Markets move in cycles and while there are increasing discussions around when the next market crash will occur, there is no need to panic; a correction is a normal and expected part of investing. Measures we take to manage the impact to your portfolio are already on our radar.
While I hesitate to use the word ‘crash’, it is the term used by most (overused by the media) to describe a ‘drop’ in share market values. It is part of a normal market cycle that has repeated for decades. As companies grow their earnings, their value increases; the Rally. The market factors in ‘expected’ future earnings and depending on its level of optimism, the market price overshoots fair value. If, or when, earnings disappoint relative to expectations, or an event or new information triggers a lower assessment of value, prices go down; the Crash. The drop is generally an overreaction and in due course prices return to their previous levels; the Recovery.
What is different this time is the length of the current rally. Historically market cycles have generally ranged from 4 to 7 years between peaks. It has now been 10 years since the last meaningful drop in market prices. So, does this mean a correction is imminent? In a word – no. There is certainly an increased risk of a correction as time passes, but it doesn’t mean it will be next week, next quarter or even next year. The doomsayers have been warning of a crash for years. This headline from the NZ Herald warning of a crash was from October 2016; almost 2 years ago. Since then the Dow Jones Industrial Average Index has gone from 16,000 to 28,000, this is a 75% gain over two years.
What will we do when markets ‘crash’? We will not pre-empt the drop and sell out of shares before they drop (research shows that attempting to time the market is futile), and we will certainly not recommend selling after the drop. That is not to say we are not prepared for a drop. In fact, we have been preparing for the next drop since the last one. We manage your portfolio knowing that the rally-crash-recovery cycle will always repeat.
These are four of the steps we have already taken to ensure your portfolio is well positioned to survive the next correction, whenever it may be, and benefit from the subsequent recovery and rally.
We limit exposure to riskier, share market investments to appropriate levels:
We periodically measure your risk profile, including your risk tolerance and risk capacity. This is often done using a formal tool such as the FinaMetrica or Morningstar test, or a conversation during initial or annual meetings. By setting a benchmark asset allocation, and during a bull market periodically rebalancing the portfolio back to those weightings, we are in effect selling high and buying low all the time. We are reducing the exposure to assets that have increased the most, and buying more of the safer, less exciting assets. Conversely, when shares go down, we will take advantage of lower prices and increase holding in those cheaper assets.
Diversification across and within sectors:
We spread portfolios across shares (equities), infrastructure, property, fixed interest and cash. Even within sectors, such as shares, we invest in different geographical areas, business sectors and company styles. Fund managers may hold 50 to 100 stocks within their fund, and we may hold 3 to 5 funds in a sector (or more). We tend to limit the exposure to any one fund to around 5% or 10% of a total portfolio. (You can see the exposure to each asset, and asset class, in the far-right column of a valuation report.)
Active funds management:
We outsource the day to day analysis, buys and sells of individual stocks to fund managers with a depth of resources to be able to do this far more efficiently than we could. We use a range of managers with different styles to actively buy and sell assets at their discretion. We regularly meet with them and buy research on all NZ and Australian based managers. If a manager feels that the markets are overly expensive, they may choose to take an active position away from the market – i.e. holding more cash and less shares.
Maintaining sufficient cash and short-term fixed interest to rebalance and fund withdrawals:
For clients that take regular, or even ad-hoc withdrawals, we try to maintain several months’ worth of expected drawings on call, and enough funds in short term fixed interest to cover several years of withdrawals. This way the access to cash is not impacted by share market movements, and we are able to buy more shares when they have ‘crashed’ to lower values.