Do’s and don’ts to survive a horror market

With share prices falling to long-time lows, unnerved investors face a growing risk of making the nasty mistake of over-reacting. Remain calm and think extremely carefully before making any significant changes to your investment portfolio.

For many investors, the smartest move is to simply sit tight and make few, if any, changes to their portfolios until the market settles. This is a time to avoid pressures to make hasty decisions that may turn out to be costly errors.

Some of the biggest potential blunders for shaken investors at this time can include charging out of the sharemarket into residential property investments, cashing out of shares at prevailing depressed prices, and failing to recognise that the sharemarket is producing some great dividend yields – despite the prospects of cuts in dividends.

And here’s a bonus; your self-managed super fund – the most-favoured means of investing for many SME owners – can possibly deliver a big cash injection into your business that may well be much needed as the economic outlook gets tougher.

Here are eight do’s and don’ts to help guide you through these tough times for investors:

ONE. Don’t charge into investment property: The lower-end of the residential property market may seem appealing to many cash-up investors who have taken large amounts of money out of shares – hopefully before the sharemarket savagely turned downwards.

Prices of less-costly properties that appeal to first home buyers and many investors may seem to be holding up well – except in Western Australia and south-east Queensland. But take extreme care; there are hidden traps for the unwary.

This end of the market could be extremely fragile. Louis Christopher, head of property research for investment researcher Adviser Edge, suspects that values of properties in this price sector are being artificially propped up by the Government’s first home-buyer grant and other lesser-known Government schemes aimed at low-income earners.

Christopher warns that rising unemployment is likely to be detrimental to property values, particularly in the lower-end segment favoured by first home-buyers and investors. His overall tip to cashed-up investors is to stay out of the residential property market for the time being – unless a hard-to-resist, standout bargain becomes available.

TWO. Don’t rush to buy individual shares you think have become bargains: You might strike it lucky with a few selected shares, but there is a good chance that almost all share prices will keep falling over the next few months at least.

Veteran Sydney financial planner Graham Horrocks suggests there is a smarter way for cashed-up investors to increase their exposure to the sharemarket without trying to pick individual possible winners. His tip is to drip-feed or to gradually invest in low-cost and widely-diversified index funds, listed investment companies or indexed exchange-traded funds (ETFs).

Horrocks says this cautious re-entry into the market particularly makes sense because of the uncertainty about whether the bear market is nearing its lowest point.

He is convinced that investors shouldn’t be tempted to invest large amounts back into shares until they are absolutely certain that the lowest point has passed. “It can be very tempting at these prices,” he says. “But make sure that the market hasn’t [just] reached a false bottom.”

THREE. Do consider selling assets owned by your business to your self-managed super fund: This is a great means to raise perhaps much needed money for your business as the economy slows while having control over the assets in future as a trustee of your self-managed fund.

Graeme Colley, superannuation strategy manager for self-managed-fund administration service Super Concepts, says such assets could include business real estate – including, perhaps, the premises of your business – and listed shares. Your fund would buy the assets at market prices.

Perhaps your self-managed fund is holding a large amount of cash, partly as a precaution during the bear market, and your business is run out of a small strata office that your business owns. Your fund may have enough cash to make an outright purchase.

But if your fund hasn’t enough cash at this stage, Colley suggests that its trustees consider buying a business property progressively from your business in accordance with provisions in the Superannuation Industry (Supervision) Act.

Since September 2007, SMSFs have been legally permitted to use instalment warrants or similar arrangements to buy geared investments such as business real estate – provided strict conditions are met including that an asset being purchased must be held in a trust (separate from the self-managed fund) until the final payment is made, and any recourse by a lender is limited to the asset being purchased.

FOUR. Do think about the income you are potentially surrendering by moving out of shares into cash: The average yield of shares in the All Ordinaries Index is above 7% – without taking into account the value of franking credits. Try getting that on cash deposits or bonds – you haven’t got a chance.

This alone should make anyone who is still tempted to move from shares to cash to think again.

As economist and investment commentator Don Stammer noted in The Australian last week, the average yield of shares in the All Ordinaries is the second highest yield since 1945. (Stammer had examined yields dating back to that year.) His article is well worth a read.

And Shane Oliver, head of investment strategy and chief economist for AMP Capital Investors, emphasises that shares will still pay much higher dividends than bonds and cash even allowing for cuts in dividends, as widely expected.

