In the face of recent market volatility, Jonathan Davis explains why a calm approach is best
No matter how much wise advice they receive in advance, few investors find their first encounter with a sharp market sell-off a comfortable experience. The stock market decline that seemed to materialise out of nowhere this month is, so the market historians tell us, the fourth quickest 10% decline in the Dow Jones Industrial Average since Charles Dow started measuring share price performance more than 120 years ago. That makes it a particularly short and sharp “correction”, a correction being the term that market pundits these days use to describe a 10% fall in the overall level of the stock market (not to be confused with a “bear market”, a fall of 20% or more).
How best to react to such a sudden movement? Mark Dampier, Head of Research at Hargreaves Lansdown, says that the best thing you can do if markets take a sudden downwards lurch is to switch off your laptop, leave the newspaper in the wastepaper basket, and go sailing, or whatever your favourite pastime is. That may sound flippant, but it is actually wise advice, for a number of reasons.
The golden rule about market declines of this rapidity is not to panic. Alarmist headlines in the media disguise the fact that immediate explanations of what has caused sharp market setbacks tend to be of an apocalyptic nature and frequently wrong. Don’t be bounced into doing anything hasty; the chances are that you will regret it. Assuming you have made your investments for a sound reason, a spot of market turbulence does nothing to invalidate your reasoning.
The second thing to do, assuming you have not headed out to the beach, is to put what has happened in context. The recent falls follows a more or less unprecedented period of calm in the markets, with no setback of more than 5% being seen for more than two years. J.P.Morgan famously said, when asked what the stock market would do next, “it will fluctuate”.
Until this month the market has been defying that characterisation, lulling many investors – though not, I am happy to say, the readers of the Investment Trusts Handbook – into a false sense of security.
In fact share prices have been rising at a faster pace than normal in the last few months, with many investors becoming over-confident about the prospects for economic growth and company earnings. A lot of professional traders have been betting heavily – many with borrowed money – that so-called market volatility would remain low. Such overconfidence always comes at a price. It has been a very profitable trade for some time, but they have now had their fingers badly burnt as volatility has returned with a vengeance. (In this year’s handbook veteran investment company investor Peter Spiller warns specifically against the risk of putting money into many types of ETF).
Once the immediate storm has settled down, what does do no harm is to review your portfolio when episodes like this occur to see whether it has performed markedly differently to what you expected. Investment companies are by their nature diversified - that is one of their strengths - and a portfolio of investment companies investing in different asset classes will add a further layer of diversification that should protect you against the worst of the storm. If it has failed to do that job you may need to review how your portfolio is structured, as a different mix of assets may be warranted.
It is true that one of the advantages that investment companies enjoy is the ability to use gearing (or borrowing) to enhance returns. That cuts both ways – helpful when markets are rising (which they do three years out of four) and potentially a negative when they sell off. But the fundamental principle remains: diversification is the only effective way to reduce the risk of excessive exposure to market swings.
Yes, there are some good reasons for thinking that the stock market is now in the later stages of what has already been an exceptionally long positive bull market, dating back to 2009. The discounts at which many investment companies trade had narrowed to historically low levels before this month’s sell-off, a signal that the markets may have a short-term run ahead of themselves. Bond yields have been rising. Calmly monitoring and adjusting the risk of your portfolio in the light of such new circumstances is never wrong – indeed sharper market falls often create attractive new entry points for investment companies that had been trading at rich prices - but trying to time the market when it is moving around so fast invariably and categorically is.
The Investment Trusts Handbook 2018, featuring an investment company directory, analytical advice and contributions by a dozen leading investment company experts, including Peter Spiller, Robin Angus, John Baron and many more, is available as a hardback book or as a (currently free) e-book download. Link here.
The Investment Trusts Handbook's editor, Jonathan Davis, a former columnist in The Independent and Financial Times, and a qualified professional investor, welcomes ideas and suggestions for next year’s edition. Email: jd@independent-investor.com.
