive skill-based outperformance, or alpha.

Few investors – even passive disciples – can legitimately claim alpha doesn’t exist, but its infrequency and fleeting longevity mean that only a handful of active managers globally genuinely deliver it.

Study the evidence

Academic research, the likes of which informs our own evidence-based investing approach, suggests that sources of alpha have dwindled in recent decades.

In the 1960s when William F Sharpe established the concept of alpha, the huge information asymmetry meant that professional fund managers could relatively easily outperform the average investor.

But in the digital age where information is abundant and electronic traders can buy and sell at the blink of an eye, this advantage has been severely eroded.

The success rate of an investor who picks individual stocks has fallen, and the outcome is unlikely to improve during extreme market moves.

In a crisis, active investors need to make two correct decisions: when to sell and when to buy again. Resisting the urge to intervene reduces the human tendency to mistime that crucial second decision.

The investors who are likely to emerge best from a crisis are those that steadfastly maintain their process and asset allocation in line with pre-established risk tolerances.

Restoring balance

Those with a rigid process do need to restore their asset class and sector weightings as their portfolio’s shape shifts following a market shock.

This means if the equity allocation shrinks because of a downturn, the only intervention is to restore it to the pre-set level.

This somewhat contrarian principle systematically takes advantage of market volatility to secure discount prices for assets, often purchased with cash raised from the sale of defensive assets.

10-year US Treasury yields hit 0.7 per cent on March 16. The strong performance of safe-haven bonds has again provided both the intended balance to equity holdings and the source of capital to fund the rebalance.

Making rational subjective decisions during a crisis is extremely difficult. Perhaps counterintuitively, Sparrows Capital’s rules make us contrarian investors, something that has led to our portfolios recovering more speedily from these unprecedented times.

Mark Northway is investment manager at Sparrows Capital