Strategic diversification of your investments can be your first line of defence

The world of financial markets is a fascinating and ever-changing landscape. Much like the weather, the climate of these markets can shift rapidly. One moment, everything might be calm and sunny, with investors full of optimism and bullish about the future. Then, a storm may roll in the next moment, causing the same investors to scramble for cover and reassess their strategies.

Predicting these shifts is a complex task. A sudden change can catch investors off guard even when everything seems calm. This is especially true when it comes to ‘black swan’ events – unforeseen occurrences that have a significant short-term impact on the markets. These events can cause major disruptions, even in otherwise stable markets.

Financial markets fluctuate due to numerous factors
Just as the weather changes based on factors like atmospheric pressure and temperature, financial markets fluctuate due to numerous factors. Investor sentiment, economic growth projections, inflation rates, geopolitical events – all these and more can cause the market’s mood to shift.
These black swan events arrive as a bolt from the blue, posing a risk not significantly factored into prices beforehand. Prime illustrations of such events include the Covid-19 pandemic, the war in Ukraine, and the Liz Truss emergency mini-budget. So, faced with such unpredictability, how do you fortify your portfolio and yourself to withstand the inevitable inclement periods that characterise the financial markets?

First line of defence against these financial storms
Strategic diversification of your investments can be your first line of defence against these financial storms. By spreading your investments across a range of asset types and geographic regions, you can minimise the impact of a downturn in any one area. Also, building resilience into your portfolio is critical. This means having a mix of investments likely to perform well under various market conditions.

These might include defensive stocks that tend to hold their value during market downturns or alternative investments that aren’t closely tied to the performance of stock and bond markets. In times of financial turbulence, it’s crucial to remain focused on your long-term goals and not be swayed by short-term market fluctuations. Remember, investing is a marathon, not a sprint.

‘Permanent’ diverse portfolio is a strategy
Adopting a ‘permanent’ diverse portfolio is a strategy that can serve you well in the unpredictable world of financial markets. Timing the market, or moving into and out of riskier assets, is an exceptionally challenging task. A more feasible alternative is to maintain a properly diversified portfolio that is periodically rebalanced and possibly tilted according to the general outlook, specific opportunities and perceived risks.

This approach keeps you invested, allowing you to benefit from the long-term wealth-generating effect of asset prices. By blending a variety of ‘uncorrelated’ investments – those whose price movements are largely independent of one another rather than moving in tandem – it’s possible to create a portfolio resilient to market fluctuations yet capable of delivering robust performance.

Balancing simplicity with variety
Ideally, your portfolio should strike a balance between simplicity and variety. It’s essential to spread your investments across different sectors and areas to mitigate risk, but it’s equally important to avoid creating an unwieldy ‘stamp collection’ of investments that’s difficult to monitor and manage.

Sticking to your investment strategy is crucial, especially during periods of market volatility. Focusing on the long term rather than reacting to every passing market gyration can lead to better decision-making as an investor. If you clearly understand what your ‘permanent’ portfolio should look like, adjusting these allocations might sometimes make sense as asset prices fluctuate to maintain weightings and diversification.

Practising patience during market volatility
However, for much of the time, little or no adjustment should be required. Having a plan to adhere to and accepting that events will inevitably test your resolve can make navigating the financial landscape easier. Otherwise, there’s a risk of slipping into panic mode and making poor, spur-of-the-moment decisions.

During periods of market stress, emotional reactions from investors can exaggerate price falls, making rational thinking more difficult. In such circumstances, it’s important to remember that hasty buying or selling can result in being on the wrong end of price swings.

Value of income-producing investments
Including income-producing investments in your portfolio is another option to consider. While market volatility can be frightening, an asset’s income is often more consistent than its capital value. Amidst a fast-changing economic landscape, it’s easy to overlook this crucial component of your overall return.

When markets are flat or falling, the steady influx of income can bolster and stabilise the value of your portfolio. The income from your share or bond holdings is also why timing markets, or selling out then buying back in, is generally unwise as it interrupts the flow of income.

Balancing market volatility with bonds
In addition to dividend-paying shares, a common strategy adopted by investors to counterbalance the turbulence of share markets and enhance overall returns is the inclusion of traditionally less volatile bonds. In their typical form, bonds provide a fixed annual income (often called a coupon) and pledge to return the initial capital at the end of their tenure. This asset class appeals to investors willing to take calculated risks with their capital, banking on the possibility of garnering higher long-term returns than cash.

Capitalising on market downturns
The key to successful investing lies in leveraging market falls to your advantage. The objective is always to buy when asset prices are low and sell when they are high. However, accomplishing this goal requires both time and patience, and many individuals often make emotionally driven, short-term decisions that result in the opposite effect.

A significant market drop could provide the opportunity you’ve been waiting for to invest in an area you’ve had your eye on but felt was too expensive. Yet, timing the market is notoriously difficult, requiring a mix of luck and judgment. Market highs and lows are often influenced by human psychology and numerous unseen factors; thus, employing this strategy carries the risk of missing out on the long-term benefits of being fully invested.

Benefits of regular investments
One proven method to navigate the crests and troughs of the market and alleviate investment-related stress is to make regular contributions, such as monthly investments, rather than large, one-off lump sums. This approach eliminates the need to worry about market timing. By investing regularly, an investor buys more shares or units when prices are low and fewer when prices are high. Persistently investing during market drops can, over time, turn market volatility to your advantage.

This strategy, known as ‘pound cost averaging’, can help smooth out the market’s highs and lows over extended periods. However, it’s important to remember that all investments carry risks, and you may get back less than you put in. Once you reach the stage where you’re withdrawing rather than accumulating investments, you may be unable to capitalise on pound cost averaging or ‘buying the dips’. This makes maintaining a diverse portfolio to reduce volatility even more crucial.