PracticeConsultingPersonal finance: What should you do when share prices head south ?

Personal finance: What should you do when share prices head south ?

What should you do when the world's stockmarkets go pear-shaped? This, not to put too fine a point on it, is the worry for millions of investors in the UK who may have felt, until the past few weeks at least, that share prices could only travel in one direction - and that was up.

Hardly surprisingly, when markets start heading south, many investors may feel that the best way to react to what is happening is to sell up and wait until things get better, then go back in again. Or to look for fund managers who claim to have special stock-picking skills that allow them to weed out poorly-performing stocks from their portfolios.

Yet the experience of most stockmarkets in recent years does not support either the theory that timing or that of stock-picking is key to a successful investment strategy.

Research by Fidelity Investments, the giant US-owned fund manager, looked at the 12-year period between the end of 1987 and the end of 1999. It shows that investors who tried to time an investment in the UK market and missed the best 40 days (just three to four days a year) in that overall period would have reduced their returns to 6.7% from 16.2%.

Of course, for anyone who can time the market right the rewards can be spectacular. For example, anyone who had avoided the 40 worst days in the UK stockmarket over the same 12-year period would have seen their portfolio worth 26.3% instead of 16.2%.

Isn’t this an argument in favour of careful timing after all? Sadly, no. Fidelity’s research suggests that the worst stockmarket days tend to follow shortly after the best ones, for example when investors ‘take profits’ after a particularly good number of sessions.

So what is the moral here? Paul Kafka, Fidelity’s executive director, says: ‘We encourage investors not to panic or to sell out during this period of stock market volatility. We believe it is much more effective to take a long-term view and stay fully invested rather than trying to time the market.

‘We [do] encourage customers to review their investment objectives [but] if these are long-term, then it is appropriate to continue on a steady course.’ Further evidence to back up the ‘invest-and-sit-tight’ strategy comes from a recent study of the period from 31 December 1969 to 31 December 1999.

The study tracked the results of three identical investments made on the same day each and every year – at the highest point in the market, the lowest point, and on an arbitrary date – in this case 1 January.

In the UK, investing at the highest point in the market that year delivered returns of 16%. The lowest point delivered annualised returns of 17.9% and the random investment date showed growth of 17.2%. It is important to note that these figures are based on getting the low or high investment points exactly right, year after year after year.

What then of specialist stock-picking? Here too, research suggests that over a longer period so-called ‘active’ fund management does not work. Tracker funds, which simply replicate the performance of various share indexes, tend to do better in the long term.

WM, a research subsidiary of Deutsche Bank, recently published a study showing that over a five-year period, only 46 out of 171 unit trusts out-performed the FTSE All-Share index – without taking management charges into account. When charges and other costs were included in the performance weighting, the number of funds fell to 29.

Over a 20-year-period, only nine out of 58 funds outperformed the index. This fell to seven when costs were included.

Clearly, costs will affect both tracker and actively-managed funds. However, trackers are almost always cheaper than actively-managed funds, which ensures that they enjoy that cost-determined performance advantage.

Moreover, the WM study suggests that while active fund out-performance works over three-year cycles, most investors have imperfect knowledge of the market. By the time they realise that a fund is doing well and are ready to invest in it, they have probably missed out on a least 18 months of that out-performance.

The report concludes: ‘For investors seeking a bit more excitement and who genuinely think that a style bias or niche play might serve them well relative to index, there are a host of ways of implementing their view. [But] such strategies require constant monitoring and restructuring, a costly exercise. Therefore, for such investors, a strong case can be made for a tracker funds being the bedrock of any long-term investment strategy.’

Roddy Kohn, an independent financial adviser at the Bristol-based firm Kohn Cougar, says: ‘Sure, trackers can and should be an important part of any investors’ strategy.

‘Equally, you need to diversify in order both to minimise risk and also to ensure the best possible chance of adding extra value to your portfolio.’

Mr Kohn adds: ‘For example, high-tech stocks may have taken a tumble in recent weeks, but no-one is seriously suggesting that a few judiciously-chosen dotcom and high-tech companies can deliver staggering returns. An expert fund manager will find them more easily than you or I might.

‘Where I do agree with all the research is the importance of regular investing, without trying to endlessly, and fruitlessly, interpret every market move. The key is investing for the long term, looking for value where possible, but also using any other yardsticks around to give you that little bit of an extra edge.’

Nic Cicutti is head of content at www.FTyourmoney.com, the personal finance website

The four cardinal rules of investment
ú Don’t try to read the market by withdrawing and then going back in.
ú Don’t believe claims that active management will deliver consistent outperformance
ú Always look for value – the cheapest funds are often the best overall performers when costs are taken into account.
ú Be prepared to add some spice to your portfolio both to minimise risk and enhance potential gains.

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