Two things surprised me last Thursday morning that should not have done. The first was that Heathrow in February is around 20 degrees colder than Cape Town. I was not correctly dressed. The second thing I learned when my phone reconnected at Terminal 5 was that Russia had invaded Ukraine. Again, I might have expected this. But I was not alone in being blindsided. Many other investors had also fallen victim to wishful thinking on that front.
This is what long bull markets and V-shaped buy-the-dip recoveries do to investors’ critical faculties. We get used to things turning out better than we feared. But sometimes they don’t. The events of the past week have handed us a long list of lessons about how we should and should not manage our portfolios at times of crisis. Here are a few of the more important ones.
The first is to understand that sometimes things are cheap for a reason. The Russian stock market has looked ridiculously cheap for years, trading on single digit multiples of expected earnings when most developed markets were valued at least twice as highly, and the US was around three times as expensive. There were a couple of reasons for this. The first is that Russia has for a long time ticked pretty much every box when it comes to emerging market investment risk. Weak property rights, over-concentration in a few industries, autocratic rule, currency risk, inflation, poor corporate governance, sanctions, lawlessness. You get the picture.
The second reason is Russia’s dependence on energy exports. Most countries suffering from the ‘resource curse’ are trying to diversify their economies away from oil and gas for two reasons – their reserves will one day run out and, even if they don’t, the greening of global energy infrastructure will in due course limit demand.
The second mistake investors made in the run up to last Thursday’s attack was to assume that both sides would behave rationally. The conventional wisdom was that there was no domestic support nor any really compelling geo-strategic incentive for Putin to annexe more of Ukraine than he already has. This was always a rash assumption, as my rapid re-reading of the first chapter of Tim Marshall’s excellent Prisoners of Geography made clear. If you are looking for a quick primer on why Russia has always seen Ukraine as its vulnerable underbelly, you won’t find anything better. Equally ‘irrational’ and so misunderstood by investors has been the West’s, especially Germany’s, willingness to pay a high economic price in order to stop a tyrant in his tracks. It was widely assumed, wrongly, that Europe’s dependence on Russian gas would get in the way of the implementation of really effective sanctions. It has not.
A third mistake some investors have made is to assume that because something is unlikely it cannot also have a big impact. It was very unlikely that a virus leaping from the animal world to humans would bring the global economy to a standstill two years ago but when it happened the odds became irrelevant. Only the consequences were then important. Many investors simply disregarded the possibility of war in Europe because it was unlikely to happen. But it did. Investors should ask themselves what other improbable events could have an unacceptably big impact on their wealth.
A related mistake that investors often make with regard to unlikely events, is to make excuses for their complacency in not taking the risk more seriously. It is tempting to believe that our assessment of the risks in Ukraine were correct but for the fact that Putin is (delete as appropriate): insane, past it, surrounded by sycophants, losing touch thanks to Covid isolation. It doesn’t matter if any of these is true. The fact is that our analysis was incorrect. Investors need to be honest about the limits of their knowledge.
Misunderstanding the relationship between risk and reward is a further mistake that we often make with our investments. This is an essential part of the investment process, but it is tempting to focus more on the potential upside of a trade than what could go wrong. A Russian government bond trading at a significant discount to face value may have looked attractive a couple of weeks ago. Today, it looks like an untradeable debt that will very likely default and which you either wouldn’t want to or wouldn’t be allowed to hold anyway. Things change.
Sometimes the mistakes that investors make at times like these are ones of timing. Last week it was instructive to watch the yield on the US 10-year Treasury bond. It started the invasion week at 2.05pc, fell on haven buying on the Thursday to 1.9pc, but ended the week at 1.97pc. Investors seemed to be reserving judgement on how significant the financial and economic implications of the obvious human tragedy would turn out to be. The flight to safety since the weekend, pushing yields, particularly in Europe sharply lower, shows that occasionally there’s just a delay on the line and Mr Market soon catches up with reality.
One final risk for investors is that their time horizon becomes overly compressed during crises. This can lead to them missing the big picture. A great deal has changed in the last week, but some things have not and indeed some pre-existing trends will have been accelerated by the last week’s events. One of these is the shift to a more ‘stagflationary’ investment environment. Technology shares account for 40pc of the value of the US stock market and commodities just 5pc. In 1980, the reverse was true, and the pendulum is swinging again. It is not just the return of Cold War thinking that is an unpleasant reminder of my 1970s childhood.
