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Market volatility series part 2: Should you change your strategy when markets fall?

When it comes to investing, every investor has a different comfort level in terms of how much risk they’re willing to accept.

Many factors come into play – from the risk associated with each asset class, to an investor’s financial situation and investment timeframe, and even their lifestyle goals and personality.

 

It’s hardly surprising that each investor reacts differently to market volatility. While some are quick to sell up, others are willing to ride out short-term fluctuations by keeping an eye on the longer-term prize. But when markets are volatile, how do you know if it’s time to change your strategy?

How do investors react to volatility?

An earlier study1 examined investor sentiment during a period of volatility and how it impacted people’s investment decisions.

 

The results showed that as investor confidence declined, portfolio activity increased – with more investors moving away from the share market. In fact, the group most likely to switch out of shares were investors aged 50 and over – perhaps because they were seeking to preserve their capital and minimise their risk exposure as they neared retirement.

 

While investors of all ages often respond to uncertainty in markets by taking a more active approach to their investments, this may not always work in their best interests. Not only can switching be costly, but it can also mean missing out on opportunities when the market recovers.

Should you switch your investments?

Before you withdraw from an investment, it’s important to make sure you understand all the implications, including the risks and costs involved. For one thing, if you sell your asset you may be liable for capital gains tax, which can reduce the potential profit you stand to make.

 

But that’s not all. If the value of your investment is falling, this is only a hypothetical or “on paper” loss. Once share prices begin to rise again, your investment could soon return to profit without you doing anything. However, if you sell your investment while its value is down, you essentially crystallise your losses – making them real and irreversible.

 

What’s more, even if you’re only planning to sell off part of an investment, it’s not just the face value you’ll be giving up – you’ll also miss out on the benefits of compounding, which means you won’t be able to earn further returns on the shares you sell.

Before you withdraw from an investment, it’s important to make sure you understand all the implications, including the risks and costs involved.

What other strategies are there?

The research also revealed that Australian investors tended to react to uncertainty overseas by reducing their exposure to international shares. While this may seem like a sensible move in theory, it also means your overall portfolio could become dependent on a smaller pool of asset classes.

 

Diversification should be considered a key part of any long-term investment strategy, as a diverse portfolio of investments could allow you to spread your risk exposure across different asset classes and markets, rather than putting all your eggs in one basket. This offers a financial buffer whenever an individual asset class declines in value.

 

For example, a well-diversified Australian shares portfolio is better placed to withstand a market correction than a single Australian shareholding. A global shares portfolio is likely to weather the storm better than a single-country share portfolio. And a multi-asset portfolio, combining both bonds and shares, should outperform a share portfolio in a downturn. Therefore, portfolio diversification can be helpful to investors in balancing market losses during periods of volatility.

 

However, when tailoring your investment mix, it’s also important to consider how much risk you are willing – or able – to take when investing. For example, growth assets such as shares generally carry more risk than more conservative assets such as fixed interest or cash. If you’re a younger member with a longer investment horizon to retirement, you will likely have more time to ride out market fluctuations and can take advantage of growth opportunities than older members who are in or approaching retirement.

 

Thinking about changing your investment strategy? A financial adviser should be your first port of call. They can help by reviewing your portfolio to make sure you have the right investment mix based on your financial goals, investment timeframe and unique risk appetite.

 

You can learn more here about how you could reduce the impact of market movements.

Disclaimer

This document has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFSL 232468 (CFSIL). The information, opinions, and commentary contained in this document have been sourced from Global Markets Research, a division of Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945 (CBA). Global Markets Research has given CFSIL its permission to reproduce its information, opinions, and commentary contained in this document and for CFSIL to authorise third parties to reproduce this document. This document has been prepared for general information purposes only and is intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of CFSIL at the time of writing and may change over time. This document does not constitute an offer, invitation, investment recommendation or inducement to acquire, hold, vary, or dispose of any financial products. CFSIL is a wholly owned subsidiary of CBA. CFSIL is the issuer of super, pension and investment products. CBA and its subsidiaries do not guarantee the performance of CFSIL products or the repayment of capital for investments. This document may include general advice but does not take into account your individual objectives, financial situation or needs. The Target Market Determinations (TMD) for our financial products can be found at www.cfs.com.au/tmd and include a description of who a financial product is appropriate for. You should read the relevant Product Disclosure Statement (PDS) and Financial Services Guide (FSG) carefully and assess whether the information is appropriate for you and consider talking to a financial adviser before making an investment decision. The PDS and FSG can be obtained from www.cfs.com.au or by calling us on 13 13 36. Past performance is no indication of future performance. Stocks mentioned are for illustrative purposes only and are not recommendations to you to buy sell or hold these stocks. This document cannot be used or copied in whole or part without CFSIL’s express written consent.