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
With the end of the financial year approaching, it’s worth revisiting whether there is anything else you can do to proactively minimise your tax liabilities.
Here are four considerations for you. Remember there is more to financial effectiveness than managing taxation, so please seek out personal advice when considering making changes.
Prepay Health Insurance
The current Private Health Insurance rebate drops from 1 July 2012 for singles who earn over $84,000pa or for couples who earn over $168,000.
If this includes you, there may be a benefit of paying for your Private Health Insurance 12 months in advance. Please keep in mind the impact of such a prepayment on cashflow.
If you wish to review the table for the new rebate levels, you can refer to the rebate table in the 2012 Federal Budget overview.
Delay the receipt of any taxable income and maximise deductions
There will be a drop in the tax rates come 1 July 2012. Accordingly, you will benefit from a tax perspective by delaying the receipt of income until next financial year or bringing forward deductions to this financial year. If you want to check the new tax rates, we have them in the 2012 Federal Budget overview.
If you are employed, it’s worth starting to get your tax affairs in order. Gather your receipts and document expenses. Deductible expenses may include travel, training for work, a brief case and other work related deductions. Also make a note of items such as donations to appropriate organisations.
Maximise deductible contributions to superannuation
Currently for over 50s, the maximum tax deduction for super contributions is $50,000 in the current tax year. This will drop to $25,000 from 1 July 2012. If you have the money available and it fits with your financial plan, you may benefit from putting more into super prior to 30 June 2012.
Importantly, if you’re in this age bracket and you contribute regularly to superannuation, it would be worth reviewing your arrangements come 1 July 2012. You don’t want to be in a position where you go over these limits. Read more about concessional/deductible contributions.
Maximise co-contributions to superannuation
Currently the government will match up to $1000 of personal super contributions in a year however from 1 July 2012 the super co-contribution will be halved.
Not everyone has access to this entitlement though. To review the conditions to be eligible for a super co-contribution go to this page in the superannuation learning module.
When considering making additional contributions to superannuation, it’s important to consider this in hand with your other financial commitments such as meeting debt repayments and similar.
While these are a few of the strategies available to manage taxation, keep in mind there are other things you can do both now and throughout the year.
If you want to read more about taxation and tax planning, click here to go to the learning module.
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.