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Investment markets: will there be a crash?

16th Aug, 2018

By Robert Little

 

Stormy investment market

It is very easy to find articles and videos which suggest there could be a crash in investment markets. So is this correct?

The easiest answer to this question is: nobody knows. The best answer is: it really does not matter, as long as the following points hold true:

  1. Your investments are diversified
  2. Your investments are suited to your financial goals
  3. You can let yourself ride out any storm

In this post I will delve into these topics in greater detail. If you would like to review your current investments please call 01642 477758 or visit our Contact page to book a free initial meeting with one of our advisers.

Diversifying your investments

Diversification was described as “the only free lunch in investing” by Harry Markowitz, a Nobel prize winning economist. (If you are interested in portfolio construction theory, you can read his paper here: Portfolio Selection by Harry Markowitz).

By this he meant if your portfolio is spread over lots of individual investments, and if these investments do not move perfectly in line with one another, you can get the same return with less risk (compared to holding a smaller number of investments).

Broadly speaking, if your investments are all in one country or, worse still, in a single company, they are not diversified. However this is only the tip of the iceberg when it comes to diversification.

Ideally a diversified portfolio will include different countries (e.g. the UK, USA, Europe, Asia and so on) and different investment types (for most investors a combination of shares and bonds is the bare minimum). Shares can then be spread across lots of different companies in lots of different sectors and industries, plus different sizes of companies. Bonds can be spread across government debt and company debt.

The amount you hold in each of these different segments will determine the risk and the potential return of your portfolio. For example, many investors seeking lower risk and lower potential returns will minimise the amount they hold in shares and many investors seeking higher risk and higher potential rewards will minimise the amount they hold in bonds.

If you have a well diversified portfolio, you should find yourself less affected by market events compared with someone holding a poorly diversified portfolio.

For example, if all your investments are in one company’s shares and they have a period of bad news (such as poor financial results, tax investigations, the sudden departure of a key manager and so on) you are likely to see a significant drop in your portfolio value.

In contrast, someone with a well diversified portfolio might hold less than 1% of their portfolio in the same company’s shares, so they might not even notice this drop.

We often find some of our new clients have significant holdings in the shares of a single company, which is normally their current or former employer. If this applies to you, you should bear in mind that you are highly exposed to this company, particularly if they also pay your salary or your pension.

In summary, one of the key things you need to check is whether or not your portfolio is diversified. This will help you dampen down some of the ups and downs of the markets compared with someone who has a poorly diversified portfolio.

Matching your investment portfolio to your financial goals

Put simply, if you are investing for a long period of time (e.g. 10 to 15 years, or more) you should be able to afford to take greater investment risks compared with someone who wants to invest for a shorter term.

Thinking like this can help you check if your investments are fit for purpose. First you have to establish exactly why you are investing – is this money for retirement, to be passed on to your children/grandchildren, is it to provide a house deposit in the next few years?

Then you have to consider how much loss you would be able to afford without it affecting your financial plans. For example, if you are saving for retirement at age 67, you are currently 40, and your portfolio falls by 15% then it shouldn’t have a major impact on your retirement plans. In contrast if you are saving to buy a house next year and your deposit falls by 15% you might not be able to complete the purchase.

Finally, you have to consider how much your portfolio value could feasibly drop if there is a market crash. For example, if your money is in a bank account (which is fully covered by the Financial Services Compensation Scheme) then you will still have the same amount of money if markets fall. In contrast if you are invested in UK shares your investments could in theory fall anywhere from 5% to 40% (or more).

If all three of these factors link in together then you should not need to worry if there is a market crash. For example, if you are saving for a house deposit in one year, plus retirement in 27 years, your house deposit is in the bank and your retirement savings are in investments, then a market crash should not affect your plans.

If any of these three factors does not match up then you should take action. This might mean changing the way your investments are structured to ensure you can withstand any potential loss. It is, of course, best to seek professional advice from a qualified financial adviser before you take any action. You will also need to consider any taxation implications of making changes to your portfolio.

Riding out the storm

In the modern world we are bombarded with bits of information all day long. Unfortunately a lot of it is negative, because bad news sells easier than good news.

Also, most people know an amateur investor who considers themselves to be an investment oracle. They can normally be found suggesting the next best investment or warning of an impending fall in stock markets.

Finally, everyone (even professional investors and advisers) experiences behavioural biases which affect decision making. For example, “regret aversion” can occur when an investor worries about a potential fall, sells their portfolio and invests in something lower risk (which does not suit their financial goals), all because they worry they will regret taking no action if markets fall.

With all of these distractions it can be very tempting to make a snap decision which could derail your investment plans. Some investors, particularly those who select their own investments, can end up selling their investments after a market crash and buying the same investments when prices rise, which is the complete opposite of the mantra “buy low and sell high”.

If you find yourself in worrying about your portfolio, speak to a regulated adviser. They will help you re-visit your financial goals and see if your investments are still suitable.

If you have long term investment goals and you are willing to take a risk, but you are still a bit nervous, they should help calm your nerves. Alternatively they might suggest that your current level of investment risk is unsuitable and recommend a change. Either way, you will not know unless you ask.

Summary

No-one can predict what will happen in financial markets. While it is easy for someone to say “There will be a market crash”, this information is useless anyway.

For example, this doesn’t tell you when the crash will happen, which investments which will be affected, how big a drop there will be, how long the crash will last for or how fast the markets will recover.

It also might be meaningless for you – if you are investing for the long term and take a higher level of investment risk there will definitely be drops, crashes and volatility along the way. Without these “bumps in the road”, higher risk investments wouldn’t be higher risk investments.

If you get jitters when you hear about a potential fall in financial markets, it is important to slow down, speak to a regulated adviser and really think through your options.

If you have any questions about this post, or if you would like to review your investments and financial goals, please call 01642 477758 or visit our Contact page to book a free initial meeting with myself or one of our advisers.

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