The economic crisis: Impact on perceptions of market risk

The global financial crisis of 2008 has undoubtedly brought uncertainty with it, made investors more risk conscious and risk averse. But history has also taught us a few lessons in this regard.

Investor’s behaviour in terms of their willingness to accept risk depends upon their risk appetite or market sentiments, which are associated with the market at the time of investment. Moreover, investor’s knowledge and their optimism about market volatility also influence their decision to select risky investment.

According to Shaun le Roux of Alphen Asset Management many of the best investors of all time have been happy to swim against the tide of the prevailing conventional sentiment, the essence of contrarian investing. Baron Rothschild is quoted as having suggested that "the time to buy is when there's blood in the streets" and apparently made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon.

Famously, in 1939, John Templeton bought $100 of every stock trading below $1 after the onset of World War 2 sent markets tumbling. He made four times his money in four years.

Investing with the crowd

The best value investors, Warren Buffett included, have all been happy to consistently bet away from the crowd. As Buffett puts it, "you pay a very high price in the stock market for a cheery consensus". If there is a cheery consensus around a particular outcome, it is highly likely that all the money has been made and the likelihood of disappointment is elevated. Unfortunately, for the man on the street, investing with the crowd feels more comfortable. Hence, the generally abysmal timing of retail flows into and out of risky assets.

Take last year as an example. Local unit trust flows showed clearly that while institutional investors had the confidence to pile back into equities in the second quarter, many individual investors clearly stayed in cash until late in the year (or altogether) and missed a large portion of the rally. Many of those individual investors were also late to move out of the equity market into cash in 2008/2009, thereby permanently locking in their capital losses.

Contrarian investment style

A contrarian investment style requires both discipline and patience – attributes that hard to come by in today's world of instant gratification and short-term investment horizons. To be buying when the market in general is selling, and vice versa, never feels comfortable.

Although there is concrete evidence that markets have already encountered a strong economic recovery, markets tend to be volatile as a result of individual fear and greed, which emerges during periods of instability.

Strategy for uncertain investors

In current conditions the following three steps will assist uncertain investors.

• Step 1: Obtain a Risk Profile - In setting up a suitable investment portfolio, questions should be asked about the investor’s financial and lifestyle goals. Using this, plus details of assets, liabilities and income, the level of risk the investor is prepared to tolerate can be determined. From this, an appropriate mix of assets can be allocated to the investment portfolio.

• Step 2: Understand the underlying risk factors - Because investments can rise or fall unexpectedly, the primary risk associated with investment (the market risk) is characterised by the variability of returns produced by the selected portfolio invested in.

• Step 3: Finding a trusted financial advisor – Investors need a financial planning professional with a platform on which they can determine an asset allocation solution that will have a high probability of achieving their goals.