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Markets never go in a straight line. In a bull market there will be corrections. In a bear market there will be rallies. The value of your investment, as we always say, can go down as well as up.
While market falls are an inevitable part of investing, you can protect yourself to some extent. With smart asset allocation, you can put your portfolio in a good position to potentially fall less than the wider market. This way, when the market bounces, you may be rising from a higher level. This is known as downside protection.
Investors wishing to reduce their risk should consider diversifying some of their equity holdings into other investments. You could hold a variety of asset classes such as bonds; infrastructure; property; cash; absolute return (a type of fund that will try to create a return in all market conditions); and even gold.
Adding these types of assets can help reduce the overall risk of your portfolio in two ways. Firstly, funds such as low risk absolute return, high quality bonds or even cash are typically less volatile than equities. Secondly, some of these assets are uncorrelated or lowly correlated with equities. This means that if the market tumbles, they may fall less or they may even rise. Of course, it’s important to understand these assets could also fall as much or even more than, the market, but the point is they provide diversification because there is minimal connection between their movements and the broader stock market.
Recently, correlations between asset classes have been increasing and this has made constructing portfolios more difficult. Bonds and equities used to behave very differently, for example, but now their performance can be quite similar. The prices for perceivably ‘safer’ assets, such as government bonds, are also high at the moment.
Some assets that typically remain relatively uncorrelated to equities are physical gold, cash and certain types of absolute return funds1.
You can also help protect your portfolio by choosing more defensive funds. Some equity funds have a bias to cyclical industries such as banks, which are dependent on the economy. These funds are more aggressive and are likely to fall more than the market during a sell-off, but rise more than the market on the way up.
Conversely, there are funds that invest in more defensive non-cyclical industries, such as utilities or healthcare. Specialist equity infrastructure funds are another example. Typically, these funds will be less affected by the wider economy and will therefore fall less than the market in the case of a sell-off. They do, however, tend to lag if the market rises quickly. Investors wishing to reduce risk could consider adding some of these more defensive funds into the equity portion of their portfolio.
For bonds, consider high quality, low duration funds that are less sensitive to changes in interest rates. You could also look at certain strategic bond funds that have the tools to react to changing market conditions.
You can also diversify globally. Investors typically have a home nation bias, but by spreading assets across different countries, you become less exposed to the risk of one currency or country. The Brexit vote aftermath has shown how important this is, with many overseas funds taking large jumps in sterling terms following our currency drop.
The US dollar is typically treated as a ‘safe haven’ asset, which will offer some protection in times of market uncertainty. Always remember that the mix of asset classes in your portfolio and the percentage you allocate to each will depend on your personal attitude to risk and return. Consider what level of equity and other exposure you are comfortable with before building or amending your portfolio. If you require individual investment advice you should contact a financial advisor.
1FE Analytics, Bloomberg Gold Sub vs MSCI World vs MSCI United Kingdom vs Bank of England base rate correlations. 06/09/2001–05/09/2016. Data accessed 06/09/2016