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How to prepare a portfolio for market volatility

Rather like becoming seasick from rolling waves, market ups and downs can test the resolve of any investor. Rob Morgan looks at ways to plan ahead for when market volatility strikes.

| 8 min read

Financial markets can display a variety of climates. One moment fine and sunny with investors optimistic, the next cold and stormy, tempting them to seek shelter. Trying to predict these periods is fraught with difficulty. Even in tropical weather a storm could be approaching unnoticed and catch out the unprepared.

As well as the usual market swings that can result from investor sentiment ebbing and flowing according to expectations around economic growth, inflation, geopolitics, and a myriad of other factors, it so-called ‘black swan’ events that tend to have the biggest short-term impact. They arrive as a bolt from the blue, so they represent a risk that isn’t already significantly factored into prices. A prime example is the Covid-19 pandemic, which set off a market tumble before a rapid recovery took place.

But how do you prepare your portfolio, and yourself, to endure the inevitable inclement periods? Here are five possible approaches to counter the risks of market volatility.

1. Adopt a ‘permanent’ diverse portfolio

    Timing the market, moving into and out of riskier assets, is exceptionally tricky, so a more realistic alternative is to have a more permanent and properly diversified portfolio that is rebalanced and perhaps tilted one way or another according to the general outlook, specific opportunities and perceived risks. This approach keeps you invested to benefit from the long-term wealth generating effect of asset prices without betting the farm.

    As investment legend Sir John Templeton put it, “The only investors that don’t need to diversify are those that are right 100% of the time”. The sensible thing to do then is to prepare for different outcomes and spread your money around so you are not reliant on a single company or investment area. In other words, have a big enough umbrella for when it rains.

    By blending a variety of investments that are ‘uncorrelated’ (i.e., their price movements are largely independent of one another rather than moving up and down in tandem) it is possible to build a portfolio more resilient to market fluctuations but that can still deliver good performance. Ideally, this should balance simplicity with variety. Spanning different sectors and areas is important to spread the risk, but equally a portfolio shouldn’t become an unwieldy ‘stamp collection’ difficult to monitor and manage.

    2. Stick to your strategy,

    Rather like becoming seasick from rolling waves, market volatility can test the resolve of any investor. When at sea, keeping your eyes on the horizon, rather than on the churning ocean below, allows you to rebalance your senses and regain your orientation. As an investor if you keep focused on the long term rather than every passing market gyration you stand to make better decisions about what to do next.

    Hopefully you will already have a plan for how much money you are investing, or seeking to invest, and which areas it is allocated to. One that is in harmony with your objectives, time horizon and level of risk you are happy with. If you have a good handle on what your ‘permanent’ portfolio should look like, it may sometimes make sense to adjust these allocations as asset prices move around to maintain weightings and diversification. However, for much of the time little or nothing should be required.

    Either way, if you have a plan to stick to and accept that events will inevitably arrive to test your resolve it can make things easier. Otherwise, there could be a tendency to slip into panic mode and make poor, spur-of-the-moment decisions. At times of market stress, emotional reactions from investors can mean price falls are exaggerated, which makes it more difficult to think rationally. In these circumstances be aware that buying or selling in haste can result in being on the wrong end of price swings.

    3. Include income-producing investments

    Although it can be scary when the markets are volatile, the amount of income an asset produces can often be more consistent than the capital value. Amidst a challenging and fast-changing economic backdrop it is easy to forget this is an important part of your overall return. When markets are flat or falling the steady arrival of income adds to and stabilises the value of your portfolio. Income from your share or bond holdings is also a reason why timing markets, selling out then buying back in, is usually unwise as it interrupts the flow.

    As well as dividend-paying shares, to balance the choppiness of share markets and help smooth overall returns, investors often add traditionally less-volatile bonds. Typically, bonds pay a fixed amount of income each year (known as a coupon) and repay the original capital at the end of the term. It’s an asset class that attracts investors looking to take some risk with their capital in exchange for the prospect of a higher longer-term return than cash. You can find out more about this on our latest bonds and fixed income sector review.

    4. Plan to use market falls to your advantage

    Buying when asset prices are low and selling when they are higher is always the aim with investing, but it can be difficult to achieve without time and patience. Many people end up making emotionally led, shorter-term decisions and doing the opposite. However, a large fall could be just the opportunity you have been waiting for to invest in an area you have had your eye on but felt was too expensive.

    Some more active investors like to keep a little ‘dry powder’ to capitalise on any market turbulence, particularly when markets are looking expensive. This could, for instance, be through holding very safe investments such as money market or short-term bond funds that can quickly be sold and reinvested into riskier areas at opportune moments. However, market timing is notoriously hard and tends to require luck as well as judgement. Market tops and bottoms have much to do with human psychology, as well as many factors we aren't aware of at the time, so this strategy comes with the risk that you miss out from not being more fully invested over the longer term.

    5. Invest regularly to capture lows as well as high

    A tried and tested way to counter market ups and downs, as well as take some of the stress out of investing, is to contribute money at regular intervals, say once a month, rather than a lump sum in one go. The advantage of dripping money into the market is that you don’t need to worry about market timing.

    By contributing regularly in chunks an investor ends up buying more shares or units when prices become cheaper and fewer when they become more expensive. If you just keep buying the market falls you could, over time, turn volatility to your advantage. This effect is known as 'pound cost averaging', and over longer periods it can help smooth out the highs and lows of the market; though there are still risks and with all investments, you could get back less than you put in.

    If you have reached the point that you are drawing from rather than accumulating investments you are not going to be able to take advantage of pound cost averaging or ‘buying the dips’, which makes maintaining a diverse portfolio to reduce volatility even more important. If you want to learn more about the risks of taking money from your investments, read my previous article on pound cost averaging.

    Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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