Six Ways to Avoid Financial Disasters

23 Apr 2013

By Andrew Pidgeon

For the most part, the period since the Global Financial Crisis (GFC) has been characterised by years of market volatility, and with 'risk aversion' the dominant theme across the globe.  We only have to look at bond yields to know that investors have craved capital security, regardless of return. Think here of the US 10 year bond yields at 2.01% while inflation continues to run at 2.2% in the United States (US).

More recently however, equity markets have experienced strong gains, with the US market trading at near all time highs. Whilst the Australian sharemarket hasn't staged such a strong recovery, the past six month returns have nevertheless been quite spectacular, albeit confined to certain sectors rather than the 'rising tide lifts all boats' rally we have seen in the US where gains have been more or less across the board.

There is growing evidence of investors moving funds from cash and term deposits and investing into the market. Amidst this backdrop of a return to risk assets it is worth taking stock and reminding ourselves of the risks that exist in markets with a view to avoid the mistakes that many investors have made in the past, particularly in the period leading up to the GFC.

The intention here is to by all means be positioned to participate in the growth when it occurs, but is a reminder not to take an eye off the risks that exist that have the potential to erode capital should one of the many risks come to the fore.  What follows are six simple tips to avoid exposing retirement savings to undue levels of risk, and end up a statistic telling your story on Four Corners.

1. Devise an appropriate asset allocation

Studies show that asset allocation attributes to 94% of an investor's return, with security selection accounting for only 4% of return while market timing made up the remaining 2%.

With this in mind, it is critical that an appropriate asset allocation strategy be a priority. An appropriate asset allocation can help tie together three risk elements being;

  • Liquidity risk - quite simply the risk that you don't have access to liquid funds when you need it.  Many asset allocations are designed to achieve capital growth over the long term but fail to address cashflow and liquidity needs, resulting in investors needing to sell growth assets sometimes at undesirable times in the cycle.
  • Longevity risk - weighs up an individual's starting capital versus their needs ie. living costs.  In many cases when inflation is factored in to living costs many individuals can't afford to allow their capital to sit in term deposits not earning any growth.  As the cost of living increases this effectively erodes the true value of capital, which can result in wealth becoming exhausted prematurely.  In which case investors need to take a calculated level of risk with the expectation of achieving a higher rate of return than inflation to allow capital to last their lifetime. Clearly where living costs exceed a level that can be comfortably supported with the starting capital base there needs to be some serious adjustments made.
  • Comfort factor - it is all well and good to take some risk by having some exposure to growth assets, but if it sends you to an early grave worrying about the markets then you have defeated the purpose of taking a calculated level of risk.  Hence a balanced approach needs to be taken, with a level of exposure to growth assets that is suited to the individual's attitudes and comfort level.

2.  Invest in good quality assets

Experienced investors will tell you that you make your profit when you buy. Buying good quality assets, choosing a proven management team and an asset with a history of growing earnings and paying dividends can all help reduce the risk of having a loss. Forget these principals and making a profit becomes difficult, if not impossible.  Often investments that fail have limited track records, but they do come with an unrivalled 'promise of high returns'.

3.  Diversify

A simple principal of not putting all your eggs in one basket ensures that if you invest in an asset or asset class that does not live up to expectations the implications are not disastrous, an investor in these circumstance is not placed into a position of making a forced sale or a hasty decision as weak returns in one asset can be offset by stronger returns in other assets.  No-one can predict the future, despite what they say.  Investing is much like life, it is about taking a series of calculated risks with the aim to get a pay off, but invariably some will not.  Make sure your exposure to any one asset is not so great that if it happens to fail, it does not derail your entire financial strategies and objectives.

4.  Take a long term approach

We constantly hear commentators and experts make assertions about the state of the investment environment, this was the case last year when many commentators were talking up the risk of there being a tech bubble, warning investors to not lose sight of the 'fundamentals', and warning that prices needed to correct to reflect fair value.  Whilst it might be too soon to say that they got it wrong, timing your entry and exit from a market is an entirely different prospect that no-one has consistently got right.  Too often we see investors erode capital by trying to time markets; which is basically saying they are better informed and more knowledgeable than the market - that's a big call!

5.  Regularly rebalance

Instead of trying to time the markets, stay disciplined and regularly rebalance your portfolio back to the benchmark asset allocation. This will naturally cause you to sell assets after they have appreciated in value and buy assets when markets are at low points to restore the portfolio back to the long term asset allocation strategy.

6.  Don't panic and be patient

Douglas Adams wrote two simple words on the cover of the Hitch Hikers Guide to the Galaxy – 'Don't Panic'.  This principal applies providing you have stuck to all the other disciplines of being invested in good quality assets, being diversified, sticking to a benchmark asset allocation, rebalancing back to that benchmark position on a regular basis and taking a long term approach.

What we have seen over the past six months in markets is investors who have been patient and stuck to their strategy during the GFC have been be rewarded with solid returns.  At various times through the cycle these strong returns will be seen again, and hopefully the next event the size of the GFC is a long way - but this can never be guaranteed. There still remains considerable risks and challenges in the world that, if not carefully managed, have the potential to return markets to the chaos we saw in 2008 and early 2009. Therefore it is essential for investors to review their asset allocation now and take profits where market growth has caused equities exposure to breach the benchmark allocation.

It is devastating to hear investors interviewed in documentaries such as the recent Four Corners story after losing their entire wealth in Prime Trust, Basis Capital and Banksia Financial Group. But if they had only followed the aforementioned principals and hadn't investing their entire life savings into a single investment or scheme; if only they had invested in quality assets with a proven track record; if they had a strategy or a target asset allocation and had managed their portfolio having regard to their needs, how different would the outcome be?  And for some, the lure of 'making a quick buck' was just too much, rather than adopting a patient long term approach to investing.

As they say, if it sounds too good to be true, it often is...

If you have any questions in relation to this article please don't hesitate to contact the Shadforth Financial Group.

If you like this article, please feel free to share it with your family and friends.

Educational guides