DIY Funds Management

The investing public deserve the best possible investment advice to assist in protecting their capital base while providing adequate growth, but with limited risk, within their portfolio.

This short statement on the surface appears to encapsulate the key requirements that financial planners would normally exercise when maintaining an existing or developing a new client’s investment portfolio.

When markets are relatively normal, the process is somewhat more simplified as, over time, they provide investor support by trending upward with the occasional downside movement. Therefore a long-term buy and hold position is a strategy undertaken by many planners.

In the downward market conditions experienced during the past 12 months, strategies such as buy and hold have not proved ideal.

Investors have experienced portfolio falls of 30 per cent or greater (in some that I have witnessed, up to 50 per cent), with their potential for recovery anticipated taking a lot longer than many of the previous recovery periods experienced in the past.

The share market took over five years to exceed its previous high following the 1987 crash, approximately two years from the high in 2001, and since 1980 the average recovery period is 15 months (to recover a paper loss of 30 per cent, a portfolio would need to grow by 43 per cent).

Therefore, short-term recovery of an investor’s portfolio in the current climate is unlikely.

Should investors be faced with the dilemma of waiting for a recovery, while only receiving ongoing correspondence reassuring them of eventual recovery? Or are there other alternatives that can be explored?

The answer depends on the nature of the individual or entity that manages the respective investment monies.

Fund managers endorse the buy and hold strategy because it is in their interests, however, there are alternative strategies that will produce better results and lessen the downside while still capturing the majority of market upside.

Let’s consider the strategy options available under the first point above: capital base protection, limiting downside risk, and portfolio construction.

Capital protection

One of the prime components in dealing with other people’s money is to ensure the base capital invested is not eroded through market downturns.

This can be achieved by understanding market movement and identifying key indicators that enable proper assessment of market volatility.

Once significant trends are identified either in single stock positions or markets generally, positions can be taken to protect capital. This may even mean moving investors into cash or other assets.

Investor behavioural attitude is a major cause of over-fluctuation in the marketplace. When markets become over-inflated, sentiment rather than logical investment process becomes the driver. Learning to recognise when this occurs is a specialised skill. Good investment mangers will have either rebalanced portfolios, begun exiting the market, or already have exited the market, thus taking positive action to protect capital.

It is not a question of timing to obtain exactly the bottom or top of a market; recent market events have proven a more active roll is required.

The argument to buy and hold, as is so often suggested during volatile down trending markets only results (albeit a paper loss) in eroding capital. However, building capital growth by retaining a larger capital base is a far better proposition.

Financial planners who want to be successful and stand out from their colleagues will be those who have the ability to manage investors’ money in a proactive manner.

Limiting downside risk

Firstly, never let emotion dictate the outcome of an investment strategy. It is so often advocated that investors make incorrect decisions because of the greed factor. Ever considered that this is exactly what happens in a buy and hold proposition? The investment is retained with no exit strategy.

Rule: always be prepared to sell if your investment falls below your predetermined risk level — take your loss as soon as the trigger event occurs.

The key is to evaluate and monitor individual stock selections and market movement using both fundamental and technical analysis, making your own decisions rather than following the herd or market speculation.

One approach is to buy low and sell high and to set stop losses, because knowing when the risk is unacceptable is the key to limiting the downside.

I am continually surprised by the neglect by many in the professional area of not utilising available resources to protect downside risk. Minimising downside risk and retaining capital enables a ready position for the next investment purchase or phase.

As an industry we have an obligation to our clients in limiting the downside risk and maximising portfolio growth.

Portfolio construction

Once a portfolio has more than 12 individual stocks, diversification risk begins to impact negatively on a portfolio. The more stock held in a portfolio, the more likely the investment yield will gravitate to an index style return.

In a managed fund, there is a perception that risk is better managed by diversification across a larger selection of stock. However, by exercising your own stock selection strategy, control of the portfolio is not left to a third party.

In addition, with the ever increasing advent of improved technology, it is possible to monitor stock holdings while still being able to provide comprehensive reporting for investors.

Selection of assets for an individual’s portfolio needs to be tailored to the client’s risk profile and current stage of life needs.

Small and micro cap stocks will have less liquidity available whereas most stocks in the ASX 100 will provide a ready source of growth and income.

A solid weighted portfolio of eight to 12 stocks in a client’s portfolio will outperform most managed funds in both the short and long term.

It’s time to consider

There has never been a better time to entertain change.

Managed strategies that have materialised with the widespread growth of managed funds over the past 20 years have removed much of the expertise that existed in stock market trading.

Colin Owens is the director of marketing at Wealth Within.