Strategies

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Keeping cool in a market crisis

Economies and markets are often affected by unexpected economic, political or natural calamities, like the current US sub-prime mortgage crisis. So how should investors approach these events?

Stay calm

Don’t panic. History tells us that events — however catastrophic — are soon swamped by the longer term trend. The chart below shows what we mean. It shows the performance of international sharemarkets (MSCI World Index) since 1987. As you can see, a whole range of events — the 1987 crash, the Asian currency crisis, the Russian bond market default and September 11 — have all been blips on the long-term ascent of sharemarkets.

Impact of key market events on global shares since 1987

This chart illustrates how important it is for investors to think long term when crisis strikes. There is compelling evidence that panic selling is bad for your wealth in the short term as well. Enlarge chart in new window.

Plunge, then bounce

After the terrorist attacks on September 11, US markets stayed closed until September 17. In the five days following the re-opening, the S&P 500 index fell 11.6%. In a warning against short-term panic, legendary investor Warren Buffett said; “Whatever you thought about the stock market before the World Trade Center is what you should be thinking now”.

As usual, he was right. By 15 October, the S&P 500 and the NASDAQ indices were back near their 10 September levels. Investors who panicked simply crystallised losses rather than protecting capital.

Sharemarkets do react, often sharply, to crises. Yet they tend to snap back quickly as investors reassess the real economic impact of these events. During the Iraq invasion of Kuwait in 1990, the S&P 500 dropped around 5% within a month. Within six months, the market was up almost 16%. Within a year, it had leapt 26%.

Coping with crisis

Economics, nature and human nature being what they are, we will undoubtedly face another market-mauling crisis in the future. Yet we know that over the long term, the effect of these crises will fade. In the late 1980s, the Asian economies were the scourge of world markets. Today Asia is the key to rising commodity prices, cheaper consumer goods and one of the reasons Australia’s share market has been booming over the past two years.

Yet there are still sensible precautions any investor can take to deal with a future crisis. The most important is to have a financial plan — a written document that reminds you why you’re investing, what your objectives are and how long you plan to invest for. Such a plan is the perfect antidote to the tendency to panic, a reminder that long-term investors have nothing to gain from short-term reactions.

Understand risk

Coping with crises such as those outlined above should form part of your risk management plan. By understanding risk, you will be in a better position to manage it in times of calamity — plus benefit from risk over the long term.

One way to manage economic and political risk is to diversify your investments across different types of investments. Both the initial impact and repercussions of a major event will affect each type of investment differently. Property, fixed interest and shares may react differently to the prevailing economic and political conditions. By investing in a number of different markets, you reduce the effect a fall in one market has on your overall portfolio.

Keeping cool in a market crisis

Stay calm

Plunge, then bounce

Coping with crisis

Understand risk

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