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How to handle your portfolio in extreme situations

Leonora Walters explores how investors can reduce the negative impact of market falls
How to handle your portfolio in extreme situations
  • Stopping or reducing withdrawals can reduce the negative impact of market falls on your portfolio
  • You should take what income you need from a cash reserve and or dividends
  • If your portfolio is well diversified some holdings may not fall or fall less during market volatility

Russia's invasion of Ukraine has been followed by considerable market volatility. And when markets experience severe falls you should ideally stop making withdrawals from your investments.

“Upping withdrawals, or even continuing to take the same level of income, during periods of market stress can mean a portfolio drains much quicker than anticipated, making it very difficult for it to recover,” says Rob Morgan, chief investment analyst at Charles Stanley. “When you are drawing from a portfolio it is not just the long-term average return that matters but the sequence of returns. Negative returns earlier on can have a particularly detrimental impact on the value of a pot, even if they are then followed by good returns.”

Taking withdrawals during volatile markets when the ups and downs are greater means that the remaining assets have to work harder to get the portfolio’s value back to where it was.

“For example, if a £100,000 portfolio falls 10 per cent in one year and rises 10 per cent in the next, it will not return to £100,000 – it will be £99,000,” explains Morgan. "If you make regular withdrawals] high volatility increases the chances of taking money out when the portfolio is falling, locking in losses and reducing the chance of there being enough money invested to meet future needs. Unlike pound-cost averaging – the positive effect of investing regularly in volatile markets – losses created by selling assets regularly to meet income requirements have the reverse effect. Taking too much out of an investment pot just after market falls risks exhausting it too early.

If this is part of your retirement income, it could result in you running out of money before the end of your life.

The table shows how the sequence of returns impact a portfolio’s value when an investor sells units to create an income. Earlier losses mean the portfolio will be worth less than if they happen later because when you sell units you lock in these losses. “In a market that trends upwards, selling units in a fund to generate income works fine,” says CJ Cowan, income portfolio manager at Quilter Investors. “But in a sideways, down trending or particularly volatile market a different investment strategy is required.”

 

  Portfolio 1 Portfolio 2 
YearWithdrawalAnnual returnsAnnual portfolio value Annual returnsAnnual portfolio value 
0  £100,000 £100,000
1£5,00030%£125,000-20%£75,000
2£5,00020%£145,000-15%£58,750
3£5,0005%£147,2505%£56,688
4£5,000-15%£120,16320%£63,025
5£5,000-20%£91,13030%£76,933
Cumulative return11% 11% 
Source: Quilter Investors

 

By selling when markets are falling, as well as eroding your portfolio's capital value, you reduce the potential for income because you have fewer units and shares in investments to pay it out. “Being out of the market means you are no longer collecting and potentially reinvesting any income your investments are paying,” adds Morgan.

While there is market volatility you should instead take income from a cash reserve. Advisers generally suggest holding about six months of your expenditure in easily accessible cash. But if you are retired and your investments contribute to your annual income they suggest having around two years’ worth of your expenditure in easily accessible cash. This is also useful for emergencies or covering the costs of big-ticket items.

But if you are selling because of fear rather than financial necessity with the aim of moving your money into cash, Ben Yearsley, investment director at Shore Financial Planning, points out that at the moment this asset is making very low or, relative to inflation, in effect negative returns.

 

What if I don’t have a cash reserve?

If you need income and do not have a cash reserve, see if you could generate enough money by just taking the dividends and bond coupons of your investments. “Just taking the natural income to fund withdrawals means you are not eating into capital which is the crucial component for generating future income,” explains Morgan.

Income tends to be a more stable return driver than capital growth so you can plan your requirements in advance while remaining invested.

“By choosing a natural yield strategy, investors are likely to see their portfolios tilted to different asset classes, regions and sectors compared with a portfolio that invests solely for long-term capital growth,” adds Cowan. “These include sectors more associated with cheaper or value segments of the market such as energy and mining. At a time of elevated commodity prices, this is a good thing. Having had a strong start to the year, we expect dividend paying equities to continue to perform well in the current inflationary environment. These companies pay back much of their profits to shareholders upfront, which is eminently desirable in a world where the value of those profits is being eroded by inflation.”

If you are not currently taking the income from your investments, and hold shares, investment trusts or funds’ income units, instruct your broker or platform to distribute the income instead of reinvesting or allowing it to accumulate. If you hold funds’ accumulation units switch them to income units. “Implement a switch instruction, rather than selling and rebuying the different units yourself, or you could be out of the market for a short period and suffer an adverse movement,” advises Morgan.

If the natural income from your investments does not match what you were drawing by selling capital, consider whether you could manage on a lower income or, at least, if you could sell a lower value of investments than you were.

If your portfolio is well diversified, even if some holdings have fallen steeply, hopefully others haven’t fallen as much or maybe not at all. In which case, these would be the ones to sell. “Only take capital from things which have not fallen or not fallen too badly so as not to lock in losses,” says Yearsley.

