The Coronavirus is scary. When it’s possible to make reasonable comparisons with the Spanish Flu, that should make you sit up and take notice. Aside from the reasonable precautions that you should be taking, what should you be doing to protect your investments from the disruptions that the Coronavirus may cause?
We’ve already seen significant disruptions in global supply chains (which is pretty much all of them), and with Wednesday’s announcement of the US’s first confirmed infection from an unknown source, it’s likely that the situation is going to get worse before it gets better. From an investment perspective, this expectation is incredibly important.
As an aside, there is a difference between this and the last few crises that have temporarily shaken the markets. The Coronavirus is an exogenous shock to the system – this was not an internal problem for the financial markets like we saw in 2008. There will certainly be long term impacts from this (changes in how we manage supply chains, travel restrictions, changes in consumption patterns, etc), but our economic system is still fundamentally strong. Once we figure out how to manage this strain of the Coronavirus we won’t need to make any wholesale changes to how our financial system operates.
This is normally where I point out that there is always some threat that people are claiming will bring down the market (Greece, Brexit, inverted yield curves, and even the market being too calm). And it’s a fair point – we are wired to identify the potential negative outcomes of almost every situation we’re in. But this is starting to feel different than the normal financial media circus. So it’s worth going back to first principles, and checking to see if something has substantively changed with how we should approach our investments.
First off, just like everywhere else, panicking is wildly counterproductive. From a purely investment perspective, the drops that we have seen this week (I’m writing this on the morning of Thursday, February 27th) are eye catching when viewed in terms of points, while still significant, they aren’t particularly unusual in terms of percentage points lost. But this is where my earlier point about expectations comes into play. Everyone is expecting this to be bad – the only question is just how bad it is likely to get.
And this is what has caused the market drops. All of the information that we have, and all of our expectations about the future, has already been incorporated into the markets. We’ve already taken the financial hit for everything that we currently know and suspect. What matters now is what happens next – and specifically how that squares with what we expected to happen next. If the future isn’t as bad as we expect it to be, the markets will go up. If it’s even worse than our expectations, then the markets will go down. The market is currently pricing in those probabilities. Again, it doesn’t matter whether the next piece of news is objectively good or bad, what drives market movements is whether that news is better or worse than what the market expected.
It’s important to remember that we have no way of guessing whether things will be better or worse than our expectations. Our expectations are, by definition, our best guess about the future. We simply can’t make any significant statements about short-term market movements (and short-term is pretty much anything less than a decade). Trying to change your investment plan to side-step the negative economic effects of the virus is a fool’s errand. The market has already dropped about 10% since this writing, and while you may get lucky and avoid further losses, the odds are significantly against you.
This is also where investment discipline comes into play. We all know about risk and reward and we want to take advantage of the fundamental, long term, risk and return relationships that the market offers. Right now, we are dealing with the risk part of that equation. If we are experiencing the risk, we may as well stick around for the reward. We seem to be on the cusp of the scary part of the fear vs. greed roller coaster. Sticking it out isn’t always easy, but it’s the only way that we can harvest the long-term returns that we want to build our portfolios around.
These are the times that you need to trust in your asset allocation. This doesn’t mean that your portfolio will not go down. Rather, a well designed portfolio will help you weather bad markets just like it will help you capture returns in a good market- wherever in the world they may occur.