How to manage risk through stock market cycles

By: Tim Bennett

In his latest video, Tim Bennett outlines a long-term approach that should help equity investors to deal with stock market volatility.

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How to manage risk through stock market cycles

Following one of the longest bull markets in the history of the S&P 500, this year (2018) we have seen two corrections of 10% or more, one in February and one in October. The key issue for investors is to ensure they are positioned to ride out these dips. Here is a reminder about the best approach.

A look back

Whilst the path of the US S&P 500, the leading index for the biggest stock market in the world, has been upward for much of the ten years following the financial crisis of 2007-9, this chart is a reminder that volatility is part and parcel of equity investing. Since there is nothing an investor can do about the fact these dips happen, what matters is how they are managed.

What can go wrong

One temptation that long-term investors need to resist is market timing. This requires a tricky judgement about when to sell shares and then when to buy them back. The chance of getting both calls right are slim, to say the least.

A better idea

Rather than wasting time trying to catch short term dips correctly, investors are better off setting themselves up so that they don’t matter. This requires a three pronged approach;
Most people will be familiar with the concept of a rainy day fund and also the idea of leaving long-term funds in equities, which have proven their inflation-beating credentials in the past. So, here I will focus on the second pot above, designed to meet foreseeable calls on your capital.

A simple example

Let’s say you know you will face a school fees bill when your child reaches the age of 11 and have decided you would like to pay it up front in order to get a discount on the total amount. This is an amount of money that you can estimate, even if you are not 100% accurate.
A few judgements will be needed along the way and you may wish to seek advice in terms of how you make these.
The question then becomes, how do you position your portfolio so that you have a reasonable chance of having sufficient funds available to meet this one-off bill. Whilst no-one can know the answer for certain, the length of previous stock market downturns can act as a guide.
This chart (taken from the Autumn Issue of Confidant) reveals that the longest bear phase in the S&P 500 has lasted about 8.5 years. That is longer than the equivalent bear market in the UK, which is why I have chosen it. It is therefore reasonable to conclude that once a call on capital, such as school fees, is only 8-10 years away you should start reallocating equity investments into bonds and/or cash. The exact proportion will depend on your attitude to risk and where you perceive that we are in the equity cycle. The closer you are to the date at which the capital will be needed, the more conservative your investment approach should be. Sure, this isn’t a 100% scientific process but then again;
In other words, whilst forecasting cash flows isn’t easy, it is better than the alternative which is to avoid planning and put your long-term financial objectives at risk.

Multiple cash flows

Modelling more than one forward cash flow gets trickier but it can be done easily enough with the right spreadsheet and a bit of judgement. Since lifetime goals evolve and change for all of us (for example, as we have children, or get divorced or come into inherited money) this modelling exercise needs to be revisited and repeated regularly.

Want to know more?

For a more detailed look at the history of both UK and US stock markets and the resulting three-pronged investing approach this suggests, please ask your Investment Manager for the latest Confidant.