World events in the aftermath of the 11 September terrorist atrocities have added to the sense of ne...
World events in the aftermath of the 11 September terrorist atrocities have added to the sense of nervousness among investors who were suffering from the effects of a prolonged bear market. A global slowdown is now well established with the prospects of recovery clouded by the recent shock to the financial system. In such an environment the outlook for equity markets becomes increasingly uncertain.
It becomes apparent at times like this that successful investing is not just about sitting back and waiting while markets go up. A bear market reminds investors of the need to build a portfolio that can cope with different market conditions and deliver smooth returns in various stages of the economic cycle.
Weathering a bear market is, by its very nature, difficult, but a well founded investment policy should limit the downside. Sticking to the objectives of that policy is paramount and helps investors to see through short-term panic and focus on their longer-term goals.
Few investors, for example, would have wanted to sell their technology stocks at the height of the bull market when these positions were racing ahead. But this is precisely when a sophisticated investment adviser can offer advice on trimming holdings that have grown substantially to avoid giving back profits when markets retrench.
A similar approach minimises the tendency to capitulate and 'sell at all costs' when markets are at or near their bottom and a rally is due. Maintaining a longer-term focus helps to see past short-term corrections and allows investors to build solid portfolios for future growth.
Falling equity valuations may present opportunities for the more adventurous investor, but many are not prepared to take such a contrarian view and will look to make asset allocation shifts towards products that can offset such declines. This is where diversification becomes important. While global equity markets may have fallen more than 26% this year, government bonds have benefited from falling interest rates and investors' appetites for less risky securities, delivering a positive return of almost 3% over the same period. The critical factor of course is knowing when and how to diversify ahead of downturns. This takes years of experience, exhaustive research and a constant monitoring process.
An interesting dimension has been the shift in styles of investing that occurs at times of market dislocation. At the height of the bull market, investors demanded stocks with high growth rates and were prepared to overlook the dividend yield on their holdings. But as markets fall back their appetite for income increases and previously unfashionable 'value' stocks, which offer a steady dividend, rather than pure 'growth' plays have been among the best investments during this bear market.
Moreover, empirical evidence shows that the value style has outperformed the growth investment style over the last 75 years. Once again it is important to choose a sophisticated partner in the investment process who can help to recognise these shifts and not get blinded by fashion.
Identifying the right mix of assets or products at the outset is essential. The costs of changing a portfolio too frequently can often outweigh the benefits of moving into other asset classes. Poor timing can exacerbate the problem and investors who try to time the market frequently end up chasing its tail ' particularly in times of increased volatility such as 2001. A much better approach is to create the right mix of complementary strategies and stick with it, making minor adjustments to enhance performance.
Choosing those strategies forms a fundamental part of the investment process and getting the right mix will do much to mitigate the effects of a bear market. Already, with global equity markets set to record a second year of negative returns, clients are recognising the value of asset classes such as high yield debt, real estate, private equity and alternative investment vehicles such as hedge funds.
The CSFB Hedge Fund index has delivered positive returns of 2.2% this year despite the major sell off in equity markets. Not only can hedge funds enhance returns in favourable conditions but they also offer downside protection in falling markets as well as reducing overall portfolio volatility.
We should also mention the importance of achieving the highest possible yield on the cash component of the portfolio. Banks with a strong treasury function can shop around to achieve optimal market rates. Furthermore, the use of structured deposits can enhance yields by linking the rates of return to other market indices using simple options. Current market conditions make these an attractive consideration.
Every investor has unique needs and will employ a different approach to maximising returns while minimising risk. Achieving a broad spread of investment exposure is the key to this but smaller portfolios may find it difficult to meet the minimum investment levels for some instruments. The use of mutual funds to spread the investment load can overcome this problem and allows for fine adjustment within the underlying portfolio on an ongoing basis.
History rarely repeats itself. For this reason the construction of a flexible portfolio with a long-term focus and a broadly diversified base should offer investors the best opportunity to overcome difficult and volatile markets and maximise their portfolio gains whatever the market conditions.
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