With markets at all-time highs, what can you do to prepare your portfolio for the worst, without sacrificing growth? Moneywise investigates
The FTSE 100 stock market of the biggest companies listed in the UK reached a record high of 7,859.17 on 21 May; at the time of writing on 6 July it has since fallen to 7,617.7.
But to hit their high, markets suffered a bout of volatility and losses at the end of January until the end of March, when the FTSE 100 dropped to 6,888.69.
This raises the question of whether we’re about to see a return to volatile markets, or even whether we’re on the precipice of a deeper fall. By definition, a bear market is a sustained fall in equity markets of at least 20%. Moneywise highlights four key questions – based on research from asset management firm Sarasin & Partners – you need to ask yourself to help you stress-test your portfolio for such an eventuality.
1. Are you aware that the value of your portfolio could suffer a sharp setback from time to time? What will your family say when this happens?
Anyone who places their money at the mercy of the markets needs to realise that their investments could take a short, sharp knock at any point. This could lead to considerable loss of cash value.
While times have been good for investors over nearly a decade of growth, the market has suffered setbacks too. Panicking and selling when dips occur is an easy way to lose a lot of money.
When you buy an investment, such as a particular fund or investment trust, you are buying units or shares in that fund or trust. When markets dip, the cash value of those units or shares will drop, but you will still own the same number of units or shares.
Alex Neilson, investment manager at robo-adviser Investec Click & Invest, comments: “Any time you invest money, you should have a good understanding of the risks associated with it. No investments should ever keep you up at night worrying. Know your risk tolerance and stick to it.
“Take a good look at the funds within your portfolio: how much are they affected by the rises or falls of the market? This gives you a rough idea of how they should perform in certain market conditions.”
Mr Neilson recommends checking ‘key feature’ documents, such as fund factsheets, to assess what you’re actually buying. If you’re unsure of doing such detailed research yourself, Mr Neilson suggests considering ‘managed’ investing that wealth managers or companies such as Investec Click & Invest, Nutmeg and Wealthify provide.
Being able to discuss your finances with loved ones is also important. In the event of a bear market, they may struggle to understand if you decide not to withdraw your money from exposure. Making sure they appreciate the risks will reduce your stress levels, too, when a downturn happens.
Mr Neilson adds: “There is a real issue in the UK with talking about money between friends, peers and family – we’re so prudish! I’m not talking forensic accounting of your finances, but talking about how your money is invested, or if you want to invest but don’t know how.”
2. Are you aware that very few are likely to see a bear market coming?
Preparing for a bear market is difficult because it is nearly impossible to see one coming. If that wasn’t the case, investors and fund managers would always know how to mitigate for it. However, some experts are currently predicting tougher times ahead.
Tom Stevenson, investment director for personal investing at investment manager Fidelity International, explains: “The main stock markets have been on a roller-coaster ride so far this year and ended up pretty much where they started. It looks like it could be the same story again for the second half of the year.
“We don’t know how Brexit will end, what the impact of the Trump trade war will have on economies across the globe, or if there’ll be a high street after Amazon has finished tearing it apart. There’s so much we don’t know.
In fact, the only certainty is that there will be uncertainty. Almost by definition, bear markets come when they are least expected. When markets are riding high, the outlook is always bright. And when everyone has bought into the optimistic story, there are no new buyers to keep fuelling the bull market.”
Richard Hunter, head of markets at Interactive Investor (Moneywise’s parent company), agrees: “At a time when market progress seemed unassailable, with the global economy in an unusually synchronised phase of growth, political intervention threatens to derail this progress. That being said, for the time being the US remains the world’s largest economy and it is currently firing on all cylinders, with little sign of a let-up.
“Nonetheless, a shock will come at some stage, and more than likely, if history is anything to go by, when we least expect it. The important point to remember is that investment is more around ‘time in the market’, not ‘timing the market’.”
3. Are you likely to need cash soon, either a lump sum or income from the capital?
Investors at different stages in their lives need to protect their portfolios differently. A 30-year-old with a small pot of money can afford to bear the brunt of a downturn as market falls tend to be short and sharp. In most cases, their portfolios will be back in the black before long. After the FTSE All-Share Index reached its zenith in June 2007, climbing to 6,732.4, it plummeted nearly 50% by March 2009, to 3,512.09 at the low point of the financial crisis. From this low, the index recovered all of its losses by the summer of 2013.
For older investors, particularly in regard to pension freedoms, a market downturn presents something of a difficulty.
Alistair Wilson, a savings expert at financial provider Zurich, explains: “Retirees in drawdown need to be flexible about how much money they take from their pension. Withdrawing more than the return of their portfolio, or when the value of the underlying investments has fallen, could lead to a savings shortfall in later life. When stock markets are volatile, retirees should be prepared to adjust their income to ensure they can sustain their pot throughout the course of their retirement.
“The danger is that selling after markets have fallen locks in losses, leaving investors with a lower-value pot that will in turn generates less income. This can make it harder for the pot to recover.”
Mr Wilson recommends building in an element of a ‘cash buffer’ to protect against downturns. While this might reduce some of the yield of your portfolio, in the event that markets take a turn for the worse you’ll be able to ride the storm.
Mr Wilson says: “Holding one to two years’ cash means you won’t be forced to sell when prices are falling, thereby locking in losses. Instead of cashing in funds, you can dip into cash reserves, giving your pot a chance to regain lost ground.”
Mr Hunter agrees with this proposition: “Investors should always have a ‘rainy day fund’ in place (minimum six months’ salary, for example) before even considering investing in the market.”
4. Is your portfolio suitably diverse?
What has become clear in 2018 is that volatility is here to stay.
James Hutton, business partner at Sarasin & Partners, says: “Given the magnitude of absolute (and after-inflation) returns investors have enjoyed over the past five years, we believe that it is now essential to ensure that you don’t have to be a forced seller at an inopportune time. The best planning you can make for a shakeout in markets is to ensure that you can ride out any volatility, as, while it won’t feel like it at the time, markets will recover.”
Diversification is the key to riding out volatility, according to the experts. At this point in the cycle, it is more important than ever to think carefully about how your portfolio is positioned.
Mr Stevenson is clear: “With the outlook for the remainder of the year riddled with doubt and uncertainty, it would be prudent for investors to protect themselves by ensuring they are well diversified.
“A well-diversified portfolio should consist of a mixture of asset classes spread across a range of geographical regions. However, it can be challenging putting together a portfolio of funds that complement each other, so you may want to consider leaving it to an expert.”
To conclude, Mr Hunter adds: “Fund managers didn’t even see the (now 10-year) bull market coming, let alone any bear market. So, the longer time horizon that an investor can take, the better.
“A good adage which has been applied to investing is that history does not repeat itself, but it often rhymes.”