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How to tread carefully when stockmarket investing

Investment | Shares

By Justin Modray, published 27 September 2010.
Helpful? 57

So you’re nervous about stockmarkets but don’t want to sell out entirely – what can you do?

General wisdom seems to suggest that it pays to stay invested in stockmarkets long term, which I reckon means 10-20 years. But if you’re nervous and/or pessimistic about the shorter term outlook for markets what should you do? I doubt you’d go out for a long walk if it looks like a bad storm is brewing, so why should investing be any different?

The trouble is, stockmarkets are even unpredictable than the British weather. I think there’s a pretty convincing case for believing stockmarkets will fall (see my recent article), but they could surprise and rise - which would be annoying if you’ve just sold off all your stockmarket investments. So how can you sensibly retain stockmarket exposure without getting crucified if markets do plunge?

Here are a few approaches you could take. None are failsafe and will likely lag in rising markets, but they’re probably better than doing nothing if you believe stockmarkets might fall.

Look for high dividends

Investing in companies that pay high dividends potentially offers two ways to reduce the impact of falling markets - the dividend income can help offset falls in the share price and the types of company that pay high dividends tend to be well established cash generators that fare better than many in difficult markets (ok, the banks are probably an exception!).

For example, the Newton Higher Income fund is paying dividend income of around 7% a year at present while the Schroder Income Maximiser fund (which sells off some potential future growth to boost income now) currently yields just over 6%.

Pick defensive shares

Dull, well established industries, such as tobacco, health and public utilities, tend to be pretty consistent. Smokers don’t seem to base their consumption on the economic climate and we all need to use water, electricity and medicine, recession or no recession. These types of company often generate lots of cash and pay nice dividends too, so there’s likely to be some overlap with the previous category.

Invesco Perpetual (High) Income manager Neil Woodford has invested heavily in these areas for a while now.

Protected

Protected stockmarket funds and investments try to avoid a loss at all costs, but usually at the expense of decent returns in rising markets. For example, the Close UK Escalator 100 fund has returned just 12% over the last five years – less than cash. So-called ‘structured-plans’ that usually last for 5 or 6 years can fare a little better, but expect minimal returns if markets are flat or fall – for example, the Investec FTSE 100 Deposit Growth Plan 3 offers 100% of FTSE 100 returns over 5 years (capped at 52.5%), but this ignores dividends and you’ll simply get back your initial investment if the index falls over the period.

Short

If you want to be sure of making money when the market falls then you’ll need to go ‘short’ – basically the reverse of buying shares normally. By shorting a share you gain when its price falls. Holding ‘short’ investments alongside conventional ones can help hedge your bets.

Simple ways to do this include using exchange traded funds (ETFs) and spread-betting.

Some ETFs, such as the dbx Trackers FTSE 100 Short Daily, track an index in reverse, so for every 1% the index falls you profit by 1%.

Spread betting allows you to bet on share/index price movements, either up or down. For example, you could bet £10 per 1p a share price falls. If the share price falls from 100p to 90p you’ll make £100 profit, but you’ll lose £100 if it rises to 110p. Spread betting is potentially high risk, but straightforward and tax-free. You can read more about short ETFs and spread betting in my answer to his recent question.

Absolute Return

Absolute return funds typically try to use a combination of shorting and diverse investing to deliver positive returns regardless of markets. Unfortunately, they have a patchy track record of actually working and the managers tend to charge excessive fees (often a standard 1.5% annual fee plus a fifth of any profit). These types of fund are probably worth holding in moderation (choose carefully) but I’d be wary of trusting them for the bulk of your portfolio.

Conclusion

The sure-fire way to protect your portfolio from falling stockmarkets is to hold cash. But as this will miss out on any stockmarket rises (v difficult to predict) the above strategies offer a way to protect against stockmarket falls while leaving the door open to some return if markets rise. They’re not a perfect solution, but I don’t think one exists – if you know of one please tell me!

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Readers' Comments (1) - To post a comment please register or login .


Comment by pvcdoc at 5:44pm on 07 Oct 2010:

Generally the more complicated the fund, the higher the management charges and so the less profit is left for the investor. "Protected Funds", Hedge Funds and - to a lesser extent - "Absolute Return" funds are all quite complex on close inspection: they tend to make more money for their managers than for their clients.

An old adage: only put money into the stockmarket which you can afford to loose.

You cannot avoid taking risks in life. Even if you put all your money on deposit, you're likely to loose wealth after allowing for tax and inflation.