If you are selling chunks of investments held outside tax wrappers such as individual savings accounts (Isas) and self-invested personal pensions (Sipps), trimming holdings which have done well is also a good way to prevent a large capital gains tax (CGT) liability from building up. When you sell investments which have made gains, these can be offset against your annual CGT allowance of £12,300 and losses on investments which you have realised in current and previous tax years.

Another reason not to sell, or sell as little as possible, during volatility is because trading costs eat into your income. That said, if you have cash in addition to your emergency fund, during market volatility you could reconsider investments that suit your investment aims but you previously thought were too expensive. However, only add them if they still suit your investment purposes, risk appetite and time horizon. You should not buy something just because it is cheap.

When the market volatility is over, your priorities should include building up a cash reserve so you are not in this position again. You could do this by saving some money each month or “modestly increasing your withdrawals after a period of good returns for the portfolio and putting this into a reserve,” suggests Morgan.

 

What is a diversified portfolio?

All investors should have a diversified portfolio. At a basic level, this means having a selection of investments that don’t all do the same things, and don’t move in the same way at the same time. This is so that if some of them are falling, hopefully your overall portfolio does not fall as much because it includes investments which are doing better.

But don’t make major changes until the market volatility has passed.

“Large falls can be followed by large rises, so you risk losing on both sides by selling when prices are depressed and not buying in until they have moved higher,” explains Morgan. “Selling also disrupts the flow of income, which gives you a return without doing anything if you are in bonds or yielding stocks. In the absence of a crystal ball, keeping invested is often the best strategy, even though it can uncomfortable.”

Exactly what you have in your portfolio and in what proportions depends on the purpose of your investments. This very broadly falls into two categories – growth or income. The other key determining factors are the length of time over which you are investing and your appetite for risk which is, in part, determined by your time horizon.

There is a perception that having a diversified portfolio means holding low returning investments such as bonds. But this is not the case, especially if you have a long term investment horizon.

“Investing for long-term growth tends to be pretty straightforward – generally maximise equity exposure,” says Morgan. “There is nothing wrong with 100 per cent in equities if you have an investment horizon of 20 years plus. That’s particularly the case for people adding to their investments each year or saving monthly which irons out volatility a bit. But they should still spread their assets around different sectors and geographies so they are not too reliant on a single area.”

This means diversifying your equity exposure geographically and by industry sector, but also by investment style. So don’t only hold funds that invest via a growth style, which has done well in recent years, but also ones that take a ‘value’ approach – investing in stocks which appear to trade for less than their value. This is because even if your portfolio has exposure to several global equity regions, growth stocks listed on different markets could move in line with each other.

For example, if you hold many Baillie Gifford and or technology funds which are typically growth orientated, also consider some value investing funds which are appropriate for your asset allocation. Examples include Jupiter Global Value Equity (GB00BF5DRJ63), Schroder Global Recovery (GB00BYRJXP30) and Temple Bar Investment Trust (TMPL), which could be useful if your asset allocation requires a global equities or UK equity income fund.

Also see Isa asset allocation for unsettling times (IC, 11.03.22) in this week’s supplement for more fund suggestions and how to diversify an Isa 

If you invest in direct shareholdings look to select value as well as growth stocks.

Yearsley also suggests diversifying your exposure by size, and to include small- and mid-cap exposure as well as large companies. Doing this also reduces the likelihood that your funds hold the same stocks as each other.

And he argues that long term-investors should have a small allocation to non equity investment trusts focused on infrastructure, which can offer long-term inflation proofing, and property. The exact amount you allocate to each asset depends on your individual circumstances. But, for example, a long-term pension portfolio could be 70 per cent in equities, and 15 per cent in each of infrastructure and property investment trusts.

If you do not have such a long investment horizon or high risk appetite, and are taking a more balanced approach, Morgan argues that just holding equities and bonds won’t necessarily mitigate downside in your portfolio. “In particular, a portfolio of interest rate sensitive bonds and growth-style equities has recently been shown to be vulnerable to rising inflation and interest rates,” he explains. “To provide a well-rounded portfolio, investors could consider areas such as infrastructure, property and alternative strategies to complement core positions.”

Yearsley adds that you should also diversify bond exposure. It is arguably harder to asset allocate across bonds than equities so for many investors strategic bond funds are a good option. These typically hold different types of debt, and their managers can invest across the debt spectrum, focusing on the areas that look best and avoiding less desirable ones. However, strategic bond funds can allocate to high risk areas such as high-yield bonds and emerging markets debt so may not be suitable for lower-risk investors.

If you are just starting an investment portfolio and it does not have a great value you should not hold many funds as this would be relatively expensive. A good initial option is a broadly diversified fund such as a global equities or multi-asset fund, depending on what your asset allocation requires.