Equity markets have taken a turn for the worse following the US’ probable imposition of “section 301” tariffs on China.
Undoubtedly, events that increase uncertainty about the likely path of profits are bad news for any company’s share price. In a sense, given that the likelihood of President Trump’s action was high and much-discussed particularly in the last two weeks, some might say that this path should have been discounted by the market already.
Of course, markets can be influenced by an incredibly large number of related but constantly shifting factors and “knock-on” effects. Even when the next event can be reasonably clear, the fact that it happens triggers other events. It’s that creation of new paths and possibilities which can destabilise markets through increasing uncertainty.
Even when events occur which have equally positive or negative future impacts, if the likelihood of extreme outcomes rises, investors tend to want to insure against the bad ones. Some investors buy options to sell their assets, an explicit insurance contract. As a whole, the market builds in an implicit insurance.
That insurance is the risk premium, the extra expected pay-out an investor estimates that they need to make it worthwhile to hold a risky asset (in comparison to a non-risky asset like a bank deposit or short-term government bond). An event which has balanced outcomes (upside and downside) for a company’s earnings shouldn’t change analysts’ forecasts for earnings. However, because an investor needs a greater return in order to take the risk, the share price they’ll pay to buy some more of the company goes down. The “valuation” of the company, (such as the price-to-earnings or P/E ratio) falls.
Most investors are in for the long-term and don’t sell. That’s because (we would say) the main point of long-term investing is to get paid a diverse portfolio of risk premia on a pretty constant basis. Also, because investors (generally) get information at the same time as everybody else, prices move quickly to discount everybody’s worries. One would have to have good reason to believe that one had better information or analysis than others to justify selling. And then, at some point in the future, one would have to decide when to buy.
What matters for each investor is getting the long-term holdings aligned with their risk appetite. A useful working definition of long-term is “not needing the money for a number of years”. If one’s savings aren’t needed in the nearer-term, then history shows that the best strategy is to get the asset allocation aligned to the risk appetite and then leave it that way through thick and thin.
What can happen is that an investor realises that they’ve taken on more risk than they really wanted. Often, it’s because their circumstances have changed but, because investments have been good, they haven’t got around to thinking about it. When the environment changes, they’re left having to decide while feeling uncomfortable and possibly fearful. (As an aside, this is why clients are asked to review their risks at least annually, hopefully when market moves aren’t influencing their perceptions of risk).
