10 things to know about investing in volatile markets

With dark economic clouds on the horizon, Faith Glasgow examines how to invest in volatile markets.

If you’re an investor in 2022, you’ll know all about the worry and stress involved in steering your money through volatility triggered by a toxic mixture of macroeconomic and geopolitical pressures.

There is nothing we as individuals can do to influence the causes; but we can manage our investments to try and ensure they weather current market ups and downs effectively and recover quickly once prospects eventually brighten again.

Here, then, are 10 simple steps to take to protect your portfolio in volatile times: hopefully you’re doing most of them already.

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1) Take the long view

Sounds very obvious, but it’s important to hang on to the fact that while markets are deeply gloomy now, the global situation will evolve and eventually improve. To put that in context, look at annualised net returns from the MSCI World index since the end of 1987 - almost 35 years ago. As at the end of July, they stood at just over 8%.

That period has encompassed huge economic growth globally, and it would be foolish to assume more of the same going forward; but it has also seen numerous crises, including the dotcom bubble bursting in 2000, the great financial crisis of 2008 and the Covid pandemic of 2020. Despite those setbacks, developed markets have repeatedly recovered and continued to grow.

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2) Don’t panic and sell

It’s all too easy to look at a sea of red indices and decide your money is better on the sidelines for a while. That may be the case - cash won’t fall in value like a stock or fund would – but it’s not that simple.

First, when do you re-enter the fray? As a longer-term investor it is notoriously difficult to call the top or the bottom of a market, and most experts advise against even trying because you’re likely to get it wrong, which is a costly business.

For instance JP Morgan calculated that $10,000 invested in the S&P 500 over 20 years to 31 December 2021 would return an average 9.5% per year if it was untouched during that time. If you went into cash several times such that you missed the market’s 10 best days of those 20 years, your annualised return would fall to 5.3%.

Moreover, the best days in the market typically come hot on the heels of major falls. In the JPM study, seven of the market’s 10 best days occurred within two weeks of its 10 worst days.

Furthermore, cash in inflationary times is inevitably losing purchasing power. It may be safe from market risk, but it will still be falling in value in real terms.

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3) Remember the importance of diversity

Markets across the world, and even parts of a single market, can behave differently over the same period. It therefore makes sense to hold a mix of investments covering a variety of countries, sectors, market capitalisations and investment styles. Including different assets – bonds, property, commodities, infrastructure, gold – in your portfolio alongside equities helps bolster its strength further by reducing the overall highs and lows. Over the long term, that more balanced approach tends to outperform an equity-only portfolio.

As a rudimentary example of the importance of diversity, if you held nothing but a Nasdaq tracker through 2022, your investment portfolio would have lost around 20% year to date. If you had half in a FTSE 100 tracker, that money would be worth roughly the same as at the start of the year, so the total loss to the portfolio would be only 10%.

4) Stick with your regular investing plan

Regular investing into funds or investment trusts are a great way to save from your earned income – and they really come into their own in falling markets, so stick with them.

Why? It’s down to a concept known as pound-cost averaging. You’re paying in the same amount every month – so over the months when the price of shares/units is falling, your money buys a progressively larger number of them. When prices start to rise again, you may own more units than if you’d invested an equivalent lump sum at the start of the volatility.

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5) Consider adding defensive assets

You may be a relatively adventurous investor, keen on equities and maybe with a taste for emerging or single markets, AIM investments, private equity or very focused funds of ‘best ideas’. But at volatile times you can protect your portfolio by using cash or maybe selling down some racier holdings to add some exposure to more defensive assets.

Defensive stocks tend to be found in sectors that people can’t do without: healthcare, utilities, food and drink, tobacco. Often they are large, well-established companies with generous dividends that will be paid even if the share price is struggling - characteristics that further boost their defensive nature.

What about other assets? Historically, bonds were seen as much more defensive than equities, but in inflationary times many parts of the bond market tend to struggle. Successful bond fund managers are likely to be focusing on high-quality, short-maturity bonds.

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6) Pick businesses with good fundamentals and long-term prospects

If you are inclined either to tweak existing holdings or to add to your portfolio while prices are low, it’s really important to do your homework. As a stock picker, you should be looking for robust businesses that are not only cheap but well-placed to continue making a profit through difficult times and beyond.

That means looking at a range of financial indicators such as the debt to equity ratio, price to earnings, return on equity and profit margin, but also reading around to get a sense of qualitative factors such as the quality of the management and strength relative to direct competitors.

7) Use cash to top up high-quality but battered holdings

The investment guru Warren Buffett recommended that investors should be greedy when others were fearful, and it is, of course, sound advice for longer-term investors.

If you have holdings in investments that you know to be well run, profitable and future-fit, but where valuations have been hard hit by a reversal in market sentiment or wider macro problems, this is the time to be brave and buy more at current low prices. It may take time for their values to recover, but provided you can wait, you’re positioned to enjoy the full uplift.

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8) Review regularly and rebalance

Markets may be volatile, but that doesn’t mean it’s a good idea to ignore your portfolio completely until normal service is resumed. A diversified portfolio still needs to be reviewed on a regular basis, because some holdings will inevitably have done better than others.

The past months, for instance have seen a surge in oil and gas prices; if you had bought an energy-focused exchange-traded fund (ETF) at the start of the year, it could have gained around 60% over a period when other holdings struggled to hold their value.

The danger of such misalignment is that you end up with a far larger proportion of your portfolio than you intended in a niche and inherently volatile market. By trimming holdings that have done best and topping up others that could be set to recover, you’re reducing the overall risk profile.

9) Don’t take more than natural income

Income investors should be particularly careful when their pension portfolio is falling, because of ‘pound cost ravaging’. If you usually take a certain sum from your investments as income each year, then you’ll do increasing damage to the pension capital if you maintain that level of withdrawals when markets are falling.

It’s especially risky in the early years of retirement, because if you make a big dent in your capital at that stage it can be very difficult for the portfolio to recover.

The safest solution is to make use of savings and avoid using your pension fund at all during volatile times; if that’s not feasible, withdraw only ‘natural’ income from dividends or interest and don’t touch the capital.

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10) Maximise tax savings, minimise fees

Every little counts when markets are falling, so make sure you are utilising your tax allowances to the full to minimise the amount going to the taxman. Think also about broker fees: for portfolios worth more than around £50,000, flat-fee arrangements work out progressively cheaper than percentage-based fees. Savings can amount to tens of thousands of pounds over the long term.

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