Why you need a Financial Fire Drill - Peace of Mind during crisis
Thursday, April 05, 2018
Another summer has passed full of family, fun and... bushfires. How comforting is it to have the Fire Brigade and CFA on hand to deal with any fire that arises? We believe employing a Financial 'Fire Drill' will provide you with the peace of mind to deal with the next crisis that eventuates across investment markets.
Having been trained in firefighting at the age of 16 as part of Army Cadet training, I learnt there is no time to develop mastery when faced with an emergency. That's why firefighters regularly carry out drills in which they rehearse their responses to a major fire. Being operationally prepared with a concrete strategy makes everyone feel more confident.
It's similar with your financial plan. The time for preparing for a crisis is not during a crisis. Instead of trying to predict when a downturn will occur, the focus for the wise should be on preparing an agreed strategy and planning what will happen when it does.
One should expect investment markets to experience periods of heightened volatility. It is what markets do. Difficult markets do bring a natural sense of anxiety. Having a financial fire drill will see you better prepared to survive and thrive through the next investment market crash.
Lessons from History
Ten years since the global financial crisis, global equity markets have climbed back to multi-year or record highs, leaving memories of past crashes fading. This makes it a perfect time, then, to review what financial fire drill you have in place.
Of course, no-one can reliably predict when the next bear market will arrive. If one could accurately predict the investment future, and how the investment community will respond to that future, one should mortgage everything they own and borrow as much money to invest on their own account!
As someone who experienced the 1991 property crash, 1998 Asian contagion and Russian crisis, 2000 tech wreck, 2008 global downturn and the scores of market falls, pullbacks, corrections, ‘bloodbaths’ and crashes in between, I can confidently say that while down markets are always tough, they are even more so for the unprepared.
If the history of financial markets has taught us nothing else, it is that one should expect periods of extreme investment market volatility. It is what markets do. Behavioural finance teaches us that as humans we have an emotional response to the various market phases (refer to Figure 1 below). For those without a robust investment philosophy and plan in place this often translates into heightened state of fear, chasing the latest fad only to sell at the point of maximum pessimism. I do acknowledge the natural anxiety brought about by difficult markets. But we have seen again and again, the net result from selling on fear and buying on greed is that investors end up with significantly less than the capital market rate of return.The looming 10-year anniversary of the collapse of investment bank Lehman Brothers and the unsettling events of October 2008 mean there inevitably will be a flood of stories in the media about the past financial crisis and the possibility of another in the future. In late 2008, many good people lost their jobs. And those investors who were not adequately diversified or able to remain patient and disciplined suffered significant financial loss. Retirees, in particular, faced a grim future at the time.
While it's natural for the media to commemorate such a major negative event, there is unlikely to be much mention of how those investors who kept their nerve and stayed with their plan were rewarded for their discipline. That reward is the payoff for having an investment philosophy that allows you to sleep better at night and a plan you can stick with through extreme volatility and uncertainty with confidence. (See Figure 2)
Do the Drill Before the Fire
Drawing on decades of experience in wealth management, my financial fire drill checklist looks something like this:
Ensure you have sufficient cashflow to see you through a downturn. For those who rely on their investments to fund their lifestyle, we ensure our clients have adequate cash flow of 2-3 years in accessible liquid assets that they can use to meet day-to-day expenses without the need to sell growth assets. This ensures there is a buffer of time in which assets that have fallen in value can recover.
Prepare both for the range of possible outcomes and the manifestation of those outcomes. Review what happened in past bear markets and stress-test your asset allocation to demonstrate extreme scenarios. If you don’t think you can withstand the pain of a 30-40% downturn, consider reducing exposure to growth assets.
- Don’t make presumptions
Remember that markets are unpredictable and do not always react the way the experts predict they will. For instance, you’ll see economists on the TV every night talking about what might happen when Europe or Japan eventually raise interest rates. But even if you could pick the turn, you still don’t know how markets will react. You don’t need to speculate in order to have a successful investment experience.
- Someone is buying
Quitting the equity market when prices are falling is like running away from a sale. When prices fall to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks”, remember someone is buying them. For every seller there is a willing buyer. Those people are often the long-term investors.
The results can be devastating when your investment base is reliant on one asset or heavily concentrated in a particular asset class, sector or country and things don’t work out how you expect. Ensure your portfolio is well diversified. If it makes sense for your age and circumstances, ensure your portfolio includes a risk-dampener, including cash and fixed interest. The investor of 2008 who had a concentrated portfolio of financial stocks based on Wall Street faced a real risk of permanently losing a significant part of their life savings. The core portfolios we advise our clients on have exposure to more than 8,000 different listed businesses, more than 400 different property trusts, more than 400 different fixed interest securities and cash representing assets from more than 40 market places across the globe. If you are as diversified as practical you are better able to withstand the next market shock. Put another way, when the business news is brought forward to the front page of the newspaper and the first two minutes of the TV news bulletin to show graphs consisting of emotive headlines of the days action, would you prefer your financial future to be reliant on what could amount to 9,000 different investment assets or the speculative activities of the few?
- Markets and economies are different things
The world economy is forever changing and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector, but good for consumers. New economic forces are emerging as global measures of poverty, education and health improve. Competitive forces are also constantly evolving to change the market landscape. For example, all of us use a mobile phone today, but hands up who still uses a Nokia?
- Nothing lasts forever
Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.
- Discipline is rewarded
Market volatility can be worrisome, no doubt. The feelings generated are completely understandable. But through discipline, diversification, keeping focused on progress to your goals and accepting how markets work, the ride can be more bearable. At some point, value re-emerges, risk appetites re-awaken and for those who acknowledged their emotions without acting on them, relief replaces anxiety.
It is only natural to experience anxiety brought about by difficult markets. But this is a lot easier if you have prepared the ground beforehand. Reviewing your financial fire drill – something we review and stress test as part of our ongoing efforts to help our Private Clients – is a valuable exercise that I encourage you to undertake. Seeking professional help in this review can help ensure your plan is robust and able to withstand and prosper in the years ahead.
We acknowledge the writings of Nigel Stewart, Financial Advisor and Thought Leader, and Jim Parker, DFA Vice President and ex-Financial Journalist, in helping form the basis of this article.
ABOUT THE AUTHOR:
Angus Dockrill is a Director and Wealth Specialist at IMFG. IMFG is a financial services business with a difference. Our clients are supported by a team of specialists, not generalists. We believe that the most successful people have their financial house organised within an elegantly simply framework aligned with their dreams, vision, values and goals.
Identity McIntyre Pty Ltd and its specialist financial advisers Scott Douglas, Dan Blatch, Lisette Walsh, Matthew Bull, Martyn Carroll and Angus Dockrill are authorised representatives of Apogee Financial Planning Limited, Australian Financial Services Licensee Registered Office at: 105 - 153 Miller Street North Sydney NSW 2060. These representatives are trading as IMFG.
This article is intended to provide general information only and has been prepared without taking into account any particular person's objectives, financial situation or needs. Persons should, before acting on this information, consider the appropriateness of this information having regard to their personal objectives, financial situation or needs. We recommend persons obtain financial advice specific to their situation before making any decision regarding a financial product or decision.