Interactive Investor

How to invest for difficult times

4th March 2022 10:13

by Faith Glasgow from interactive investor

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It isn’t easy knowing what to do with your portfolio during times of volatility, but there are things every investor can do to mitigate the effect. To help, Faith Glasgow has built a checklist to see you through every rough patch.

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We’ve come through two years of global pestilence and intermittent storms, only to be confronted with spiralling prices and now an aggressive war in Europe.

It really feels as though times are tougher than usual, and that leaves many people worried and uncertain about what best to do with their funds and shares. But there are sound investment principles that can help us all navigate such difficult periods, and it’s well worth reminding ourselves of them.

Don’t panic

Markets are bound to be volatile in the face of widespread uncertainty, although that can amount to a lot of day-to-day yo-yo behaviour and sideways trading. Over the first two months of 2022, the FTSE 100 index has processed inflationary shocks and the Ukraine war, and still only lost 0.3% of its value. That’s better than every other Western stock market.

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The worst thing you can do is to listen to grim news, check your portfolio, throw a big wobbly at the fact that it’s lost a lot of value in a short space of time, and crystallise those losses by selling the lot.

You may think you’ll simply reinvest when markets are quieter, but history teaches us that recovery, when it happens, can take place very rapidly – so if you’re not already invested, you’ve missed at least some of the bounce.

To put that into context, the S&P 500’s recovery from the initial shock of the Covid emergency - the fastest in history - saw the index return to pre-pandemic levels within four months after losing 20% between December 2019 and March 2020.

Of course, other crashes have been much more prolonged: the S&P index fell 46% during the financial crisis between October 2007 and March 2009, and took four years to rebuild itself.

So there’s no saying how long a bear market may last. But it is the case that if you’re out of the market on key ‘bounce’ days, you’ll miss out on important gains that can have a long-term effect.

Recent research from 7IM found that if you stayed fully invested in the FTSE 100 over the 20 years to the end of 2021, you’d have seen annualised total returns of 5.6%. If you’d missed only the five best days for the market in those two decades, your annualised gains would have fallen by two-fifths to 3.4%, while missing the 20 or 30 best days would have resulted in annualised losses of -0.4% and 2.3% respectively.

It is also that case that the best days often come very quickly after the worst days, reinforcing investing legend Warren Buffett’s oft-quoted advice for investors about being “fearful when others are greedy, and greedy when others are fearful”.

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Remember your investment timescale

As an equity investor, you should be thinking in terms of several years at least, and many investors have the luxury of a multi-decade investment time frame. Over that kind of period, markets can continue to deliver for investors despite shorter-term setbacks.

To put that into perspective, over the 50 years to the end of 2021 – which include the bursting of the tech bubble in 2000, the 2008 financial crisis and the Covid pandemic – the S&P 500 has achieved a nominal annualised return of 9.4%. Even adjusting for inflation, real gains averaged 5.4% a year.

But year-to-year fluctuations are inevitable. The index was up by 20%-plus in 19 of those years, but it lost ground in nine others, and fell by 20% in three. The key, as we stressed above, is not to panic.

Diversification eases the pain

The basis of a diversified portfolio is simple: different asset classes respond differently to circumstances, so by holding a mix of investments some of which tend to rise when others are falling, you help to protect the overall value of the portfolio.

It therefore makes sense to own non-equity holdings such as bonds, real estate and commodities that will not be affected to the same extent (and may even gain) if equity markets are hard hit.

The same is true to a lesser extent when it comes to different markets within global equities. For instance, the US markets made a much stronger recovery than the UK after coronavirus struck. The S&P 500 gained 18% in 2020, powered by its heavy weighting to tech stocks, while the unloved, tech-light FTSE 100 lost 14% over the year.

Similar differentiation can be seen between the fortunes of small and large cap stocks, different industrial sectors and different investment styles.

For example, earnings for growing small-cap stocks or high-growth technology businesses with large bank loans are likely to be hard-hit if inflation pushes central banks to increase interest rates.

Conversely, modestly priced ‘value’ stocks enable investors to earn their investment back more quickly than expensive ‘growth’ stocks – and in an inflationary environment, money now is worth more than money in the future.

But it’s a mug’s game to try and second-guess what’s going to prosper in the complexities and uncertainties of any specific environment – or when the tide could turn again. Maintaining a well-diversified portfolio as a matter of course is the key.

Consider whether anything about your investments has changed

Having said that, it makes sense to review your existing holdings in the light of current disruptive events.

If your fundamental reason for owning a stock remains the same, and if the underlying business is still operating normally and prospects have not been permanently affected by current events, then it’s reasonable to assume that in due course the share price will recover.

If that’s not the case, you could reallocate the holding. You might also decide to make adjustments on the grounds of rebalancing, trimming your exposure to high-growth stocks or funds, for instance.

In which case, assuming you don’t want to hold too much cash (see above), where might you reinvest the money?

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Beef up your dividend-paying holdings

Equities that pay reliable dividends provide a buffer of returns even when markets are falling and capital gains are hard to come by. They also help to protect against inflation, particularly when the company follows a progressive dividend policy (aiming to increase dividends year on year).

And such companies tend anyway to be higher quality and better able to weather macroeconomic storms than non-dividend payers, with stronger balance sheets and less debt. Defensive areas such as utilities, tobacco and pharmaceutical companies are good hunting grounds.

Tweak your allocations defensively

We’ve already mentioned sectors that will continue to profit regardless of inflationary pressures or interest rate rises, such as tobacco, healthcare and consumer staples, as obvious defensive choices if you decide to tweak your portfolio.

Additionally, a gold ETF that tracks the price of the precious metal could provide ‘safe haven’ reassurance in the face of both inflation and war, and act as a hedge to the risk of losses elsewhere in your portfolio.

For a ‘one-stop shop’ approach to capital preservation, consider the handful of multi-asset investment trusts run with that focus as a primary objective. These include Personal Assets (LSE:PNL), RIT Capital Partners (LSE:RCP) and Capital Gearing (LSE:CGT), and typically hold a wide range of assets (including gold).

But while you may decide to beef up your portfolio this way, remember that growth stocks will bounce back faster when sentiment eventually becomes more positive. Again, it comes back to maintaining an effectively diversified balance of holdings.

Buy beneficiaries of the current situation

A more tactical approach involves allocating a portion of your portfolio to sectors that stand to profit directly from current difficulties. For instance, the Ukrainian crisis means arms manufacturers, cyber technology companies and natural resources have all seen their prices rise recently.

Consider a short ETF

A short ETF, or exchange-traded fund, provides a way to profit from share prices falling. They work by utilising short-selling, futures contracts and other derivatives to create an investment that moves in an inverse direction to its benchmark. But these tend to be short-term trades and have specific risks attached.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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