Simply put, investors are believed to feel the pain of loss twice as strongly than the pleasure of gain, as illustrated in Figure 1.
In Figure 1, the dark green line illustrates fund performance – on the right-hand side of the vertical axis performance is positive (investors make a profit) and on the left, performance is negative (investors make a loss). The light green line represents investors’ experience of that profit or loss, illustrating that the pleasure investors receive from incremental profits is less than the pain associated with incremental losses.
Unfortunately, this theory is proven true time and time again during market corrections such as we are currently experiencing. Unable to stomach these significant losses, many investors panic and switch from their growth investments to cash, thereby crystallising what was only a paper loss until that point.
An analysis of the Association of Savings and Investment (ASISA) industry flows reinforces this. ASISA has data for the periods around the last two bear markets (2002 and 2008) prior to the current one. Simply, in the final stages of the bull market, investors were pouring money into equity funds (higher risk/higher reward investments), and then in the year following the stock market collapse they were withdrawing money from equity funds and investing the proceeds into money market and income (lower risk/lower reward) funds.
In the following section, we consider the client experience following all SA equity market corrections of more than 20% over the past 50 years, including the latest correction from February 2020. As illustrated in Figure 2, you will note that since 1965, there have been no fewer than nine corrections where the market has fallen by more than 20%.
Figure 2: History of SA bear and bull markets since 1965 (FTSE JSE All Share Total Return (logarithmic scale)With the benefit of hindsight, was the decision to switch to cash the right one?
We believe not and point to the following analysis in which we have considered the outcome of two investors who both invested R10 000 prior to each of the last eight bear markets (i.e. at the market peak). Let’s call them Mo’ Money and Lo’ Money.
While admittedly concerned about the impact of the market collapse on his nest egg, Mo’ Money weathered the storm, remaining invested throughout. Lo’ Money unfortunately could not stomach the impact of the market collapse on his nest egg and switched to cash at the market trough. Then, true to the psychology of many investors, noticing that the stock market was recovering and not wanting to miss out, he reinvested into the market a year later. Lo’ Money subsequently repeated this behaviour in each subsequent bear market. The following table illustrates just how punitive Lo’ Money’s decision to switch to cash was on his potential retirement capital.
Figure 3: Comparing staying invested versus switching to cash
Mo’ Money experience (stay invested) | Lo’ Money experience (switch to cash and repeat) | |||
Bear market | Value of R10 000 | Annualised return | Value of R10 000 | Annualised return |
OPEC increase ‘71 | 15,407,974 | 15.7% | 1,043,952 | 9.7% |
‘73 | 9,754,812 | 15.9% | 1,194,268 | 10.8% |
Oil price shock ‘76 | 7,820,321 | 15.6% | 1,568,150 | 11.6% |
Rise in interest rates ‘82 | 2,095,307 | 14.5% | 378,058 | 9.7% |
Black Monday ‘87 | 439,143 | 12.3% | 153,715 | 8.7% |
Russian Debt Crisis ‘98 | 110,920 | 11.7% | 53,371 | 8.0% |
Dotcom Bubble ‘02 | 67,717 | 11.3% | 38,326 | 7.8% |
Financial Crisis ‘08 | 20,704 | 6.3% | 15,140 | 3.5% |
Source: Ninety One Benchmark database.
As a final point, we considered the case where Mo’ Money invested R10 000 at the peak prior to each of the last 8 bear markets (i.e. a total investment of R80 000) and compared that to Lo’ Money making the same investments at the peak, but then at the trough of each bear market switching his accumulated investment to cash for a year before switching back to the market. The results are astounding. Over 50 years Mo’ Money’s investment grew to approximately R35.7 million (an annualized return of 15.6%), compared to Lo’ Money’s R4.4 million (an annualized return of 10.4%).
The following graph further illustrates just what a poor investment cash is in preserving the purchasing power of your money over the longer term. You will note that over the last 10 years many components of inflation (electricity, health costs, education and petrol) have increased by more than the return achieved by the average money market fund. So, anyone invested in the average money market fund would have been spending a greater portion of their income on these necessities, which they would have had to subsidise from other sources (if possible) as their money market fund investment has not kept pace with these increases.
There are several behavioural biases that lead to investment mistakes. The analysis provided illustrates just how detrimental succumbing to loss aversion is to investors’ potential returns. During these uncertain times, together with your financial advisor, you need to revisit your long-term financial goals and stay true to the plan that you have put in place together to achieve them. You need to act rationally and calmly as you expect your financial advisor and investment manager to do on your behalf.
In our view, the optimal investment solution for many investors may be an inflation- targeted multi-asset fund that also seeks to shield investors from negative market corrections, such as the:
In both instances, diversification, active asset allocation and disciplined portfolio construction are important tools in managing downside risk.