Eight doses of sharemarket reality

The smartest tip for handling a difficult sharemarket is to hold your nerve, have faith in a quality portfolio and don’t panic whenever prices dip. MICHAEL LAURENCE reports.

By Michael Laurence

The recent sharp falls in share prices followed by an upturn have understandably left some investors a little stunned. But now is the time to remember some fundamentals about the markets and investor behaviour.

So take a dose of reality with these top eight facts:

FACT 1. Shares are volatile by nature

Fluctuations in share prices of a little over 1% a day are regarded as the long-term norm for developed sharemarkets. This is a reality that anyone in the market should expect. If you have a problem with volatility, don’t invest in shares.

A long-time student of sharemarket and investor behaviour, the executive chairman of IPAC Securities, Arun Abey, told SmartCompany: “The last three years have been unusual with quite low volatility, and any volatility has been mostly on the way up. In any case, when the sharemarket is going up investors usually don’t think this is volatility.”

FACT 2. Shares will become increasingly volatile

Abey attributes the rising volatility to shares having become more fully priced following the sharp rise in the market since March 2003, and to increasing debt levels. A highly indebted community is much more sensitive in their spending habits to, say, a rise in interest rates, and in turn this is reflected in the prices of stocks exposed to their spending habits.

And highly geared investors, including the increasingly influential hedge funds, are particularly sensitive to any economic and corporate surprises.

FACT 3. Holding your nerve is the best strategy in a choppy market

The courage to hold your nerve and not panic when the market begins to experience sharp downturns should largely come down to having carefully done your homework before buying any of your shares, Abey says. “If you have done your research and know the companies in your portfolio inside out, you should have confidence in their resilience, in their management and in their earnings.

“If you have bought quality and have a diversified portfolio, holding your nerve is easy,” Abey says. “You will be able to go to bed early and get a good night’s sleep.” But he adds a caveat: “If you have junk stocks in your portfolio, maybe you should cut your losses on those stocks [if prices are falling].”

FACT 4. Long-term asset allocations don’t require significant short-term adjustments

A portfolio of quality investments that is carefully diversified for the long term between the various asset classes (shares, property, bonds and cash) doesn’t need rearranging because of short-term volatility in the sharemarket, Abey says. “If your personal needs haven’t changed, there is no reason your asset allocation should change.”

FACT 5. Rebalancing of long-term asset allocations is a fundamental of sound investment practice

A determination to hold to your long-term asset allocation when the market begins to jump around doesn’t mean you should not regularly rebalance your long-term portfolio as a matter of course. Part of the discipline of having a long-term asset allocation is to rebalance it when required.

Rebalancing means that if the long-term asset allocation of your total investment portfolio includes an exposure to shares of, say, 50%, it should be rebalanced if that exposure falls to, say, 45% or rises to 55%, Abey says. But rebalancing is only necessary when there are significant changes in your long-term asset allocation, not just 1% or 2% – the transaction costs would be too high, particularly considering that movements are expected in the day-to-day life of the market.

The process of rebalancing not only has the benefit of ensuring your portfolio remains an accurate reflection of your personal requirements, including your expectation for returns and tolerance to risk, but also has another great attribute: you will be buying to return to your long-term asset allocation when share prices are low and selling when prices are high.

Put another way: you will be buying when the headlines look terrible, and selling when the headlines are dominated by good news stories.

FACT 6. Shares are not currently over-priced

Strong corporate profit growth means that the widely expected share prices for 12 months ahead – when measured against earnings (the price-to-earnings ratio) – will not be far above the bear market lows of 2003, points out Shane Oliver, head of investment strategy for AMP Capital Investors.

FACT 7. Company profits should remain strong

“Global growth will slow enough to take pressure off interest rates, but not so much to crunch corporate profits,” Shane Oliver says.

FACT 8. Self-managed funds are, on average, well placed to handle volatile markets, including big corrections

Statistics released by the tax office recently show that self-managed funds are generally well diversified between asset classes. Self-managed funds are, of course, a preferred investment vehicle for SME owners.

The favoured investments of self-managed funds, according to these tax office figures, are Australian shares (54.4% of their portfolios on average), cash and fixed interest (23.1%) and property (11.7%). Less than 1% of their portfolios are in overseas investments. See the tax office report here.

Graeme Colley, technical manager for DIY fund administrator Super Concepts, says self-managed funds are generally well positioned to handle volatile markets because of their diversified portfolios. Clients of Super Concepts typically have more balanced portfolios that the averages in the tax office figures.

“Our clients have, on average, portfolios that have relatively equal holdings in shares, property, bonds and cash,” Colley says. “And our clients have higher overseas holdings than the ATO averages.”