Article

The measured risk of stock-market investing

Even in bear markets, there are companies, sectors and even countries where money can still be made by buying and holding shares.

| 5 min read

Investing in the stock market involves taking risk and often entails holding investments during periods when markets are falling. In the longer-term holding, a well-diversified portfolio of shares usually produces decent real returns – but for a limited period when inflation is high and activity is falling, equity markets may suffer. This explains why investment managers always start by asking a client how much risk they can afford to run with their savings. If you might need the money soon for general expenditure or to make a one-off large purchase, you need to keep it in low-risk investments to be sure it is there when you need it.

It’s been a bad first half of 2022 for all those who have investments in equities and bonds. Central banks have needed to respond to the rapid rise in inflation. Their policy errors last year in keeping interest rates too low and printing too much new money has been compounded by the Russian invasion of Ukraine, which has driven up energy and food prices. It has been necessary for central banks to stop creating money to buy-up bonds and interest rates have started to rise.

Central banks are fixing their own mess

It was purchases by central banks in recent years that drove bonds to high levels, which kept rates low. As interest rates rise so bond prices fall, as people want a higher running return on their fixed-income bond, which means a lower price. An extreme case of a bond with no repayment date will halve if interest rates rise from 1% to 2%. If the bond pays an annual income of £1 on its initial value of £100, to get to a 2% income the bond needs to halve to a price of 50p so the £1 of income is now 2% of the purchase cost of the bond. Holders of shares also suffer.

If you can get a higher income on a bond, then why not expect a higher dividend income on your shares? As rates rise, there are also worries that economies will slow or even go into recession, which means less turnover and profit for businesses, cutting their earnings and capacity to pay dividends.

People often ask how they can protect their capital in these adverse conditions. If you want a low-risk portfolio then you need to keep your investments closer to cash and deposits whilst interest rates are rising. The shorter the time to repayment on a bond, the lower the loss there will be when rates move up. If you hold a 1% one-year bond and rates go to 2%, your bond will fall in value by around 1%.

The £100 bond paying 1% for a year drops to about £99 if the rate rise occurs at the start of the year. A new buyer of that bond will get the 1% interest and the 1% of capital gain when the bond matures for £100 at the end of the year, the 2% return they want. If you as the owner hold it for the year and do not sell, you make your 1% interest return with no capital loss. High-grade bonds with a short time to run to repayment give you the best protection amongst quoted securities.

Inflation-linked investments

Some think inflation-linked bonds should be the answer. After all, they are designed to increase the repayment amount of the bond by the inflation rate – and also increase the interest paid as prices rise. The problem is that, as general interest rates rise, people want a higher overall return from their indexed bonds as well as from their conventional ones. That means the longer the time until they mature, the bigger the capital loss to adjust to expectations of a higher interest rate. This is similar to the situation with conventional bonds, though the inflation linking provides some offset. Shorter-dated inflation-linked bonds can offer some better protection.

Savers willing to take more risk understand that shares can go down as well as up. Many people buy into the idea that shares usually provide good positive returns over the longer term, and you just need to accept the odd year of poor performance when there is a bear market.

Even in bear markets, there are companies, sectors and even countries where money can still be made by buying and holding shares.

As timing when dips in markets will occur is difficult, there are many who buy and hold through difficult times. It’s also true that even in bear markets, there are companies, sectors and even countries where money can still be made by buying and holding shares.

Over recent difficult months, there have been run-ups in the prices of energy and numerous other commodities. The companies that produce and trade these have also benefitted from the windfall elements. This is why countries and stock markets with a high proportion of commodity exposure have done better than the more mainstream equity markets.

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.

The measured risk of stock-market investing

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