Fortune favours the bold and patient

Jessica Schlosser, Investment Analyst at ClearView

What to do when everyone else is doing it

A synchronised global expansion coupled with ultra-low interest rates created prime conditions for global equity investors in 2017. For the first full calendar year in history, US equities climbed higher month-on-month with the S&P 500 Index ending the year at its second highest point (the first being the dot.com boom). The MSCI China Index and the MSCI Emerging Markets Index also soared, returning 53 per cent and 34.8 per cent respectively for the year to December 31, 2017. Even Iranian bonds were oversubscribed.

But the stellar performance of global equity markets is creating concern, not only joy.

The problem is that overvalued equity markets are nothing new and usually precipitate a correction or crash.

Throughout the 1920s, the US economy was booming. Investors saw shares as an easy way to make money rather than a long-term stream of discounted cashflows. The combination of economic prosperity and corporate earnings growth justified pouring into the share market without regard for valuations. 

As economists and professional investors Benjamin Graham and David Dodd observed in their book Security Analysis, "it was only necessary to buy 'good' stocks, regardless of price, and then let nature take her upward course. The results of such a doctrine could not fail to be tragic".

Indeed it was for those who applied this logic during the 1920s and also the dot.com boom.

Yet despite better economic tools and the benefit of hindsight, investors are still prone to following the 'herd' and making poor investment decisions. At this critical juncture, it's clear that more care must be taken to ensure history does not repeat itself.

Part of that involves investors understanding the role they play in contributing to, and sustaining, extreme valuations.

A key contributor to current day valuations is the rise of index investing. When buying the index, investors ignore a company's valuation, debt levels, corporate governance, strategy and ability to grow earnings over the long-term.

Active managers, on the other hand, identify risks and underweight risky or overvalued stocks. As a result they may underperform in the short-term when share markets are running hot but good managers also provide some downside protection, ensuring that their portfolios don't fall as far as the market during market corrections.

The catch is that good managers are hard to find.

There is a general misconception that equities are guaranteed to increase wealth over the long-term.

Furthermore, given equities are riskier than government bonds, investors should be financially rewarded, or compensated, for taking a higher degree of risk. This is referred to as the equity risk premium. Ironically, for long-term investors, as more people pile into equities, valuations rise to the point where the likelihood of equities continually outperforming decreases.

The chart below shows the total returns from equities (MSCI World Index), and 10 year US government bonds.

As American economist Paul Samuelson wrote: "Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas". Observing a bond portfolio for 30 years may well be akin to watching paint dry but your patience and conviction will be rewarded over the long-term.

It's also worth remembering that shares on paper don't represent net wealth or purchasing power over the long-term. According to Warren Buffet, it is the future stream of cashflow from owning shares that creates wealth, and the ideal holding period is "forever".

To avoid tragedy, investors must purchase shares for their long-term future cashflow, not to make a quick buck.

Making a good long term investment requires investors to pay fair value in order to reap the benefits of growth over time. As painful as this can be in the short-term, if the facts haven't changed, sometimes it's best to sit back, stick to a disciplined strategy and wave as fads pass by. Just because everyone else is doing it, doesn't make it right.