Investing in volatile markets

Written and accurate as at: 14 February 2012

Higher volatility in financial markets is being touted as the ‘new norm’. During choppy times in financial markets, investors are prone to making investment decisions based on fear.

Below are some tips on the different ways to manage the risk in times of high volatility.

Move to a more conservative portfolio

When markets are volatile, investors often want to protect their investment portfolio from any further falls in the share markets. This can be achieved by selling down some or all of the growth assets and investing the proceeds in secure investments such as cash and/or term deposits.

Unfortunately, it is common to sell down growth assets after prices have already fallen. Nonetheless, this strategy can protect the portfolio against further market downturns, providing some peace of mind.

However, you may not necessarily need to take big steps by selling all or a significant amount of growth assets. Rather you can reduce exposure by making smaller tweaks. By doing this you will not only have some protection on the downside but will also provide some upside should the market recover.

Keep in mind that the sale of shares may also not be optimal from a tax perspective. There may be capital gains tax payable particularly on shares, or units in a managed fund, that have been held for a long time. If the shares or units are held within a super fund, the maximum capital gains tax payable is 10% and so the tax implications may be less compared to assets held in your own name.

The biggest risk of this strategy is the risk of attempting to time the market and getting it wrong and thereby missing out on any recoveries in markets which can often be very rapid and short lived. For example, investing in a term deposit for say three years limits the flexibility to move back into the market if the opportunity arises before the maturity of the term deposit.

A lower exposure to growth assets can also mean the likelihood of achieving higher returns is reduced should the market recover, which in turn adversely affects the future value of the portfolio. You may be planning for retirement and base your plans on achieving a certain level of returns over time that if not achieved, puts your planned future outcomes at risk.

There is another risk to consider. We are living longer and this poses a risk described as ‘longevity’ risk. The option of adopting a conservative portfolio may simply exacerbate the longevity risk because it limits the potential growth of the portfolio over time.

Switch to defensive investments

Investors can switch to securities and managed funds that have a more defensive characteristic. This may be due to the share or managed fund providing exposure to companies that are more defensive either because their business tends to hold up better during economic downturns and/or it pays a higher level of income, typically in the form of dividends or distributions that cushion the total returns from a fall in its price.

Certain assets like gold can perform well when there is greater uncertainty around the markets and these are sometimes considered defensive investments.

The specific nature of the investments needs to be taken into account. If switching to a different type of investment, its essential the risks and product specific attributes of this investment approach be well understood.

Another possible outcome of this strategy is that defensive assets may not perform as well as the overall market in the case of a market recovery.

As mentioned above, any switching of investments may result in realised capital gains and transaction costs, which certainly need to be considered.

Maintain the portfolio’s diversification

Diversifying the portfolio by spreading the investments across a range of assets and investments is one of the fundamental ways for managing volatility risk in a portfolio.

Investing across a range of assets including alternative assets and debt securities can be an effective means of protecting a portfolio against market downturns. Having a concentrated portfolio with exposure to only a few assets or investments increases the portfolio’s risk should one of the investments fail.

Consider dollar cost averaging

Making regular investments over time can avoid market peaks and troughs. This is done by buying more assets when prices are low and fewer assets when prices are high. This strategy reduces the risk of making a large investment at the peak of the market. Read more on dollar cost averaging.

Lower gearing levels

Other strategies to consider include reducing the gearing levels on portfolios where borrowings have been used to acquire shares or units. This may involve selling down investments to reduce the level of borrowing and/or contributing additional personal funds to reduce the loan to valuation ratios.

Lower levels of gearing reduce the probability of experiencing a margin call and the potential losses from a market downturn. On the flip side, if you have sold down assets to pay down borrowings, it also reduces the gains from any market recovery.

Putting it all together…..

There are a range of levers that can be used to manage the impact of market volatility on an investment portfolio. Each has its advantages and disadvantages and in some cases, a combination of strategies may prove to be a better outcome than simply relying on a single approach. The implications and risks of the different approaches should be well understood to ensure an informed decision is made.