From Alexander Weis and Gerd Kommer
On February 24, 2022, the violent phase of the Russia-Ukraine crisis began with the brutal Russian attack on its peaceful neighboring country. In view of this serious political crisis, private investors are wondering what significance this event has for their portfolio.
A preliminary remark: The following text is not about the tragic events for the Ukrainian population that are dominating the media at this moment, but exclusively about the question of what effects the Russia-Ukraine war has from the current perspective on the management of a passive private investor portfolio consisting of index funds and ETFs.
We would also like to point out that these considerations only apply to a portfolio that was created on the basis of our world portfolio concept. This concept is described in Gerd Kommer's books. The five most important, scientifically derived basic elements of the world portfolio concept are:
- The term global portfolio describes a concept that is based on the conceptual division of a capital market portfolio of stocks and bonds into a risky and a low-risk part of the portfolio. The risky part of the portfolio is responsible for generating returns – it is the return engine of the portfolio – while the low-risk (“risk-free”) part of the portfolio is intended to ensure security and stability of the portfolio – it is therefore the “risk anchor” of the portfolio.
- Global diversification in the risky part of your portfolio. So a spread across thousands of stocks from all countries in the world and across all sectors in order to completely eliminate individual stock risk. This diversification is implemented in practice with classic index funds or ETFs.
- The low-risk part of the portfolio consists of short-term bonds from countries with the highest credit ratings and bonds from several hundred large companies with high credit ratings. There is no exchange rate risk in this part of the portfolio. This diversification is also implemented in practice with classic index funds or ETFs. For amounts of up to 100,000 euros, this part of the portfolio in Germany and Austria could also be used as overnight money at a bank within the state deposit protection scheme.
- Disciplined buy-and-hold combined with rules-based, mechanical rebalancing.
- There are no counterparty risks in relation to the investor's custodian bank, the fund company and its custodian bank. There are none of these three risks with an ETF portfolio.
First of all, some return figures on the current situation on the financial markets.
Table: Returns of selected asset classes in the context of the Russia-Ukraine war
► [A] iShares J.P. Morgan USD EM Bond UCITS ETF (WKN A2DN9U). ► [B] Lyxor EuroMTS Highest Rated Macro-Weighted Govt Bond 1-3Y UCITS ETF (WKN LYX0Z6). ► [C] On February 21, 2022, the Russian government announced the sending of troops to the new “people’s republics” in Ukraine. On February 24th The “special military operation” began.
So one cannot speak of a global stock market crash at this moment. It is impossible to predict reliably how the war and the various sanctions against Russia, Russian banks and oligarchs that have been decided by Western countries and have just begun will continue to affect the global stock markets.
Now to the crucial question: “What to do?”
Our answer to this will come as no surprise to regular readers of this blog. It reads: Nothing. To put it more precisely: sticking to our core investment principle Buy and hold.
We base this recommendation on the following nine arguments:
(1) The “information efficiency” of the stock and bond markets. At any given time, all public information (including expectations about future events) is already priced into the prices of securities. In terms of their high degree of information efficiency, stock exchanges are unique and fundamentally different from markets for normal goods and services. Because of this information efficiency, at any given point in time there is a 50/50 probability that further developments in the short-term future will be better or worse. This extremely practical insight is based on over 60 years of scientific financial market research.
(2) The equity portion in a passive global portfolio as described above is maximally diversified across countries, sectors and currencies. More diversification within the stock spectrum is absolutely impossible. (Russia's weight in the world stock market before the start of the Russian stock crash was less than 0.5%; Ukraine was not even a member of the MSCI EM Index.) In addition, most passive investors have a low-risk bond component to cushion the portfolio in negative market phases. In addition, most households also have other unlisted assets of a significant size, including, for example, statutory pension insurance claims and/or human capital.
(3) The fact that wars, even large wars, typically lead to a permanent or even temporary severe stock market crash is a thesis that cannot be proven with data from the last 120 years. In the greatest war catastrophe of modern times, World War II, US stocks rose cumulatively by over 50% in real terms from September 1939 to May 1945. The global stock market (for which granular monthly data is not available prior to 1970) also rose. Even with regard to later regional wars such as the Korean War (1950-1953), the Vietnam War (1955-1975), the Afghanistan Wars (since 1978), the Iraq War 1990/91 and the Iraq War 2003, one cannot speak of severe, permanent stock market losses. According to one Listing on Wikipedia There are currently numerous wars and armed conflicts taking place around the world. However, the number of deaths caused by wars and civil wars has been trending downward since the Second World War. Even if it doesn't agree with our subjective perception: the world as a whole has probably become more “peaceful” in the last 70 years. [2]
(4) Although we haven't done the math, we suspect that a "counter-cyclical political crisis investment strategy" ("APK strategy") would only lead to an attractive return with great luck. By APK we mean investing in the stock market, after (a) a war has begun involving one or more of the five largest military forces in the world and (b) the global stock market has fallen at least - say - 20%. We expressly advise against this strategy because it necessarily implies that you have to keep liquid assets outside of the stock market for a long time in order to only invest them in stocks once the two criteria have been met. The opportunity costs (lost profits) of the APK strategy compared to a buy-and-hold strategy would most likely make APK statistically unattractive (we published a blog post on a broadly comparable investment philosophy in March 2019 entitled “Timing of market entry – does it work?"). In particular, it is questionable whether there will be a 20% drop at all. In addition to the question of "when to get out", the no less difficult question would arise as to when to "get in" again. Trying to time a serious political crisis on the stock market by going “in and out” would only make sense if it were possible to reliably avoid these political crises in such a way that, after costs and taxes, a higher return results than with buy-and-hold. From a scientific perspective, no one has yet provided this proof, while there is plenty of evidence of the harmfulness of such a circumvention strategy.
