Investing during periods of uncertainty can be more complicated than investing during almost any other phase of the business cycle, particularly from a behavioural / emotional perspective. It can be especially painful for investors who already had a sizable portfolio at the peak of the cycle, and who may have to watch significant and swift declines in their overall portfolio and net worth – at least before the recovery begins.
I have received a lot of requests and questions regarding investing during and after the COVID-19 crisis and I will share my thoughts on some of the most common questions below. Before I proceed, I must say that my thoughts here do not constitute financial or investment advice and should not be taken as such.
I would also like to add that I started the Smart Investing with Nosa Podcast (available on YouTube, Spoitfyand Apple Podcasts) at the beginning of 2020 with the goal of simplifying investment principles and bringing practical insights to these principles, to enable listeners become more invested in their finances and better prepared to make smart financial and investment decisions.
In the first episode, I introduced the concept of behavioural biases such as the self-control bias, and how they could be keeping us from achieving some of our most important goals, including our finance and investment goals. In the next episode, I discussed the practical steps to becoming rich, emphasizing that, contrary to what many so-called life coaches and entrepreneurs preach, anyone could build a sizable amount of wealth from earning a salary – without having to “quit your job to pursue your dreams” or “become your own boss” – provided they adhered to some of the most fundamental investment principles.
In episode three (how to manage your money), I expanded on one of the most basic and one of the most important principles for becoming rich as a normal working young adult – keeping a monthly budget to track your cash inflows / income and outflows / expenses. Two more interesting episodes have followed.
All of the principles discussed in the first few episodes of the Podcast apply just as well during the current period of economic uncertainty as they did during periods of economic expansion. Some of the topics to be discussed in this piece will be discussed in detail on subsequent episodes of the podcast and/or in subsequent articles, so I will address the questions here in a Q&A format.
Is this a good time to be investing or should we wait for the crisis to be over?
There is hardly a bad time to invest. What is important is that you are investing in the right asset classes and securities, at appropriate prices, in line with your long-term investment goals.
A good investment plan would not need to be altered significantly during a financial crisis. If your investment plan was good before the Coronavirus Great Lockwown, all you would need to do now is to make minor adjustments to take advantage of some opportunities and to re-balance your portfolio.
As long as your personal circumstances have not changed significantly (loss of job, death of a spouse, divorce, etc.), your long-term investment goals should be the same now as they were 5 months ago. Keep investing in line with that goal.
Since share prices are low, does it make sense to buy shares now?
During a financial crisis, prices for traditional asset classes, particularly equity, tend to be low. This does not always mean that every one of these securities is “cheap” and would make a good addition (“buy”) to your portfolio. The reason for the low valuation is that investors’ expectations about the future cash flows (let’s call this earnings) to be generated by “a company”, the growth rate of the company’s earnings and/or the risk associated with these earnings generally change (for worse) during an economic crisis.
Due to lower cash flows and the higher risk associated with the cash flows, the core fundamentals of some of these companies may deteriorate to the extent that some of them may be unable to sustain their business operations. Some other companies will survive, with only a minor impact on their cash flows.
No one knows with certainty which companies will survive the crisis and bounce back to their previous valuations and which ones will go under / struggle, or how long it will take for share prices to recover. However, the market tries to reflect the expectations and risk of lower cash flows into the value of the company / the price of the shares.
With good analysis of the financial statements of some of these companies, news and capital market expectations, it is possible to have a fair assessment of which companies’ shares are cheap at the currently low prices. These are the companies you want to buy – if you have the appetite for stock-picking.
How does the crisis affect companies and their share price?
During a crisis such as the one we are facing right now, a lot of companies lose customers and do not sell as much as they used to – think about The Place (food), Heineken (alcoholic beverages) or UAC (gala) and how they would not have made as much sales during the last four weeks as they used to – hence cash inflows would be lower at the end of the year. Whereas, some of their costs and financial obligations (cash outflows) kept running during that period (e.g., salaries, interest on loans, loan repayment, etc.).
If a company does not make sales and collect cash, it may be unable to pay suppliers for raw materials, employee salaries, interest and other payments due to banks, rental costs for factory or office space, etc. If this happens, the company may be forced to borrow money at higher interest cost, sell some of its assets at low prices or go into liquidation to pay its creditors.
Due to the above, their net cash flows for the year would be lower than was previously expected – before the crisis. Since the share price of companies is simply the present value of all future net cash flows of the company, when an event occurs that would likely reduce (or increase) the net cash flows beyond what investors had previously considered in determining the old share price, the value of the shares would decrease (increase).
What about mutual funds and other asset classes?
A mutual fund is not an asset class or a type of investment. It is simply a vehicle through which investments are made into other asset classes such as equities and fixed income securities. My next article will be about mutual funds.
Fixed income securities (short term debt and long term debt, including government securities), commodities and real estate investments should also be considered, to the extent that they fit into your overall investment strategy.
Is it advisable to have as many asset classes and specific securities in your portfolio for diversification?
Diversification is an important part of any good investment strategy. Diversification helps reduce risk and protects the investor from downside. Diversification can be achieved in a number of different ways and should not be restricted to one asset class one geographic region. It should also be thought of in the context of the entire portfolio.
Including other asset classes in your portfolio could help diversify the portfolio. However, you should ensure that the assets / securities that are being included to your portfolio are appropriate given your specific circumstances and are in line with your overall investment goal. Avoid including securities in your portfolio for the sake of diversification.
It is costly and impractical for an individual with little investment experience and knowledge to achieve diversification by selecting / including individual securities in their portfolio. How many securities would you need to be fully diversified? Will transaction costs and trading fees incurred in including these securities justify the benefit of diversification? Should pooled investment vehicles and exchange traded funds (ETFs) be purchased instead of individual securities to achieve diversification? We will address these topics in later episodes of the Podcast.
It is also important to note that during periods of economic stress, the correlation between / among different securities, and between / among different asset classes tend to be higher, hence, even a well-diversified portfolio would likely have suffered significant losses over the last two or three months.
How should I go about investing if I do not currently have any ideas or experience?
- Start by obtaining a basic understanding of finance and investing concepts – at a minimum. Read books, articles, listen to podcasts about finance and investing, etc.
- Set up a monthly budget to track your expenses and income – this is the first step to taking control of your finances.
- Set up an emergency fund to be kept in highly liquid securities such as money market mutual funds: the exact amount should depend on your specific circumstances, your country of residence and the kind of unemployment protections available (if any). Three to six months of non-discretionary expenses or two to four months salary have been cited by many finance experts as good practice.
- Come up with a long term investment strategy based on your goals, age, income, planned retirement age, risk tolerance, circumstances and religious / ethical preferences, etc.
- Start investing in line with the above investment strategy.
Thanks for sharing. Really enlightening.
Thanks for the feedback Adebayo. Happy reading!