How to protect savings from market downturns
The stock market predictably will fluctuate. No matter what we do, stocks go up and down. So it goes. At the moment, the equity market is particularly unpredictable with recent events such as such Brexit and Nenegate having taken place. South African equities are similarly volatile and reflect the concerns trade union trustees and their retirement fund members have about potential capital losses.
Investors face a challenging hurdle: cash might be the safest possible option, but it doesn’t keep up with inflation compared to other asset classes over the long term. Sitting in cash only on the one hand will erode your capital, but on the other hand, you could be exposed to potential capital losses in the short term if you’re invested in more risky, volatile asset classes.
So what is the best decision retirement fund members can make?
What can you do to reduce the risk of large capital losses in this environment? Ultimately, there are two ways to withstand volatile markets. The first is by spreading risk across various asset classes through diversification. The second is protecting the investment through the use of “protective overlays” or derivatives.
Diversified asset allocation This involves adding what we term ‘uncorrelated assets’ in a portfolio to reduce the overall risk. Asset correlation is the extent to which investments move in relation to one another during market downturns. In other words, finding a set of investments whose returns fluctuate in opposite directions from each other really helps reduce overall risk. When assets move in the same direction at the same time, they are considered to be highly correlated. When one asset tends to move up when the another goes down, the two assets are considered to be uncorrelated. This concept can be applied to a portfolio of shares, but finding a basket of individual shares with low correlation of returns between them is easier said than done, as equities tend to move in the same direction. A more common strategy is to allocate assets between the different asset classes (equity, bonds, property, cash and offshore assets) since the returns of these asset classes are generally less correlated. This way the investor diversifies a degree of risk away.
The problem with this kind of asset allocation is that during times of financial distress, markets and different asset classes tend to move together (ie, are correlated). This could cause widespread losses across several asset classes, meaning substantial losses no matter where you are invested (except cash of course, but cash does not beat inflation).