Are you nervous when markets turn volatile?

Are you nervous when markets turn volatile?

 

By Gabriel Mansueto

 

As I sit down to start writing this article, my colleagues on the second floor are busy preparing investors’ quarterly portfolio valuations.

Following the revised Markets in Financial Instruments Directive (MiFID II) rule which came into force in January this year, it became compulsory for investment services providers to update their clients with quarterly valuations. Until last year, half yearly valuations were mandatory. In recent years, together with portfolio valuations, it is industry practice to update investors with a summary of the main events which characterised financial markets during the same period covered by the valuation.

The second quarter of 2018 was characterised by geopolitical tensions from the very start. The trade war between China and the US dominated headlines and was a catalyst for market volatility. In Europe, political risk took centre stage with Italy taking its time to form a new government, following an election without a clear winner. In Spain there was a change in government, while in Germany the governing coalition clashed over immigration policy. A stronger US dollar weighted negatively on emerging markets, and most high yield bonds posted negative returns.

Various Maltese investors with high exposure to foreign fixed income markets will notice that their portfolio’s fixed income exposure lost value compared to the previous three months. High yield bonds and emerging markets were among the hardest hit. These sectors are usually among the main income contributors in an investment portfolio. Hence the reason various local investors have a preference for high income funds. However, both high yield and emerging market bonds tend to sell off when investors’ risk tolerance declines during negative market periods.

 

High returns usually come at the expense of higher risks

Judging the performance of your portfolio over a short time period is not appropriate. At the outset, and with the help of an investment advisor, an investor should draw up a clear investment objective, and a defined time horizon in line with your risk tolerance. More often than not, investors tend to be very optimistic about investing while optimism fades, as short-term volatility dampens performance. Investing in financial markets does have its own risks, and hence the potential for higher returns compared to safer bank deposits.

Market downturns are a cause of concern for many investors, however downturns are part of the package when putting money in financial markets. Past performance indicators show that downturns are normally short-lived, but if they last longer investors are still likely to receive decent income. A downturn should not induce an investor, with long-term investment objectives, to make a complete overhaul of his or her portfolio. Understandably, investors may question their strategy when large negative moves hit home. At this stage, some investors may engage in market timing – and is very likely that the riskier assets in the portfolio are sold first, to protect the portfolio from further declines. However, such a decision will most probably come at the expense of long-term returns.

Research shows that it is impossible to consistently predict market direction, and those who try to time the market have generally underperformed those investors who bought and held on to their investment funds. Investors should have a good indication of how long they can remain invested and try avoiding market timing as much as possible. An investor with set goals and objectives should be doing the complete opposite. Market ups and downs are normal and here to stay, hence investors should take advantage of opportunities as they arise.

One easy way to minimise portfolio volatility is proper diversification, which aims to reduce portfolio fluctuations through a mix of asset classes with varying degrees of correlations. Hence, an investor who is after returns which are higher than cash and short-term government bonds, but who is concerned about market volatility, should make sure their portfolio is diversified across asset classes.

Investors who usually have a preference for high income bonds or funds have to understand and accept portfolio volatility before committing their money. An investor with a low tolerance to portfolio volatility should not have a big portion of his/her portfolio in investments with high potential returns, since high returns usually come at the expense of higher risks. In addition, investors who invest for income should not just look at the highest income yielding asset classes if they want to have a portfolio which does not experience high levels of volatility.

In a market environment where the benefits of asset class diversification are resurfacing, a well-diversified portfolio is more suited to weather market conditions than a portfolio made up of a single asset class. It is a fact that more diversification may come at the expense of lower income returns. Yet investors who have a limited capacity for portfolio fluctuations, should also expect more stable capital returns from a well-diversified portfolio.

Therefore, an investor who is willing to invest for the medium to long-term and is not highly concerned with short-term market downturns, should have a portfolio which is exposed to capital guaranteed products, sovereign debt, investment grade bonds, high yield bonds, local opportunities, emerging markets and equities. This might seem to be a long list, but today local funds can provide you with such diversification with a spread of two to three funds. Such strategy will help investors weather different markets. Riskier assets such as equities will predominately contribute towards capital appreciation. Safer assets such sovereign debt and short-term investment grade bonds will add to portfolio stability during negative market periods.

Investors who have a long-term investment objective are usually advised to consider more growth assets vis-à-vis income assets, yet these investors must be comfortable with the short-term fluctuations which growth assets tend to experience. If you are nervous when your portfolio fluctuates, you may need to reconsider the risk level in your portfolio. If you are not nervous when markets turn negative, take advantage when opportunities arise, while emotional investors sell.

 

(As from today’s edition, a regular business contribution will replace the MSE market report.)

This article was prepared by Gabriel Mansueto, senior investment adviser at Jesmond Mizzi Financial Advisers Limited. This article does not intend to give investment advice and the content therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company and their clients, are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For more information, contact Jesmond Mizzi Financial Advisers Limited of 67, Level 3, South Street, Valletta, on 2122 4410 or e-mail gabriel.mansueto@jesmondmizzi.com

www.jesmondmizzi.com








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