Worried about a correction?

Earlier this week I was taking questions on the markets alongside the publication of my quarterly investment outlook. We kicked off with a deceptively simple one. It asked whether, given the increasing likelihood of a sharp correction in markets, it made sense to sell up into cash.

The question was made more interesting by the questioner’s age. He was 89. And he rightly pointed out that, even if the market were to recover as thus far it always has done in due course, time was not exactly on his side. My first thought was that someone this engaged with his investments, taking the time to check into my webcast, wasn’t done just yet. But I then turned to his implied question: if you are worried about a correction, what should you do about it?

Of course, there’s an equally important question before you even get there, which is whether a correction really is round the corner. The short answer to that is that neither I nor anyone else knows. But the odds are clearly shorter than they were. The list of things to worry about has got considerably longer since the spring - inflation, broken supply chains, rising energy costs, an imminent turn in the interest rate cycle, highish valuations, stretched profit margins, slowing earnings growth. I could go on.

Even if it is not imminent, a correction will happen at some point. If you look at the performance of the S&P 500 in the three years following each of the major bear market bottoms over the past 60 years, there has been a pull-back of at least 10% at least once. We are now a year and half on from the Covid bottom and we are yet to experience that double-digit decline. Given the 5% or so retreat in September, it is not unreasonable to wonder whether the inevitable correction is underway.

So, it’s going to happen at some point. What about my questioner’s nagging doubt about the market’s time to full recovery? I know why he is concerned. Whenever you read supposedly reassuring stats on this subject, the timescales are always depressingly long. I found one just now that promised me that holding shares for at least 20 years would have delivered a return of less than 5% a year only twice in the past 100 years. In 40 of those years the average annual return over a 20-year holding period would have been 10% or higher. That really is reassuring if you are 29 but less so if you are 59 let alone 89.

For most of us, without a lifetime of investing still stretching ahead of us, there is merit in Warren Buffett’s ‘rule number one’: don’t lose money. The question then arises, how to do it? Should we, as suggested by my octogenarian correspondent just run up the white flag and head into the safety of cash? Or is there a less extreme approach to protecting ourselves from the discontented market winter ahead? Here are four suggestions.

First, do raise your cash holdings a tad. You will be in good company. There is not a fund manager I speak to today who is not turning a bit more defensive to the extent that their investment mandates allow. Remember, you don’t have the same constraints. You can have as much cash as you like and when that correction does come you will be glad you have it to hand. But remember too that the cash you do hold is guaranteed to lose money in real, inflation-adjusted terms right now. And remember too that cash is only useful if you put it to work at some point. So, take the opportunity now, while your mind remains calm, to set yourself a target level at which you will get back into the market - however queasy it makes you feel. Do it now, because you won’t feel like it when the market has fallen 15%.

Second, take a look at your current portfolio. Make sure that the recent winners have not grown too big. If you have benefited from the extraordinary rise in technology stocks, consider taking some of the gains off the table. If you have a record of how much these stocks were worth in your portfolio a year ago, perhaps sell down to that level and redirect the proceeds into less frothy investments. The same is true of geographical markets. Is the US now a materially bigger proportion of your overall portfolio than it was? Japan is oversold, has a revitalised vaccine program and a new prime minister. Some of your American holdings might do better across the Pacific over the next year or so.

Third, make sure you are sensibly diversified. Why sensibly? Because the traditional way of doing this - via bonds - may no longer work so well. If inflation and interest rates rise, US Treasuries, gilts and corporate bonds may move in the same direction as a correcting stock market. Gold, real estate, some commodities and infrastructure may hold up a lot better. Within the stock market look for stocks that don’t behave like bonds. Those high-flying tech stocks thrive in a low interest rate environment but high dividend paying value shares might do better if yields start to rise.

Finally, fix the roof while the sun is still shining. If you are investing with borrowed money, don’t. If you are sitting on stock market gains but also have a big mortgage, consider using your highly valued investments to pay down your still cheap borrowings. They may not stay that way for long.

And, if you are 89, go and treat yourself. You’ve earned it. And thanks for your question.

Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63.