An investment sea change
Volatility is a fact of life and a timely reminder to check goals and timeframes.
Share investors have had a great run over the past 10 years. Memories of the global financial Crisis (GFC) have dimmed and we have been lulled into a false sense of security; we have forgotten that markets don’t always go up.
The GFC in 2008 was bad news at the time, but it resulted in a set of circumstances which put wind in the sails of share markets. The
S&P500 index is now three times what it was at its lowest point after the GFC and 70 per cent higher than it was at its highest peak before the GFC. While there was a small degree of volatility in the first few years after the GFC, there has been no major correction since then, and the last 18 months in particular have been plain sailing, with the markets continuing to reach new heights.
However, the world is changing. Post-GFC, markets were fuelled by central banks injecting cash into their economies and dropping interest rates, as a means of avoiding recession. Now that unemployment rates have dropped and company profitability has improved, the threat is not recession but inflation. It’s time to take the foot off the accelerator and put the brakes on.
That means tighter monetary policy and higher interest rates. Alongside this the world political situation has changed and presents risks which could interfere with global economic growth. We are entering a new phase. The recent volatility in share markets is a timely reminder that we need to prepare for the next market correction. There is more volatility to come.
Volatility is a new experience for KiwiSaver investors who have known nothing but stable markets in recent years. For long-term members, KiwiSaver balances are building up to a level where regular contributions will not be sufficient to offset a drop in unit prices. There will be plenty of opportunity over the next two or three years for nervous investors to make bad choices about how their funds are invested.
Let’s be clear on a few basics. Volatility is the reason shares provide higher rates of return than bank deposits. It is nothing to be afraid of; it just needs to be managed.
There are two key principles for managing volatility. The first principle: your investment in shares must be diversified to reduce risk. The second principle: you must match your investment strategy to your investment timeframe. When investors lose money by investing in shares it is because one of these investment principles has been violated. If you are in KiwiSaver, diversification is covered off by your fund manager – no worries there. However, your choice of investment option is critical and it must match your investment timeframe.
The problem is, many KiwiSaver investors haven’t thought through what their investment timeframe is. It is probably not the time at which you retire. Young KiwiSavers have an opportunity to use KiwiSaver funds to purchase a first home. In that case, their investment timeframe is the time at which they expect to withdraw their funds to use as a house deposit.
The shorter that timeframe, the less exposure to shares they should have in their KiwiSaver fund.
For most other investors, KiwiSaver funds will be spent at some time during retirement, but not necessarily at retirement. If KiwiSaver is your principal means of saving for retirement, it would hardly make sense to spend it all at the time you retire. The plan should be to spend it gradually over the course of retirement. Given that the average 65-year-old lives to around 90, this means you will continue to invest for many years after the day you retire.
For investors with a long timeframe, short-term volatility is nothing to worry about. Good fund managers will find opportunities to buy shares cheaply during a market downturn. The best returns are made by buying at a low price and selling at a high price. Inexperienced or nervous investors do the opposite; they buy near the peak when everything looks good, then panic and sell when the market drops.
In times of volatility, always review your investment goals and investment timeframe. If they haven’t changed, then you shouldn’t need to change your investment strategy, unless it was flawed to begin with.
Make sure you have access to funds in stable investments such as bank deposits to cover your short-term spending, so you can ride out the changes in volatile investments. Then sit back and relax.
Liz Koh is an authorised financial adviser and author of Your Money Personality; Unlock the Secret to a Rich and Happy Life, Awa Press. The advice given here is general and does not constitute specific advice to any person. A disclosure statement can be obtained free of charge by calling 0800 273 847.
‘‘The recent volatility in share markets is a timely reminder that we need to prepare for the next market correction. There is more volatility to come.’’