By TERRY UPTON*
The world is in disarray. We face terrorists, war and the possibility of mass destruction. Investors have been thrown into a panic the past three years as world sharemarkets experience the worst downturn in 60 years.
How should the average investor react?
You could listen to the prophets of doom and join the panic, sell "risky" investments, accept the loss and take comfort in a term deposit.
The other option is to recognise that life as most of us know it is likely to go on, so it is important to look at investment strategies from a long-term perspective.
Some investment advisers have begun to cave in to demand from clients to make the big, bad, scary sharemarket go away and replace it with "safe", low-risk investments. These people are telling the public that the world has fundamentally changed and the old principles of investing no longer apply.
This is profoundly poor advice, given that the economic and political environment is not so radically different from past crises (World Wars I and II, or the Cuban missile crisis, for example).
What investors need to hear is that there has always been uncertainty, and it has often led to significant sharemarket downturns. However, markets as a whole have never gone down and stayed down. This downturn is no exception.
The present downturn has been unusually long, the worst since World War II. Ordinarily market falls do not last this long. Markets may remain depressed, but they could also rebound rapidly - especially if there is a quick resolution in Iraq.
This is why professionals recommend diversification across different types of assets and countries. The performance of international stocks has suffered for three years, but those with some of their money in cash, fixed interest, property and New Zealand have had their losses trimmed.
As I write I am looking at performance results for some ANZ managed funds, to the end of December.
The results look like this:
* International shares: minus 37.40 per cent for the past year; minus 17.80 per cent a year for the past three years.
* World Shares fund (20 per cent New Zealand shares): one year, minus 25.92 per cent; three years, minus 14.12 per cent a year.
* Balanced Growth fund: one year, minus 7.52 per cent; three years, minus 2.10 per cent a year.
The last one - with 8 per cent of its money in cash, 34 per cent in bonds, 8 per cent in property, 15 per cent in New Zealand shares and just 35 per cent in international shares - didn't do all that horribly.
ANZ's Balanced Retirement Fund did even better: minus 3.03 per cent for the year and plus 0.68 per cent for three years.
We have experienced many downturns over the past 200 years, but each has been only temporary, and smart investors see the dips for what they truly are - great buying opportunities.
Rather than exiting the market, those with fresh money available would be wise to introduce more. Putting my own money where my mouth is, I recently added a significant sum to my share accounts.
I have worked in the financial markets for 26 years, in the US and New Zealand. Experience has taught me one important thing - you do not alter the way you invest just because market conditions change.
Market conditions change all the time.
No one is genius or lucky enough to see such changes coming consistently. The fundamentals always apply when investing.
Now is a good time to review them.
First, investment objectives must be established along with realistic times to reach specific goals such as buying a house or providing retirement income.
Such issues are emotional for most investors, but it is important to work through them rationally.
It is also important to determine an investor's ability to tolerate market volatility (temporary market declines) and market risk (permanent capital loss).
If an investor's portfolio does not reflect their tolerance to volatility or risk, they may either experience lower returns than required to meet their objectives, or unbearably high stress levels in an attempt to create high levels of return.
Most people find it very difficult to determine their own volatility or risk tolerance, so professional guidance is usually needed.
Never lose sight of the twin evils, tax and inflation. Bank deposits may look safe, but it would be a big mistake to put all your investments in them.
Investors need exposure to growth assets such as property and shares to produce long-term returns that will outpace tax and inflation, and maintain purchasing power. Cash and fixed interest (term deposits, bonds and mortgages) generally lack the power to do so.
Next, the funds to be invested should be divided up, generally among the four major asset classes: cash, fixed interest, property and shares. This asset allocation is very individualistic and should match a person's investment goals and their risk/volatility tolerance.
Many financial professionals believe asset allocation is the single most important ingredient to successful investing.
In selecting specific investments, it is important to diversify, to reduce the impact if one investment performs poorly.
An investor looking to reduce risk through diversification would not put all their money in one bond issue, one company or even in one country.
This is particularly important for Kiwi investors, as New Zealand accounts for less than 0.02 per cent of the world's sharemarkets.
When using managed funds, another form of diversification is to use at least three or four managers so the effect of one underperforming is significantly diminished.
Another aspect of diversification involves marrying different investment styles. Most investors don't know it, but there are several distinct approaches to investing, especially in the sharemarket. Two of the more prominent styles are value and growth.
Value managers look for bargain-priced companies which they believe are undervalued by the market, while growth managers try to identify companies which are growing faster than their industry.
Over time, growth and value generally achieve similar results. Often, when one style is performing well, the other is not. By blending styles, investors can reduce risk and smooth overall performance.
An extremely important investment fundamental to keep in mind, particularly during market downturns, is time. Shares, property and even bonds will inevitably experience slumps. Given time, however, these asset classes have always rewarded investors prepared to ride out short-term downturns.
More importantly, these investments give investors a much better chance of beating tax and inflation than traditional bank deposits.
No discussion of investment fundamentals would be complete without mentioning the importance of putting money away as early in life as possible and doing so regularly.
Professionals call this "dollar cost averaging", which is just a fancy name for regular investing. The investor automatically puts in a fixed amount at regular intervals, such as $100 a fortnight. This is a powerful, disciplined method of accumulating wealth. It is also a great way to take market timing out of play, because you invest continuously regardless of the markets' ups and downs.
It has often been said that one of the most important keys to successful investing is time in the market, not trying to time the markets. Try to beat the market and you virtually assure you will end up losing.
Smart investing isn't about taking chances or chasing hunches. Smart investing is about identifying goals, analysing risk and volatility tolerance, diversification, giving assets time to perform, contributing regularly, starting as early as possible and sticking with the plan - not letting emotions rule.
If you experience a downturn, even one as nasty as this one, the value of your investment is only down on paper. When the markets recover, as they inevitably will, you will participate in the recovery.
However, if you cash up while the market is low, you will have lost real money. It's not easy to ride out a long downturn, but it is the smart thing to do.
It is a good idea to occasionally revisit issues such as risk tolerance (it changes), financial goals and asset allocation.
But, if the allocation was set accurately in the first place, I wouldn't monkey with it in the present environment - unless it was to increase exposure to shares.
I would definitely not recommend selling shares and moving to fixed interest unless a person simply refuses to stay the course.
Remember, the market can move up at any time and the only way to share in such gains is to remain invested.
What I urge people to do if their present portfolio is too aggressive for their taste is to wait for the markets to recover and then make adjustments.
However, if someone is determined to sell shares all you can do is find some alternatives, make a note in the customer file and shake your head. It's a bad move.
* Terry Upton is an Auckland investment adviser. Email firstname.lastname@example.org
By TERRY UPTON*