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What to do when markets fall

With apologies to Forrest Gump, investment returns are like a box of chocolates: You never quite know what you’re going to get. 

While sharemarkets have been very kind to investors in recent times (for example, clients in Six Park’s growth portfolios have enjoyed returns of up to 13.2% over the past 12 months), it’s worth remembering that markets have a long history of volatility and unpredictability. 

So, while Six Park’s Investment Advisory Committee sees the global investment environment as remaining generally sound, it’s inevitable that there will be a major market downturn at some point in the future. The runway for that event is likely shortening, though our IAC believes we are not yet at the end of the current favourable investment cycle.

It’s important to consider how you might react when markets drop and ensure you are as prepared as possible for that eventuality.  Consider this article the “inside” lid of your investment chocolate box – a guide to helping you get the most of your investment selections.

Chocolates

When will the next major market downturn hit?

Like most things in finance, market downturns are almost impossible to predict. Sharemarkets are influenced by a complicated mix of sentiment, global conditions and local events – and the way those factors interact changes from day to day. As a result, it is very difficult to forecast precisely when a market downturn will occur.

US research shows that between 1900 to 2017, the Dow Jones Index experienced 123 “corrections” (declines of 10% or more) and 33 deeper “bear markets” (falls of 20%+).  That suggests an average of about one market correction every year and one bear market every 3.5 years or so. The chart below shows the Dow Jones' movements over the past 30 years. 

How To Respond If Markets Tumble Djia 1988 2008

The Australian context is broadly similar. The ASX has recorded 22 years of negative returns over the past 117 years – or about one “down year” in every six – and roughly 18 market corrections since 1970, which equates to about one correction every 2-3 years.

The problem with all these statistics is that sharemarkets are not really dictated by historical trends. History might suggest a market is due for a correction, but that doesn’t mean it will necessarily happen. Markets seldom follow neat, consistent rules – investing would be a lot easier easy if that were the case. 

Take the present context. The last major bear market was more than 10 years ago with the onset of the Global Financial Crisis. While history would suggest a bear market should have occurred at least once since then, any investor who sold down equities in anticipation of a downturn a few years ago (blindly following historical trends) would have missed out on some significant gains.

What might trigger the next market downturn?

Part of the difficulty predicting market downturns is figuring out what might trigger a sell-off in the first place.  History is again not particularly instructive in this regard.  The various bear markets over the past five decades have had a range of triggers. In some cases, the catalyst has been a major external political shock (e.g. Iraq’s invasion of Kuwait sparked the 1990 bear market).  At other times it has been a swift change in investor psychology (e.g. the eventual bursting of the Internet stock valuation bubble in 2000). Occasionally, the cause can be a shift in economic circumstances (e.g. the unravelling of the sub-prime financial markets in the US in 2007-2009).

The only constant among these events is that the trigger for these bear markets has only really been identifiable in hindsight.

What should investors do?

If we can’t predict when the next major market meltdown might occur nor what might trigger them in the first place, what should investors do?

Our best advice is to focus on being prepared for a down market, rather than trying to predict when it might occur.

Here are six key tips to remember:

1. Recognise that down markets are an unavoidable part of long-term investing.

While no-one likes to see the value of their investments fall, stock market declines are (unfortunately) a normal and relatively frequent occurrence.  If you are a long-term investor, you will most likely experience several bear markets over your lifetime.  Over the longer term though, historical market returns prove that markets ultimately rise and provide solid long-term returns. Those investors who can ride out these market fluctuations are rewarded for their discipline and patience.

2. Try to control your emotions.

Bear markets can be stressful and frightening.  Share market declines can be dramatic and unexpected. At the time, it may seem like there is no end in sight and the newspaper headlines will be littered with extreme predictions of doom and gloom. It’s sadly common for investors to fret through the early stages of a bear market, abandon their investment strategies and panic-sell at or near the bottom of the cycle.  Generally, bear markets shouldn’t lead long-term investors to dramatically shift their asset allocations.  Bear markets are typically short-lived (lasting an average of ~18 months) and are followed by a rebound that occurs unexpectedly (often when the outlook appears most bleak). Most rebounds are also sharp, with markets typically gaining around 30% in the 12 months from the bear market low.

3. Avoid trying to time the market.

Trying to avoid a bear market by jumping in and out of the markets is a strategy that is fraught with difficulty, particularly because the best and worst trading days usually happen close together (and are impossible to identify ahead of time).  As Six Park explains in our investment philosophy (read more here), trying to time the market like this means that you not only have to ensure you sell at the right time (i.e. at or near the market top) but you also have to buy back in at the right time when the market bottoms. The likelihood of getting these moves right is very low and even professional portfolio managers rarely get this right on a consistent and repeatable basis.

4. Control the controllables.

While you can’t control the markets, you can control (at least to a large extent) the amount you pay to invest and maintain your portfolios. Minimising fees and costs should be a critical focus of every investor’s strategy. The fees you incur while investing can have a dramatic impact on overall portfolio returns, particularly over the longer term. This is because the lower the costs, the greater the proportion of an investment’s return that can flow to the investor and the larger the potential for that money to be reinvested and compound into the future. Over time, even small differences in fees and costs can add significant additional returns and can help generate a buffer against market declines.

5. Be prudently diversified.

One of the best ways to protect your portfolio against periodic losses is to ensure your investments are divided between a mix of asset classes that reflects your appetite for risk. A suitably diversified portfolio of higher and lower risk assets will help buffer the impact of bear market cycles, which don’t last forever. Defensive assets such as bonds and cash yield tend to offer greater protection during a bear market but are unlikely to deliver rapid growth at other times. Higher-risk assets such as shares tend to drop more during a bear market, but are also the ones most likely to climb in value when markets inevitably recover. The right diversification among these asset classes will depend largely on factor such as your risk appetite and investment time horizon. If you don’t know whether your investment portfolio is suitably diversified, seek advice from your financial advisor, or use one of the many tools or services available to assess a prudent asset allocation (such as Six Park).

6. Leave it to the experts.

If you use a financial advisor or service like Six Park, trust that the experienced professionals making market judgments will know when/if to adjust asset allocations. At Six Park, we have more than 100 years of asset management experience and an Investment Advisory Committee that has overseen investment strategies and asset allocation decisions at the highest level. Let the experts who have experienced multiple cycles of bull and bear markets worry about how to respond to market gyrations.

Six Park’s robo-advice platform provides a disciplined platform to help investors resist the emotions associated with a bear market and stay the course with their investment strategies. Guided by the deep expertise of our IAC – and aided by our sophisticated algorithms, which don’t respond to worrying news reports but rather use data to work out what’s most likely to happen next – we can help investors avoid the pitfalls of emotion-driven decisions while providing the most rational and prudent approach to reaching their longer-term investment goals.

For example, a 2014 study by JP Morgan showed that an investor who stayed fully invested in the S&P500 index from 1993 to 2013 would have earned an annualised return of 9.2% - even including the impact of the GFC. However, if that investor missed out in being invested during the 10 best market days during that period, their annualised returns would fall to just 6.1%. Missing the best 40 days - just over 1% of the total trading days - would have entirely eliminated any gains made over the period.  This highlights the real difficulties and risks of attempting to time the market.

Even a simple decision like deferring an investment "until the market recovers" could just as easily mean missing out on those crucial days or weeks when the market surges - a narrow window of opportunity which most of us are unlikely to anticipate and which could have a material impact on overall investment returns. This assumes you are successful in timing your market exit in the first place - which is certainly not assured either.

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