Horrocks adds the valuable point that the size of share dividends means that investors will need to rely less on capital growth from their share portfolios. Indeed with solid income from share portfolios, astute investors should feel less inclined to closely follow the day-to-day volatility in the market.

FIVE. Do recognise that cash holdings are going backwards: Interest rates have fallen so sharply that most at-call and fixed-term deposits entered now are almost certainly producing zero returns or losing money in after-inflation terms. And their returns are clearly negative once personal or superannuation taxes are taken into account.

Annual inflation, measured by the latest TD Securities-Melbourne Institute inflation survey, exceeds 3%. And the website of interest rate researcher Canstar Cannex includes a selection of 16 cash management trusts with rates for a $100,000 deposit – just four are paying interest rates above 3%, with the average being 2.99%.

Of course, powerful cases can be mounted for increasing cash holdings during periods of falling share prices and high volatility. However when interest rates are extremely low, investors should always remain aware that their cash, in real terms, is likely to be producing negative returns. (With fixed-term deposits, this can depend upon when the arrangement was entered.)

And the negative returns from cash provide yet another reason why investors should resist the urge to move from shares to cash after the market has already fallen so much.

SIX. Do consider holding cash both in your own name and in your super fund: There are strong cases for both that investors should understand. This is a particularly key consideration at this time because investors are typically carrying much more cash than usual.

Interest earnings in super are taxed at 15% against personal tax rates – which are typically at least double – applying to earnings outside super. But it should never be overlooked that large super funds typically charge a percentage of funds under management for investment management.

But, of course, members of self-managed super funds do not pay investment fees based on the size of their assets. This can give members of self-managed funds a clear advantage in after-tax, after-fee terms.

Alan Freshwater, co-principal of financial planning group RetireInvest in Bondi NSW, cautions that cash held in super is locked up in the super system until you permanently retire upon reaching the so-called preservation age (which ranges from 55 to 60) or take a transition-to-retirement pension upon reaching 55.

Freshwater says investors could consider keeping at least some capital outside the super system – particularly if they are many years from retirement. He says the strategy of holding extra cash in super makes most sense to higher-income earners who are, say, older than 45. 

For investors nearing retirement, it is typically a smart idea to build up the cash-buffer in their super fund as a guard against sharp market downturns during their retirement. Financial planners often advocate that retirees receiving a super pension have enough cash in super to provide them with an income for two or three years. The aim is to be in a position to hopefully ride-out without being forced to sell quality shares at depressed prices in order to pay a super pension.

SEVEN. Do ensure that your investment portfolio’s asset allocation matches your tolerance to risk: This is one of the most fundamental lessons that is being truly reinforced by the severity of the bear market. Many investors have now found themselves exposed to a level of risk that is personally unacceptable to them.

A common strategy is to regularly rebalance an investment portfolio to bring it back to its strategic, long-term asset allocation such as having 70% of it in growth assets (mainly shares and property) and the remainder in defensive assets (mainly bonds and cash). But it may be worthwhile questioning whether your previous strategic asset allocation before the bear market eroded share values was really the right one for you.

Without doubt, the bear market is serving as a huge wake-up call for investors to ensure that their asset allocation matches their ability to cope with investment risk.

A crucial starting point is to actually understand the exposure of your super and non-super investments to the different investment sectors. Many investors would not have this understanding.

Alan Freshwater gives the example of a client who was a member of four superannuation funds. Freshwater found that within each of the funds, the client was invested in portfolios with fundamental different asset allocations. One portfolio, for example, was completely in cash while another was classified as having a high-risk strategy.

“My client had absolutely no sense of the [overall] asset allocation and whether it matched his risk tolerance,” he recalls. In this case, Freshwater recommended that the superannuation savings be consolidated into the one fund so the client could “get a grip” on whether the overall asset allocation matched his tolerance to risk.

EIGHT. Don’t panic-sell quality stocks that should eventually regain favour: This is really a time for keeping focused on the long-term and to try to shut out the day-to-day market noise as much as possible.

Indeed, the point will be reached where you will probably decide to increase your exposure to the market.

Graham Horrocks says that once that point is reached – perhaps after the market has clearly passed its lowest point – the opportunity can be taken to buy good stocks at low prices. Indeed, a bear market and its recovery provide a means to really improve the overall quality of a portfolio.

Some of the stocks that an investor may want, says Horrocks, may have “always seemed too expensive” in the past.