For months all has been quiet, but for 48 hours this month, investors were rudely reminded of markets’ propensity for periodic bouts of bone-rattling volatility.

Fortunately, some easy-to-implement portfolio strategies can abate this risk, allowing trustees, both in savings and pension drawdown mode, to reduce the bumps without resorting to the sale of an entire portfolio.

  1. Bucket strategy

A bucket strategy involves holding a period of superannuation pension payments in low-risk assets or cash assets. This gives investors the comfort that they have sufficient cash or low volatility assets to hand to weather a downturn, while giving more risk assets time to recover.

This strategy (often criticised for its boring simplicity) is particularly well suited to those in the early years of retirement, where what is known as “sequencing risk” is at its highest. Deciding how many years’ pension payments to hold in the low-risk bucket reflects your tolerance for risk, but as a guide, one or two years is common.

 

  1. Disciplined stops

While few investors are prepared to realise losses, especially given the tendency of markets to recover losses quickly, simple, disciplined stop losses are hard to beat to manage volatility.

Instituting stops is very simple – at a given price level, the trading platform commits you to sell your assets. The benefit is the advance commitment to cutting a position at a pre-determined point.

The downside is that a swift recovery in prices leaves you taking the loss with no prospect of participating in the recovery. Nonetheless, a simple and oft-forgotten strategy.

 

  1. Diversification

As a rule of thumb, more than 20 assets in a portfolio across different sectors and asset classes will provide sufficient diversification, thereby helping to protect the value of a portfolio in the event one asset class suffers a sharp fall.

Consider a typical “balanced” portfolio that allocates up to half its funds to fixed income or other similar “defensive” assets. These assets typically provide low-volatility, low-risk returns where the other half of the portfolio – often in equities and property – provides a higher quotient of capital growth but, with it, volatility.

Within the equities allocation of balanced portfolios, generally half is invested in global shares, which are priced in foreign currency thereby providing another source of diversification.

Within an equities portfolio, some sectors can provide greater defensive characteristics (think health care as opposed to commodities), further helping to diversify the portfolio.

The caveat is that during periods of extreme market stress, different asset classes might unexpectedly move in tandem.

 

  1. Income generation

About five years after the 2007 S&P/ASX 200 market peak, investors in the index who reinvested dividends returned to the black, as did investors in typical balanced portfolios.

The link between the two is dividend payments. Assets that generate dividend or coupon income are generally quicker to recover due to the resilience of their business model.

Importantly, the benefit of the cash flow from dividends by allowing reinvestment during a market recovery enhances long-term returns.

Lastly, the tax benefit associated with franked income in Australia provides a further buffer. These gems should be a mainstay in any portfolio.

 

  1. Options

An extremely viable, yet infrequently implemented, approach is to buy put options over a portfolio. These give the holder of the option the right to sell assets at a specific price, within a certain timeframe.

In other words, for a price, you “insure” a portfolio at a certain market level for a certain period.

Despite their merit, investors don’t often use put options due to perceived complexity and cost. As a very broad guide, a years’ worth of coverage on an ASX 200 portfolio can cost between 4 per cent and 7 per cent of a portfolio’s value, but is dependent on a range of factors (including the volatility of markets when you implement the strategy). Do seek advice from an options adviser on these extremely effective means of protecting a portfolio.

 

  1. Protected products

As demand for products with limited downside has matured, issuers have stepped up with effective products.

Some of these include capital protected portfolios (ensuring that over a given period the portfolio value is guaranteed), “hedged” products that contain constant downside protection, structured products (warrants and instalments) and traditional products such as annuities (regular payments over the life of a product, or your life).

Annuities are a popular and rapidly growing product category. They provide certainty of income but the saver has no access to capital growth. Recent new products include BetaShares’ BEAR (which increases in value as equity markets decrease). Structured warrants can be effective in providing exposure on the upside while limiting the downside risks.

 

  1. Cash

The ATO reminds us that cash is one of the largest asset holdings for self-managed super funds, alongside Australian equities. The trouble with cash in a low-interest-rate environment is obvious.

Its effectiveness is most apparent after a market fall, as cash gives trustees the ability to buy assets at lower prices. It can also provide certainty of income even as financial markets are falling.

 

The bottom line

With markets presently relatively stable, we’re taking the opportunity to progressively implement a range of these protection strategies with our clients.

We regard further equity market volatility over the next few months as a better than even chance, given political risks, stretched equity valuations and softening economic indicators.

 

Written by Tony Davison, General Manager and Senior Financial Adviser.

Published in afr.com.au, read the full article here.

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