28 Jul Preparing for a market downturn
“There’s no harm in hoping for the best as long as you’re prepared for the worst.”
― Stephen King
Things have been pretty good for investors in world equity markets over the last couple of years – especially for UK investors where the dramatic drop in the value of the pound as a result of the Brexit vote just over a year ago led to significant currency gains on international holdings (something of a ‘pyrrhic victory’, perhaps, especially if you travel abroad or buy imported goods on a regular basis).
Not only have markets generally moved upwards, levels of volatility have also been low.
Many have speculated as to why this might be, but nobody actually knows the answer, and in any event, the reasons are not important as research shows that the level of volatility today has no bearing on the level of volatility tomorrow. We should therefore focus on what we do know.
Markets go up and markets go down. The most important thing for investors to concentrate on is ensuring that their portfolio has an appropriate asset allocation which will offer the best chance of them weathering any storms that might be on the horizon.
Dimensional Fund Advisors (DFA) carried out a Global Investor Survey earlier this year, in which the majority of our clients kindly participated. The survey aggregated the views of 18,967 clients across 436 global firms, and as such is one of the biggest investor surveys of its kind. Approximately one-third (31%) of the respondents indicated that their greatest financial fear was “experiencing a significant investment loss in a market downturn,” a response second only to “not having enough money to live comfortably in retirement” (37%).
So, what did respondents mean by ‘experiencing a significant loss’? If they meant seeing the value of their portfolio go down, well pretty much every investor in equity markets can expect to experience that at some point.
This is where the benefits of working with a financial planner come into play. The planner’s role is first to define what each client considers to be a significant loss and then to ensure that the client’s expectations and portfolio are aligned with that definition. It’s also important to highlight the difference between a realised loss – from selling the asset which has declined in value – and a drop in prices, or ‘paper loss’. Financial planners will be able to provide data detailing the frequency and magnitude of market declines in the past whilst also demonstrating and reinforcing the point that global markets have historically recovered.
Global equity markets are remarkably resilient – as anyone who was invested during the 2008-09 financial crisis will have witnessed.
Uncertainty and market declines are part of the nature of investing. No one likes uncertainty, and market downturns can certainly be very uncomfortable. But being able to accept their inevitability, and how your portfolio might be reasonably expected to behave under certain market conditions can be a huge help. Being prepared in advance for what a market downturn might look like to you can be the difference between a successful or unsuccessful investment experience.
Remember also that if investment outcomes were certain and prices never went down, we could not reasonably expect to receive more than the risk-free rate of return, i.e. the return available from sovereign quality government short dated bonds. Risk and return go hand in hand. There is no such thing as a free lunch.
For many investors, the expected return of short-term bonds is not sufficient to meet their long-term financial goals and therefore in a world of stable portfolio values, investors would end up trading one risk (volatility) for another risk—loss of purchasing power after taxes and inflation from investing only in short-term bonds. For that reason, having a lifetime cashflow forecast as part of your financial plan is invaluable.
Most financial planners will use these cashflow forecasts to illustrate ‘steady state’ (based on various assumptions they will agree with you), but can also incorporate various ‘what if’ scenarios, to demonstrate how you might be affected financially by – say – a 20% drop in equity markets. If such a scenario indicates a problem then you will have the time to think it through, determine what steps you could take in that situation. Most importantly you can agree with your planner a set of high level policy statements detailing the action you will take to modify your goals (for example ‘We will reduce or suspend withdrawals from our portfolio’) to which you and your planner can refer if the worst comes to the worst. That way, you are not trying to make difficult decisions at a stressful time – you will already know what to do.
Makes sense, doesn’t it?
Find out more in our Guide to Financial Planning, which can be downloaded free of charge.
“By failing to prepare, you are preparing to fail.”
― Benjamin Franklin