Strategies to reduce anxiety when investing in tempestuous stock markets

The GFC was a significant event, however we don’t think anyone anticipated that the subsequent recovery was going to be without some bumps along the way.
Getting businesses and countries to address their balance sheets and reduce debt takes time. In the case of Italy, Spain, Greece and Ireland, it is clear that leading up to the GFC these countries were simply spending more than they could afford. Even if the GFC hadn’t occurred in 2008, these countries were on track for their day of reckoning.

We don’t envisage that there will ever be a time when ‘all is well’ in the global economy and you can invest in sharemarkets and expect minimal volatility. If there was no risk investing in stockmarkets, then the expected return of shares would be effectively the same as government bonds. Simply, there is a ‘risk premium’ investors expect to receive for investing in shares.

Nevertheless, many investors experience various levels of anxiety when financial markets are volatile. Consequently, there are strategies that we employ which are designed to minimise psychological stress and increase the probability of investors still achieving their objectives, even when financial returns may be below longer term averages. Some of the strategies we use are outlined below.

1. Only take risks you need (or desire) to take

Quantifying your objectives and determining what rate of return you need to achieve enables us to establish an appropriate target asset allocation for you (i.e. what percentage of your portfolio should be in cash, fixed interest, property and shares). As your circumstances may change over time, this target is regularly reviewed to ensure it remains appropriate.

In an ideal scenario where the performance of your portfolio exceeds expectations, we may be able to reduce your exposure to growth assets over time, which both reduces investment risk and increases the probability that you achieve your objectives.

2. Establish a Defensive Capital Base

 

Some people achieve peace of mind from knowing they always have a minimum dollar amount invested in high quality, liquid and diversified fixed interest securities, so that in the event of a major fall in markets, they can rely on having a certain amount of funds available. 

3. Maintain 5 years of cashflow

This strategy is quite simple in execution: if you spend $100,000 each year, aim to keep $500,000 invested in cash and fixed interest at all times or have sufficient income from other sources to help meet your cashflow requirements.

The objective of this strategy is to reduce the possibility of needing to sell property or shares at distressed prices in volatile financial markets to meet your cashflow requirements. It’s a strategy which rewards patience and discipline.

If we take our model 60% growth portfolio and disregard the 40% cash and fixed interest component, we can review the rolling 5 year annualised returns of the growth component of the portfolio (which includes listed property, Australia shares, International shares and Emerging Markets) over the past 22 years in the graph below:

 

Source: Returns Program for period 1 August 1989 to 30 June 2011

Over this period, the best 5 year annualised return was 19.7% pa, if you happened to have invested in November 2002. The average for the entire 22 year period was 11.6% pa.

What is clear is that investments made since 2004 have achieved lower than average annualised returns over rolling 5 year periods, due to the effects of the GFC.
But the worst 5 year annualised result was still positive, being +0.9% pa if you happened to invest in July 2006.

So if you’d been on a desert island for the past 5 years and only drawn from cash and fixed interest investments to meet your cashflow requirements, your homecoming may include disappointment with the absolute returns of the growth component of your portfolio, but you’ve certainly avoided a ruinous outcome.

Sometimes investors aren’t in a position to have 5 years of cashflow available in defensive assets, as they need to take greater risk to achieve their objectives. Such circumstances are not necessarily a cause for alarm. There may be facilities in place to draw cash if required, or if you are still working, a regular income may provide for most of your cashflow requirements.

It is important to remember that our fixed interest approach is to invest in high quality, diversified and liquid securities. In times of financial volatility, many investors run to these assets for safety. Consequently, the returns of the defensive component of the portfolio are robust even when financial markets are volatile.

Reflecting over the past 100 years, there have always been countries facing financial difficulties that may weigh on an investors mind. Despite this, many global stockmarkets – including Australia – have continued to deliver average annual returns of around 12%. The compound effect of this has been excellent.

One of our roles is to make sure our clients have appropriate risk exposure in their portfolios. This is not a ‘set and forget’ strategy – it requires regular review. Coupled with the establishment of a Defensive Capital Base, education and discipline, these strategies provide the foundation for a successful investment experience with the highest probability that your objectives will be achieved.

In summary, despite the ‘defensive’ characteristics of most of our client portfolios, increased volatility in share markets does occasionally cause anxiety.

If anyone has any questions or wishes to discuss any aspects of their portfolio with us, as always they are most welcome to contact us at any time.

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.