How to prepare for financial market volatility

By 12 February, the FTSE 100 had risen or fallen by more than 1% from open to close on 19 trading days out of 30. That was the most in any year going back to at least 1995 and the only years which come close to this year’s figure are 2000 and 2008.

They saw 16 and 14 such movements respectively by 12 February and unfortunately neither of those years lives in investors’ memories for the right reasons. The FTSE 100 fell 10% in 2000 as the technology-led bull run in stocks came to an end and a three-year bear market began, while the index plunged 31% in 2008 as the financial crisis reached its zenith.

History is not guaranteed to repeat itself but stock markets do tend to perform best when they are calm rather than choppy, as evidenced by this graphic below. The line is the FTSE 100. The bars represent the number of days in a given month when the index rose or fell by more than 1% from open to close. 

The strong advances of 2004-2006 and 2009-2013 come with very little volatility while the bear markets of 2000-2003 and 2007-2009 are preceded and characterised by much greater swings in prices. Frankly, the market outlook will become much healthier if we see a little more conversation and a lot less action, please.

Markets do best during times of calm and find it hard to advance when volatility is elevated

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to 
be held for the long term.

Investing is as much about managing risk and protecting the downside as it is about seeking out gains to harvest the upside. As such, investors must prepare themselves for a prolonged period of wild market swings and possibly further falls, even if they are not guaranteed to occur.

The first stage is to heed a few key principles of investment:

• Only ever invest money you can afford to lose
• Never borrow money to invest
• Never buy anything you cannot comfortably hold for your preferred time horizon (as during market accidents you are unlikely to be able to sell assets at the price you want, in the size you want at the time you need to).
• Ensure you have a well-balanced, diversified portfolio that is best suited to meet your own individual strategy, target returns, time horizon and appetite for risk (and risk is best defined as willingness and ability to withstand losses in your quest for gains). This should help to protect your downside and still give you a chance of generating the income or capital gains (or both) you are seeking over the long term.

With regard to the fourth point, how you seek to diversify will again be a matter of personal taste. You may seek to use funds, actively or passively run by money management institutions, or you may prefer to do it yourself. In either case it will be important not to spread yourself too thinly, so that you keep running and dealing costs low and do not end up with a portfolio that is unwieldy and difficult to manage.

Spreading your risk

The point about building a balanced portfolio is that you are preparing for as many eventualities as possible. None of us has a crystal ball and so none of us knows what is going to happen. All we can do is assess events, look at valuations and judge asset classes and individual securities according to the balance of probabilities and what may already be priced in.

All of this requires diligent research and takes time, so if you are unsure as to how to go about building a balanced portfolio, you have at least three options available to you, once you have clearly defined your overall investment goals, target returns, time horizon and appetite for risk.

Option one – take some guidance

• You can use an investment service which provides suggested portfolios that you can then adjust and fine-tune for yourself. There are several such services out there, all of which can be found online, including our Investment guidance service. 

Option two – multi-funds

• You can pay a fund manager to pool your money with like-minded investors and run it to the best of their ability, according to a specific mandate, in return for a fee. Some funds focus on one specific asset class, such as shares or bonds, or geography, like Japan, the UK or America. Just picking one would still leave you with an unbalanced portfolio so for those investors willing to pay the fees and unwilling or unable to do the research, one possible option comes in the form of multi-asset or multi-manager funds. 

The following table shows the top five performers over a five-year view in the Multistrategy category for funds. You will still have to do your research here by reading the key investor information document (KIID) to see if a collective is suitable for you, as they all have different styles and come with different levels of risk (and fees).

Top five performing Multi-strategy OIECs over the past five years

Source: Morningstar, for Alt - Multistrategy category. 
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The next table looks at the top five performers on a five-year view from the Fund of Funds category. As with the multi-strategy funds, you will need to check out their styles and costs before deciding whether they are suitable for you, as some will be much more aggressive than others.

