In this week’s video insight David delves deeper into the behavioural science of investment markets.  The global economic environment, according to the consensus, will deteriorate as 2023 progresses, but with that said risk is not necessarily inherent in an investment; it is always relative to the price paid.

Transcript

The global economic environment, according to the consensus, will deteriorate as 2023 progresses and in this week’s video insight I wanted to focus on the behavioural science of investment markets.  As economies slow the secondary effects will see many companies cutting their cost base by retrenching staff as the economic narrative shifts from peak inflation to recession.

With excesses brought about from Central Banks allowing official cash rates to approximate nil over 2020 and 2021 – many investors were lulled into a false sense of security and often, in hindsight, paid elevated prices as an alternative to nil yielding cash.

As the Central Banks have rammed up their official cash rates over the past year, with possibly one or two more to come, those excesses came to an end in 2022. We are seeing this in Australia particularly with the number of builders going into administration. Recent examples include ProBuild, Condev, Pivotal Homes, Pindan Group, Snowdon Developments, Oracle Platinum Homes, FIRM Constructions and EQ Constructions.

The 2022 year saw a surprisingly high correlation between different asset classes. The substantial increase in official cash rates placed varying degrees of pressure on the valuation of those companies with no earnings, growth companies, Government bonds, residential property and commercial property, and in some cases, there is further downside to come.

That said, risk is not necessarily inherent in an investment; it is always relative to the price paid. For example, over the eighteen-month period of the Global Financial Crisis between September 2007 and March 2009, many share markets halved and many individual companies’ share prices did much worse. Clearly, purchasing investments post the dramatic drawdown – when opportunities are “unloved or out of favour” is much less risky.

Conservative positioning enables investors to take a long-term broad and flexible approach, be clear thinking and to focus on those opportunities. An important starting point is to be cautious around leverage, as capital markets can be extremely fickle. Leverage, particularly in combination with an economic slowdown, can drive dramatic price and valuation swings, as witnessed by the troubled Australian builders.

And because Governments are typically elected every three to four years, they cannot withstand a lot of pain in the economy or the financial markets. However, predicting the timing and benefit of a particular bail-out or rescue is impossible.

Investors who are trying to build up a solid nest egg need to think long-term, need to take a conservative approach and need to be nimble when lower risk opportunities arise.