Good financial advice should smooth out bumps from unexpected events

In last month’s column, I discussed the self-inflicted harm that often occurs when we allow external factors, that are completely beyond our control, to influence our thinking.

As if on cue, Covid-19 made its presence felt in investment markets in late February.

I could have devoted this column to commenting on the various epidemiological scenarios and the range of impacts that they may have on investment markets. But the reality is, no-one yet knows what impact Covid-19 will have on global financial markets.

News that the United States sharemarket (as represented by the S&P 500) was 11.25% off its pre-virus high and the NZX 50 Portfolio Index had lost 6.54% (as at the time of writing) can leave one feeling powerless.

What these headlines completely overlook is the fact that a family that is working with a qualified financial adviser is unlikely to experience the degree of volatility that these headlines suggest. This is because a well-constructed portfolio will incorporate a range of features to help control volatility. These features will have been incorporated well before this current "crisis" and reflect the fact that we live in an uncertain world.

What kind of features am I talking about? The checklist below starts from the broadest countermeasures to the more specific or personal.

Asset diversification

Most advised clients have portfolios which hold cash, fixed interest, property and shares. This is your first line of defence. When one asset class zigs, other asset classes tend to zag.

Asset allocation

With an advised client, the percentages held in each asset class will have been agreed based on a risk profile, investment time horizon and the need to fund withdrawals, not in a reactive way that is triggered by events.

Currency exposure

The amount of currency exposure (i.e. investments denominated in another currency) can be an important diversifier of risk. If the value of the NZ dollar is driven down by global uncertainty, then the relative value of your overseas investments will increase. With a more sophisticated portfolio, the manager will be able to "dial up" or "dial down" the amount of currency exposure, independently of the assets held.

Manager style

There is constant debate in financial circles about whether active management, where the investments held are specifically selected, is superior to passive management. With passive management you invest in a basket of shares that mimic a share market index. The costs of passive management are lower but, in that situation, investors endure all of the volatility experienced by the index.

In general terms I am agnostic on this issue. I believe that there are periods in the market cycle when one style is likely to be superior but this changes over time. For example, when we have experienced a period of very strong growth and there is a chance of asset bubbles appearing, I tend to favour active management, where careful thought has gone into each holding. In the current environment, I believe that having a predominance of active managers within the portfolio is likely to work in your favour.

Mitigation Strategies

It is possible to include assets in your portfolio that grow when investment markets decline. They are generally not used with the intention of eradicating losses completely, but they help dampen the extent of losses.It is important to remember that a loss of 20% requires a recovery of 25% to take you back to where you started, so softening the extent of losses helps to protect compounded returns.

Adviser relationship

A recent report from Russell Investments calculated that the added return from working with an adviser (throughout the investment cycle) was around 5.2% pa. My observation is that investment advisers add their greatest value during market volatility. Helping clients maintain focus and "stay the course" when media reports are suggesting that they should be heading for the hills is just one component of the added value provided by an adviser.

And finally, a quote from Warren Buffet who is considered one of the most successful investors of our time: "be fearful when others are greedy and greedy when others are fearful". It’s fair to say, many are fearful at this time.

 - Peter Ashworth is a principal of New Zealand Funds Management Ltd, and is an authorised financial adviser based in Dunedin.

 

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