Minimising exposure to volatility and market setbacks

Investing would be easy if markets rose in a straight line. Unfortunately, that is rarely the case. Over the long term, assets such as shares and bonds have tended to produce positive returns, but there have been several bumps along the way. In any event, past performance of investments cannot be taken as a guide to their future performance.

 

There are steps investors can take to minimise their exposure to volatility and market setbacks. One of the most important considerations is to apply the principles of diversification, or spreading your money across a range of assets rather than sticking with one type of investment.

By not putting all your eggs in one basket, you reduce the impact of losses on your overall portfolio. However, investors should bear in mind that a diversified approach will also limit the potential for gains from the rise in a single investment’s value.

Returns for investors
Funds make it easy for investors to build a diversified portfolio by reducing the volatility and potential gains and losses associated with individual shares. A typical fund manager investing in UK companies may hold perhaps 30 or 40 different shares in a single fund.

Shares can be volatile and may fall in value. Indeed, during a crisis, all the shares in an index tend to fall together. But it is less likely that shares in 30 or 40 companies will perform in the same way over time.

Some may perform strongly, while others may not. By holding a number of individual assets, funds tend to smooth out long-term returns for investors.

Single asset class
Investing in different assets, including shares, bonds, property or cash, further improves the level of diversification in your overall portfolio. Some funds hold a single asset class, such as shares, while multi-asset funds contain a range of these assets in a single portfolio that is overseen by a fund manager.

Asset classes offer different potential returns based on varying degrees of risk. For example, shares have historically produced higher returns but pose a higher risk of capital losses. Bonds generally produce lower returns but with a lower risk of losses.

In addition, assets can react in different ways to the same market forces. Assets that move in opposite directions in response to the same economic changes or market forces are described as having a low or negative correlation.

Offset by gains
When these assets are held together within a diversified portfolio, losses in one part of the portfolio are likely to be offset by gains elsewhere. For example, the prospect of higher inflation is often detrimental to the bond market. The income available from bonds is usually fixed, and is therefore less valuable when inflation is rising.

By contrast, stock markets have tended to cope better with higher inflation, partly because companies can put up prices to combat it, which in turn is reflected in their share prices. Likewise, the value of gold has tended to rise during periods of higher inflation, as it is traditionally seen as a hedge against rising prices.

Holding a range of asset classes is also important for income-seeking investors, who try to ensure that their income stream remains relatively steady by drawing it from a variety of sources – coupons from bonds, dividends from companies, rents from commercial property and so on. That way, if one asset class is hit by a change in the economic environment, investors would not expect to see their income stream evaporate.

Types of assets
Diversification doesn’t only apply to the types of assets in your portfolio, but also to the regions and sectors within these asset classes. For example, investors could hold shares from different regions of the world, such as the UK and emerging markets, which have tended to produce different returns over time. Emerging markets include Brazil, India and China.

Investors could also look for companies with different market capitalisations, such as large caps and small caps. Broadly speaking, a large-cap company in the UK is considered to be one listed on the FTSE 100 index, which contains the 100 largest companies by market capitalisation. In contrast, small caps in the UK are typically shares listed in the FTSE Small Cap index or on the AIM index of small, fledgling companies.

Shares in fast-growing smaller companies have tended to offer the prospect of stronger returns than larger blue-chip companies, but they are usually much more volatile. As a result, investing in small-cap stocks is riskier than investing in larger companies.

Exchange-traded funds
There are a significant number of funds available that target various asset classes and sectors, from American smaller companies to emerging market bonds. In particular, the growth in low-cost exchange-traded funds has made it simple and cheap for investors to track a significant range of stock markets and asset classes.

A further way that investors could build a diversified portfolio is to apply different selection criteria when picking assets within any given market. For example, this could mean choosing a mix of defensive and cyclical shares that are more likely to perform differently in response to trends in the wider economy.

Defensive shares, such as utilities or tobacco companies, are those that have a good track record of consistent dividends and stable earnings regardless of the economic climate. As a result, these shares have the potential to perform better than the rest of the market during periods of weaker economic growth.

Strong economic growth
In contrast, the performance of cyclical shares, such as house builders or luxury retailers, is more closely linked to the economy. These shares have the potential to perform strongly during times of strong economic growth, but often fall in value when the economy is performing less well.

The balance of assets in your overall portfolio should reflect your appetite for risk and reward. Generally speaking, the larger the proportion of equities held in a portfolio, the riskier it is considered to be.

For example, a higher-risk portfolio may hold 50% developed market equities from the UK, US or Europe; 20% emerging market equities; 10% bonds; and the remainder commodities, property and cash.

Lower-risk portfolio
By contrast, a lower-risk portfolio may only contain 15% developed market equities, 5% emerging market equities, 20% bonds, 40% cash and the remainder in property and commodities. A balanced portfolio would be somewhere between these extremes.

Multi-asset funds can offer a one-stop shop for investors looking to build a diversified portfolio from scratch, combining a range of assets from different regions and sectors to reduce volatility and the risk of potential losses.

Investors should choose a multi-asset fund to match their risk appetite based on the proportion of shares in its portfolio. Multi-asset funds commonly feature labels such as adventurous, balanced, cautious or absolute return, representing different levels of risk, while others feature a numerical risk rating.

Multi-asset funds
The Investment Association, an industry trade body, groups multi-asset funds into four categories, from ‘Mixed Investment 0-35% Shares’, which are lower risk, to ‘Flexible Investment’, the riskiest category of multi-asset funds which can hold up to 100% in shares.

Some draw upon several managers as well as asset classes. These multi-manager funds can benefit from the investment styles of a wider range of experts, and they can also give you access to managers who may not normally be marketed to private investors.

Maintaining a diversified portfolio should help smooth out returns for investors. It can protect you from some of the worst market declines but still allow you to benefit from potential upswings in performance. Diversification, in short, should make investing a less nail-biting experience.

Please remember that regardless of whether you diversify, the values of all investments can fall as well as rise, and you may get back less than you invested. Past performance is not a reliable guide to future performance.