An eye to the downside
Amid more murmurings of a market crash, John Berry outlines ways investors can hedge their bets.
The human brain is hardwired to avoid pain. That’s why the intensity of the hurt from a $100 investment loss is many times that of the pleasure brought by a $100 investment gain.
It’s also why we buy insurance and why many investors panic when markets fall.
New Zealand’s stockmarket hit new highs this month. Equity markets globally have risen since 2009, delivering the secondlongest bull market in more than 70 years.
But apprehension is growing for investors. Legendary investor George Soros warned at the end of May that a surging United States dollar and emergingmarkets ‘‘capital flight’’ may lead to another financial crisis.
When markets dive, as they did in early February, fear quickly turns to panic. Corrections happen from time to time – it’s just what markets do. However, sellers were punished when the market bounced back.
Instead of hitting the panic button, it’s better to always have an eye on risk and think in advance how a portfolio might react to a market sell-off.
There are many strategies for managing downside risk. The simplest is cashing up. It’s a blunt instrument with a symmetrical payoff – if a portfolio has 30 per cent in cash and then equity markets go down, 30 per cent of losses are avoided.
But if shares go up then, 30 per cent of gains are missed.
For this to work an investor must pick turning points. This is notoriously hard, if not impossible.
When Donald Trump was elected US president in November 2016, many investors sold and rushed to cash, yet since then the S&P 500 index is up 30 per cent.
The next strategy is to stay invested in shares, but rotate into more defensive sectors and companies that typically don’t fall as far or fast in a sell-off.
These can include stable industrial companies with long dividend-paying histories, utilities, listed property and consumer staples such as food companies.
This strategy can’t eliminate losses but may help reduce them.
Next up is an unexpected but critical consideration for managing risk in international portfolios – currency.
When global markets sell off, the New Zealand dollar typically falls as investors flee to safety.
For a New Zealander invested in US equities with no protection against currency fluctuations, the shares may drop in value but the rising US dollar acts as a buffer, reducing losses.
The global financial crisis in 2008-09 saw a brutal 53 per cent sell-off for the S&P 500. But the US dollar rose 35 per cent against the New Zealand dollar, providing a safety-release valve for New Zealand investors.
Losses were reduced to about 20 per cent through currency exposure.
Derivatives such as share or currency options (which, if used properly, can be like an insurance policy for investors) provide another tool for downside protection.
But be warned, Warren Buffett once described derivatives as ‘‘weapons of mass destruction’’ because they can quickly incinerate wealth.
A final way to reduce portfolio downside risk is taking nonfinancial environmental, social and governance (ESG) research into account when selecting companies.
A study by Bank of America Merrill Lynch found that shares in companies with strong ESG disciplines had lower ‘‘peak to trough’’ falls and lower price volatility.
In fact, investing in the top half of ESG scorers avoided 90 per cent of bankruptcies over 10 years.
James Gorman, chief executive of investment bank Morgan Stanley, described Soros’ concerns of an imminent financial crisis as ‘‘ridiculous’’, proving once again that reputation alone is no guide to success in markets.
Whoever you believe, investors should make hay while the sun keeps shining but have an eye on strategies that reduce pain if markets turn. Soros and Gorman can’t both be right.
John Berry is co-founder and chief executive of Pathfinder Asset Management, a responsible investment specialist. This is general information only with no recommendations to acquire or dispose any financial product. Seek professional financial advice before making investment decisions.