By Tim Hewson
26 March 2008
Economic fundamentals appear to mean very little of late, as global market volatility continues to rattle even the most seasoned investment professional.
So you could be excused for feeling a little sceptical and believing that behind every brave face, is a sulking portfolio quietly licking its wounds.
Global contagion of all asset classes is now a common theme. And it appears that most investors are cutting their losses and bunkering down into traditional safe havens until the storm has blown over.
So whilst you've probably already been told, now really is a good time to revisit the basics of your investment strategy.
Understanding volatility
In a nutshell, volatility is the relative rate at which the price of an investment fluctuates - the bigger the moves and the more frequency with which they occur, the more volatile the investment.
Ultimately, an investor's attitude towards volatility, like risk, relates to their ability to traverse market movements. However, it's crucial that you have an understanding of just how much volatility and risk you are prepared to absorb, and over what timeframe you make your investment decisions.
At the end of the day, you want the risks you take to be as calculated as possible.
Only time will tell
For example, most first time investors moving into the current market are likely to be more cautious, measured and conscious of the volatility of potential returns. However, maintain a long term horizon and the impact of short term volatility within a 10, 15 or 20 year plan will appear relatively small.
In contrast, someone nearing retirement and wishing to cash in his or her super will likely have a very different objective and risk appetite.
So when you set your objectives, make sure you put the timeframe firmly into perspective.
Volatility doesn't discriminate
Equity investors lost most, if not all, of their 2007 gains by mid January 2008. And whilst there has been a mild recovery, there is still a way to go. Likewise, fixed income investors have also been squeezed as short end yields decrease.
And anyone with a home or investment loan is likely to be tearing their hair out as both the RBA and the banks continue to increase rates in symphony.
Leaving the wealth accumulators, but they're also having a tough time as they separate the wheat from the chaff.
Diversify
It's an oldie, and a goldie, simply because it works. Since its birth, diversification has been proven time and again to be the best defence against volatile markets.
There are essentially two diversification types, horizontal and vertical.
Horizontal diversification spreads your portfolio amongst investments of the same type or asset class. For example, broadening your exposure from large cap equities to include mid caps, small caps, industrials, resources, mining, technology etc.
Whereas vertical diversification spreads your portfolio across different asset classes and investment types. For example combining cash, equities, fixed income, property and other investments together.
Vertical is more commonly used in portfolio construction and has also been proven to be the best weapon in volatile markets. The principle is simple, the greater the number of investments within your portfolio across more asset classes, the less likely you are to be affected by the underperformance of any single investment.
However with vertical, it is also possible to spread your investments too thinly and potentially create a negative impact on your overall portfolio's ability to generate returns. And the more likely it is that you'll incur higher fees and charges.
Rebalance your portfolio
Rebalancing, so you have sufficient defensive investment exposure to meet long term objectives is also an important consideration. Whilst it is often said that the longer the investment timeframe the higher the risk appetite, this is not always the case.
Many people feel differently about risk and in my mind, most investors are ultimately 'absolute return' focused by their very nature. After all nobody likes to see that red negative sign, no matter how small the number.
Average can be a good thing
During volatile markets, investing smaller and regular amounts into a worthwhile investment can be useful.
'Dollar Cost Averaging' lets you avoid the potential impact of making a single investment on any given day at the prevailing price.
In contrast, regular investments are more likely to normalise the overall price over a longer period of time, especially as the cost fluctuates.
In some cases, the average price of your exposure can be lower, and also generate a greater return.
Growth vs value
With all the commotion surrounding market volatility, it's important to remember you do have choice. Especially when implementing your investment plan and with whom.
Growth Managers typically pick stocks that can potentially increase, regardless of the underlying fundamentals of the investment. They also seek high Price Earnings (PE) stocks in order to generate capital gains.
In contrast, Value Mangers focus on identifying stocks that are under priced, and therefore have a tendency to generate a relatively more favourable return. They also tend to outperform Growth Managers in downward trending markets.
Whereas GARP (Growth at a Reasonable Price) Managers typically bring the best of the two strategies together.
Consider alternatives
Alternative strategies like hedge funds, absolute return funds and other non-mainstream methods can also be useful. At the very least, they provide additional diversification to the traditional techniques of mainstream managers.
This might mean they short sell, take a contagion approach to the market, use more leverage to increase their exposure, or use derivatives to leverage or hedge their strategies.
However, make sure you do your research so you fully understand the fund manager's strategy and remember to question if it's appropriate for you.
It's just like playing golf
As an avid golfer, you often hear that the longer you practice the more you'll improve your timing, accuracy, consistency and ultimately your handicap. Investing it has to be said, is extremely similar.
However, it's important to remember that it's not the timing of your entry to the market that will deliver the best long term returns. It's the amount of time you spend implementing your strategy.
So remember to keep your head down, your eyes on the ball, focus on your target. And follow through.
Beware the gifts of Christmas past
The old saying that 'past performance is not an accurate reflection or indication of future performance', also rings true.
Simply look at the Australian equities market and its past year in comparison to the previous one - and you'll see that performance is not linear or exponential.
So don't go buying last year's best performing investment thinking you're in for more of the same. Likelihood is, it'll be knocked off its perch and replaced before you know it.
Be tactful!
Sometimes the best defence against volatility is to take a different tact. The benefits of adjusting your asset allocation in time of market stress can also provide an important opportunity.
It doesn't need to be a fundamental change in your Strategic Asset Allocation (SAA), more an adjustment in your Tactical Asset Allocation (TAA), or Dynamic Asset Allocation (DAA) based on your short term market views.
Whilst it might only be a temporary shift, also think about the permanent implications. Because if the market doesn't move as you expect it to, you may end up realigning your portfolio for the worse, not the better.
Importantly, make sure any adjustment still complements your overall strategy.
The tax axe
When buying, selling, switching or adjusting your portfolio, beware the implications of tax. In many cases it often has quite an impact on the overall return generated.
Tell someone who cares
Finally, if you just can't get comfortable with what to do… get advice. But once again, make sure you are honest with yourself and that you are happy to have someone else make your investment decisions for you.
At the very least, you'll receive the benefit of removing your emotional attachment, as well as gaining your new planner's experience.
So no matter if it's a fundamental shift in the mechanisms of the global markets, or simply the realignment of a new market cycle, one thing is for certain.
Whilst it continues to become increasingly difficult for investors to invest with confidence, there are still plenty of fresh and innovative ways out there for you to try to improve your returns.
However, if none of the above feels like you, remember that sometimes a simple return to basics can bring around the best course of action.
Happy investing.