Important portfolio reminders

14 September 2015
Important portfolio reminders

3 key portfolio reminders

Source: Paul Resnik on Morningstar.com.au 09/09/2015

The current market conditions could be the start of another correction, according to some prominent commentators, with the bull market overdue for a taming. By the time the bad headlines are “top of the news” it’s typically too late to take effective action.

What we’ve learned since we launched FinaMetrica in 1998 is that in times like these, risk-averse investors often become overwhelmed by anxiety and sell down volatile assets such as shares.

Specifically, risk-intolerant investors cash out of companies that haven’t dropped greatly but hold on to the ones which have taken the biggest falls, hoping for them to recover. They sell winners and hold losers!

The risk-tolerant, on the other hand, become excited by market bargains and see great buying opportunities. They tend to buy the companies they are most familiar with, framing their decision against the recent highest price for that company’s shares rather than researching the ones that might offer greater value.

Both types of investors run the risk of making emotional decisions in the heat of the moment. History shows these are often decisions they later regret. Given the current market uncertainties, there are three key things to think about if you are an investor.

1)  Stick to your guns

If you have a portfolio mix that you agreed to with your advisor when you were in a calm and rational state, then now that markets are volatile it is unlikely to be a good time to change that allocation.

Ideally, you will have a portfolio that takes into account your risk tolerance, as well as your financial needs. You need to stick to it despite the bad news and big moves in financial markets.

If markets boom you should view this as an opportunity to take profits, and when markets drop, buy into the correction. You should rebalance your portfolio in a regular and disciplined manner.

If you feel you must trade, don’t read the newspaper headlines that scream “market devastation” and historical drops for 48 hours before you act.

2) Stay diversified

The media tends to report particular market or share drops. But remember, it’s unusual for all asset classes in a portfolio to drop at the same time. Your investments are diversified for a reason — to spread risk. All portfolio drops since 1970 for a portfolio with 50 per cent diversified growth assets and 50 per cent cash and bonds have recovered.

As you will see in the table below, there’s no pattern in drops and market recoveries so you should expect ups and downs, and remain patient.

Now is unlikely to be a good time to change your portfolio and shift to cash, bonds or property because these assets seem less volatile. In fact, it could be the worst time possible as you could be crystallising your losses on the equity sales.

 

Depth of Fall Started Falling Months in Fall Months to Recover Recovery
-21.0% Jan-73 20 13 Oct-75
-20.4% Oct-07 16 23 Jan-11
-18.0% Sep-87 2 19 Jun-89
-7.7% Jan-94 12 2 Mar-95
-6.3% May-81 10 4 Jul-82
-5.8% Feb-80 1 1 Apr-80
-4.6% Dec-01 14 3 May-03
-4.3% Jul-90 2 3 Dec-90
-4.2% Apr-84 1 1 Jun-84
-4.1% Feb-11 7 4 Jan-12

Source: FinaMetrica

3) Know your risk tolerance

The important point to understand is that your risk tolerance is generally stable over time and doesn’t tend to fluctuate with changing markets.

What changes as markets move is typically investors’ risk behaviour, driven by their perceptions of risk and not their risk tolerance. Notice from the chart below how little it changed through the market crash of 2007-08.

Average risk tolerance score

Source: FinaMetrica

The current market conditions could be the start of another correction, according to some prominent commentators, with the bull market overdue for a taming. By the time the bad headlines are “top of the news” it’s typically too late to take effective action.

What we’ve learned since we launched FinaMetrica in 1998 is that in times like these, risk-averse investors often become overwhelmed by anxiety and sell down volatile assets such as shares.

Specifically, risk-intolerant investors cash out of companies that haven’t dropped greatly but hold on to the ones which have taken the biggest falls, hoping for them to recover. They sell winners and hold losers!

The risk-tolerant, on the other hand, become excited by market bargains and see great buying opportunities. They tend to buy the companies they are most familiar with, framing their decision against the recent highest price for that company’s shares rather than researching the ones that might offer greater value.

Both types of investors run the risk of making emotional decisions in the heat of the moment. History shows these are often decisions they later regret. Given the current market uncertainties, there are three key things to think about if you are an investor.

Source: Morningstar

 

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