By Dan Kemp, chief investment officer, EMEA at Morningstar Investment Management Europe – Article published by Investment Week.
In 1985, Bernard Hinault was on course for his fifth Tour de France victory when he became embroiled with four other racers in one of the most famous crashes in the race’s 106-year history.
The Frenchman flew over his handlebars and broke his nose when he landed face first within the last kilometre of stage 14.
This event will no doubt be in the minds of some of the 176 riders of the 107th Tour as they prepare to leave Nice on Saturday.
It is also a great reminder of the challenges faced by investors in the gruelling market environment of 2020.
Like investors, the riders in the Tour face three types of challenge on their circuitous route to Paris.
The first are those challenges that are known, such as the terrain. The second are unknown but are likely to remain within boundaries that can be predicted, such as the weather. And the third are unknowable, such as the behaviour of other riders.
It is this this last type of challenge that resulted in Hinault’s broken nose and that causes the greatest challenge for investors.
In cycling as in investment, the team with the best riders, equipment, support and preparation is most likely to win. However, the unknowable elements of the race can lead to surprising outcomes, and the 2020 race is likely to provide examples of all three types of challenges for both riders and investors.
Stages to success
In order to help investors through these challenges, we can draw some lessons from how the teams on the Tour prepare their riders.
The first step is to ensure what can be known is shared with the riders (or investors). This includes challenges that are unknown but can be estimated such as market volatility and relative performance.
While experienced investors know that crashes and sharp rallies are a normal part of investing, our clients may not be aware of the impact of price volatility and, like an amateur cyclist facing a steep hill, may overestimate their ability to cope with it and give up along the way.
Those that quit in this way are unlikely to reach their goals and hence their investment strategy becomes a failure, despite the care with which it was constructed and executed.
A similar problem may occur when an investor becomes fixated on recent past performance and disappointed if their strategy underperforms over a period of time.
This is akin to a rider seeking to win every stage of the Tour rather than focusing on winning the entire event.
Each investment strategy, like each rider, will be more suited to some environments and less suited to others.
Having selected a strategy that is likely to deliver over the whole race, it is essential that investors are aware that the plan is not to win every stage so that they avoid the temptation to extrapolate short-term returns and hop from one ‘bike’ to another.
While risk-tolerance questionnaires can do a good job of helping investors visualise estimated losses, it is important that advisers communicate the potential for short-term underperformance so that the investor is not suddenly surprised by a ‘bump in the road’.
The unknowable risks are, unsurprisingly, much more challenging. As we are unable to fully prepare for them, we need to focus on what our response will be in the event of an unexpected outcome.
Unfortunately, the quality of our responses tends to be impaired in the event of a surprise, as we are typically acting under stress, which causes our minds to seek a fast resolution that may not be beneficial in the long term.
This is often known as the ‘fight, flight or freeze’ response. Such a response can have a catastrophic impact on the financial security of our investors and their ability to reach their goals.
We therefore need to establish a decision-making framework that helps us overcome the stress response.
Helping cross the finish line
An effective framework could be created using a simple series of if-then statements. For example: If the holdings in my portfolio stray from the target assets allocation by more than 2%, then I will rebalance the portfolio. In this way it is possible to avoid making the mistakes that appear obvious in hindsight but far less obvious in the heat of a stressful situation.
It is this type of clear decision-making following an extreme event that led Hinault to pedal across the finish line in Saint-Étienne unassisted following medical treatment, maintaining his position in the race, and resulting in his incredible fifth Tour victory.
And, we expect it will help investors cross whatever financial finish line they are striving for.
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