Top five performing fund of funds OEICs over the past five years

Source: Morningstar, for Funds of Funds - Multistrategy category.
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

There are also open-ended funds which are classified within the GBP Cautious, Moderate, Aggressive and Flexible Allocation categories. They will again invest across a range of asset classes with a mandate to generating income or capital gains, while taking varying degrees of risk. By way of example, the table below shows the best five performers over five years from the GBP Moderate Allocation sector:

Top five performing OEICs in the GBP Moderate Allocation category over the past five years

Source: Morningstar, for GBP Moderate Allocation category. 
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

It is not just OEICs which cater for this need among some investors, as investment trusts do, too. The F&C Managed Portfolio Growth and F&C Managed Portfolio Income trust, run by Peter Hewitt, are just two examples of investment trusts which invest in other investment trusts, though there are plenty of others.

The Association of Investment Companies has also just launched a new category called Flexible Investment category. There are nine investment trusts to be found in this area, each with a different style and mandate and with holdings which range from global stocks to bonds, real estate and even hedge funds. The performance of the grouping relative to other leading AIC categories is outlined below. Note this is based on share price performance (and may therefore miss the yield offered by some areas). The Flexible category has returned less than many of its peers since 2011, but that period has been characterised by a bull run in stocks, so it will be interesting to see if Flexible creeps up the rankings if equity markets remain under pressure for the rest of 2016.

Five-year share price returns on 100 from leading investment trust categories

Source: Association of Investment Companies
NOTE: Past performance is not a guide to future performance and some investments need
to be held for the long term.

The Flexible Invest may not appeal to everyone but at least their ongoing charge figure of 1.08% a year is no higher than then average for the AIC’s members. The top five performers from this category on a five-year view are outlined below. Again, each one has its own distinct strategy and whether any of them are appropriate for you will again depend on your personal circumstances and preferences. All of these investment trusts can be researched easily online through our own website and those of other free information providers.

Best performing North American investment trusts over the past five years

Source: Morningstar and the AIC, for Flexible Allocation category. * Includes performance fee
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Option three – Do-It-Yourself

• More experienced investors who are willing and able to research individual stocks, bonds, funds, tracker funds and investment trusts may prefer to build their own portfolio and devise a mix between asset classes and geographies best suited to their own personal needs. 

Anyone going down this path needs to remember that the idea behind diversification is to prepare for a range of eventualities and not just one. For the moment, the financial markets seem terrified of recession and deflation, while central banks are seeking to stoke a recovery and fuel inflation.

No-one knows what the outcome will be. As such, some investors might be intrigued by a strategy first proposed by market strategist Dylan Grice a few years ago when he was with French investment bank Société Générale.

Inspired by the apparently indestructible nature of the cockroach, the strategist looked at how to build an investment portfolio that would be just as durable as the doughty insect. He argued a pot split into four even parts between cash, government bonds, high-yielding equities and gold would have done the trick. 

Given the prevailing uncertainty, we have revisited this concept and tried to recreate the cockroach portfolio, going back to 1990. We have used the Murray International, Murray Income and City of London investment trusts to represent equity income, UK and US 10-year Gilts and Treasuries for bonds, the UK base rate for cash and spot gold.

Four-bucket portfolio has shown resilience over past 25 years

Source: Thomson Reuters Datastream AJ Bell Research, with thanks to and inspired by
Dylan Grice’s November 2012 piece for Société Générale The Last Popular Delusions
NOTE: Past performance is not a guide to future performance and some investments need
to be held for the long term.

The calculations do not allow for dealing costs or tax but even allowing for these expenses, the cockroach would beat cash and retail price index inflation stone cold. Although it lags the FTSE All-Share, we have just had a seven-year stock bull run that is looking tired. Also note how the third line down is the cockroach portfolio assuming a once-annual rebalance on 1 January. It has had one down year since 1990, just the sort of dependability many investors may be craving in these uncertain times, with the bonds and equity portions providing yield and cash flow to go alongside the downside protection.

Such an approach will not suit everyone’s goals, target returns, time horizons and risk appetites and nor are historic returns any guarantee for the future. But the cockroach strategy at least illustrates the benefits of diversification and preparing for a range of scenarios, not just the one you think is the most likely outcome.

Russ Mould 
AJ Bell Investment Director