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Market volatility: the value of a diverse trading strategy

10:18, 23 March 2022

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Investors benefit from diversification in a volatile stock market – Photo: Alamy

The phrase ‘don’t put all your eggs in one basket’ might sound a bit clichéd, but in the world of investment it certainly rings true.

For stock market investors, the sensible approach is to diversify.

A broad-based range of investments, which don’t all react the same way to market events, will put you in a good position to handle any volatility.

Diversifying reduces risk

How do you de-risk in times of market volatility and uncertainty?

The important thing is to react rationally rather than emotionally. By sticking to a longer-term investment perspective that accepts short-term volatility, you are ensuring a more dispassionate view.

Panic selling often only locks in losses and does not really solve the problem. It is even conceivable that there is an opportunity to exploit lower prices if a stock or sector has been over-sold.

Right now, global emerging market equities have taken a massive hit – in no small part due to the conflict in Ukraine and associated sanctions against Russia

Investors who are uncomfortable with risk may decide to sell or at least ensure that future investments are in areas unaffected by the geopolitical turmoil in Europe.

Reacting rationally means seeing the bigger picture and not just lumping all options within a ‘emerging markets’ no-go zone.

Tom McGrath, fund manager of the 8AM Growth Fund, which currently has around 3% exposure to Global Emerging Markets, warns against an impulsive exit from GEM.

“Clearly any portfolios with Russian exposure have been absolutely hammered this year and many global emerging market funds have suffered accordingly. The sell-off in Chinese equities, especially technology companies, has also dragged down many emerging markets funds, but the sector as a whole hasn’t fallen any more than the European Equity sector so I think it is a bit premature to right off the whole massive geographical sector.”

As McGrath points out: “Some emerging markets, especially the commodity rich nations, will actually do quite well from the scarcity the war will create. Unnoticed Brazil is up 25% this year for instance!”

Risks of single stock exposure

Given this perspective, emerging market exposure might not be a bad thing right now but if your exposure is to just one or two stocks and one of them is Russian majority-owned oil and natural gas producer Gazprom – then you are not in a strong position. It is a bit like playing roulette and putting all your chips on Black 29.

The great thing about diversification is that it typically lowers the overall risk of your portfolio, without necessarily reducing the expected returns.

How is that possible? Investors face two types of risk: systematic and specific. Systematic risks affect the whole market. Examples are movements in interest rates, changes in inflation and political instability. Specific risks, on the other hand, affect individual companies, sectors or industries.

There’s not a lot you can do to avoid the broader systematic risks, though being aware of the economic environment helps – for instance inflation forecasts, defined interest rate policies.

But you can reduce specific risks through diversification. When you hold a wide range of investments, specific risks tend to cancel each other out as losses in one part of your portfolio are usually offset by gains in another.

For example, your investments in the mining sector could drop sharply in value but, at the same time, the technology sector (where you are also invested) may be enjoying a period of outstanding performance.

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Similarly, if global stock markets slump, you may see your bond investments improve.

Avoiding the hype

Going back to the eggs analogy, putting them all in one basket is high risk. But it is also easily done. Media coverage of investment opportunities from gold and tech stocks to alternative assets – often result in a stampede. The danger is that as an investor you put all your faith into one hot theme and when things turn sour, there is no comeback.

There is nothing wrong with the themes themselves – it is just ensuring there is a balance and ignoring any media hype.

In theory, there’s nothing stopping any particular sector from becoming overvalued. Throughout history there have been bubbles in tulips, shipping, railway companies, cotton, Japanese equity, tech stocks and real estate – the list goes on.

All sectors are capable of hype but where you have a new asset class, there is more susceptibility. There is far less historical data at hand to sufficiently weigh up the risks.

The tech boom of the late ‘90s and early noughties are a prime example. A vast number of dot-coms with no track record of earnings had hugely inflated valuations based on ‘potential’ of stellar profits in a ‘new age’.

Diversification isn’t a guarantee that you won’t make losses; but it is smart investing and helps to increase your wealth steadily while reducing potential risks.

Importance of stock research

Easy-to-access, online trading platforms allow retail investors to trade quickly – but there is always a danger that they follow a trend, conducting little or no background research on the stocks they are buying.

The fact is that technology allows the investor to access a huge amount of information, analysis, charts etc. – it makes sense to use them and not just follow the herd.

While impulsive stock buying might mean you overweight a sector (for instance biotech) – impulsive selling might mean you exit an area of the market that has long-term potential but has just had a temporary correction.

Choosing a suitable and diversified asset allocation model at the outset to meet future financial goals makes good sense as it gives you a framework. Ignoring the noise (for instance on message boards) enables you to make a measured decision, for instance staying invested when markets are volatile (rather than crystallising an inevitable loss); or calmly appraising whether you should be tempted to invest in the ‘next big thing’.

If you are concerned about stock price falls you could place a stop-loss order say, 10% below the purchase price. This could provide a degree of protection as the sale would be automatic once this price is hit.

How to diversify your investments

  • Buy shares in several companies instead of just one. You can diversify further by buying stocks in companies across different industries.
  • Invest in different countries. For instance, buying German, US, Japanese and UK equities and bonds will reduce the overall impact of changing economic conditions in one or more countries.
  • Regularly reappraise your stock portfolio to ensure it remains diversified and is not over exposed to one company or sector. Also check the weighting of large, mid, small and micro cap stocks in your portfolio.
  • If you’re buying on recent performance, take the time to understand what has caused this and whether it is sustainable.
  • Ensure you’re comfortable with the risks involved. Chasing high rewards usually involves taking high risks.
  • Check the investment’s potential liquidity. Can you get out in a hurry if need be?
  • Don’t bet your shirt, only invest a modest part of your overall portfolio so a loss won’t wipe you out
  • Is the investment regulated by the Financial Conduct Authority (FCA)? Unregulated investments offer little or no protection should things go wrong due to fraud or suspicious activity.
  • Put your money in a range of different stocks or asset classes that don’t move in tandem with one another, for instance global equities, exchange traded funds (ETFs), bonds, cash and property. 
  • Don't duplicate investments. You may own individual tech stocks which may (unbeknown to you) be part of a collective equity fund you are invested in. If a stock falls in value, there is a double whammy.
  • Collective funds by their nature provide an element of diversity. If you do not have the capital to spread investments suitably via your own hand-picked portfolio, then a professionally managed portfolio with a broader spread of holdings might be a sensible and more cost-effective choice.

 

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The difference between trading assets and CFDs
The main difference between CFD trading and trading assets, such as commodities and stocks, is that you don’t own the underlying asset when you trade on a CFD.
You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional trading you enter a contract to exchange the legal ownership of the individual shares or the commodities for money, and you own this until you sell it again.
CFDs are leveraged products, which means that you only need to deposit a percentage of the full value of the CFD trade in order to open a position. But with traditional trading, you buy the assets for the full amount. In the UK, there is no stamp duty on CFD trading, but there is when you buy stocks, for example.
CFDs attract overnight costs to hold the trades (unless you use 1-1 leverage), which makes them more suited to short-term trading opportunities. Stocks and commodities are more normally bought and held for longer. You might also pay a broker commission or fees when buying and selling assets direct and you’d need somewhere to store them safely.
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