(5) That and how the asset class Stock Global (in contrast to individual values) even after very serious slumps in the past always has recovered, we have in ours Blog post on the Corona crash from February 2020 with figures for the last 120 years shown. Anyone who invests in stocks systematically and globally on a buy-and-hold basis will never suffer a final loss if he (a) has the time and liquid assets to ride out a drawdown, however deep, in the stock portfolio and (b) has the mental strength to do so.
(6) Stocks are the asset class with the highest long-term returns - higher returns than real estate and higher returns than gold. Stocks are not the most profitable of all asset classes despite the high volatility risks on the stock market, but because of these risks. Returns are, first and foremost, risk premiums. Anyone who wants to collect these risk premiums must also bear the associated risk. Bearing risk means that this risk materializes from time to time for the risk taker must - at least in the form of downward volatility. Of course, if you don't bear it, it won't materialize, but then there will be no risk premium in the form of a correspondingly attractive long-term return.
(7) Believing that crash risk only exists in stocks is a common belief, but also a false one. Crash risk exists everyone Asset class, at least if you look at data from the last 100 years: for stocks, for real estate, for precious metals, for corporate bonds, for raw materials, for collectors' items and of course also for bank deposits, where the individual bank failure corresponds to the crash in the share class. Historical examples of real estate crashes become here called. (In the case of individual properties, the risk of suffering high losses is even greater than with the asset class data in this article.) However, in contrast to real estate and other asset classes, crashes in the stock market can be observed in real time because, unlike the prices of unlisted assets, security prices can be observed minute by minute on the Internet.
(8) It is not true that “everyone sells” in a serious crisis. Even in the most serious crisis, as much is bought as sold. If that seems implausible to you, beware this blog post referred.
(9) If the fluctuations in your securities portfolio are too psychologically painful for you (which is no shame), you should not seek relief in “in-out” (this statistically leads to a lower return than buy-and-hold), but rather in a correspondingly more conservative adjustment of your “level 1 asset allocation”. Level 1 asset allocation is the division of the portfolio into a risky and a low-risk part. The latter consists of short-term high-quality bonds. These are just as safe as a bank balance within the state deposit insurance of 100,000 euros per bank-customer combination and significantly safer than bank balances outside of the state deposit insurance.
How should the question of rebalancing in a crash be assessed? (Rebalancing is the periodic return of a portfolio to its original percentage structure, which was originally chosen for good reasons and which determines the return-risk character of the portfolio.)
Basically, there are different rebalancing methods. We go into them in detail this one blog post. If calendar-based rebalancing is carried out (rebalancing at a fixed point in the year) and there are market-related major deviations from the portfolio target structure "far away" from this rebalancing date, it is a subjective, case-by-case decision by the portfolio owner whether he wants to rebalance early. In the event of a sharp drop in prices, this would mean reallocating from the low-risk to the risky part of the portfolio.
So far (March 3, 2022), however, the price drops due to the Russia-Ukraine conflict have been relatively small (see table above), in particular far lower than at the peak of the “Corona slump” in March 2020.
If a private investor wants to reinvest cash in the portfolio or withdraw funds from it for non-crisis-related reasons (e.g. for consumption purposes), he can carry out “ongoing rebalancing” with these cash flows. In the case of additions, this means investing in the “underweighted” part of the portfolio; in the case of withdrawals, this means withdrawing from the “overweighted” part. Fund savings plans should be continued as normal “during a crisis” and, if possible, used for rebalancing purposes.
Conclusion
We believe that investing with globally diversified index funds/ETFs on a buy-and-hold basis is the smartest of all investment strategies for liquid assets. This is proven by an innumerable number of scientific studies. Implementing this strategy over time, however, requires discipline and strong nerves, i.e. in a political or economic crisis situation, the willingness to ignore one's own "flight instincts", which evolution baked into human DNA a hundred thousand years ago.
Endnotes
[1] It is often written that a global stock portfolio based on index funds would consist of around 20 developed countries and around 25 emerging markets. This is ultimately not correct. These numbers are only correct with regard to the location of the primary stock exchange listings of these around 9,000 companies. However, the country in which a company's stock exchange listing is located is secondary for the investor and also for the real economy. In fact, companies are out of principle everyone 195 countries worldwide included in such a portfolio.
[2] Steven Pinker, Enlightenment Now: The Case for Reason, Science, Humanism, and Progress; Viking 2019, p. 156 ff.