An insistent drumbeat of increasing intensity

Friday, 25th August 2017 16:05 - by Eric Chalker

A serious investor cannot ignore the seemingly inexorable drumbeat of reasons to be concerned about the increasing riskiness of current share prices.   Some will say carry on regardless, because share prices have further to go.  That may be so, but if, as others think, we’re dangerously close to a significant setback, if not a major collapse, what to do about it?

First, what are the reasons to worry?

Does it matter?  There can be no single answer to this question, not least because personal circumstances differ.  As many have written, those who are investing for the long term – say ten years or more – should perhaps ignore any downturn, even a major one, because share prices recover.  So they do, but it does rather depend on which companies one is invested in and how well diversified one is.

There is a saying, “Time in the market beats timing the market.”  It can be Googled and many advocates will be found (although some of a commercial nature).  The trouble is, the examples given are usually an index, which may be fine for those who invest only in investment trusts, unit trusts and ETFs which follow or replicate an index, but it doesn’t help those of us who choose the companies in which to invest.  I am writing in the week that Provident Financial has crashed; while that was self-inflicted and not the consequence of an overall market drop, it does highlight the ever-present risk of losing value, sometimes permanently.

The only way to guard against this week’s crash, as with Carillion which I wrote about on 13th September 2017, was diversification.  That won’t work, though, when facing the possibility of a general stockmarket crash.  Some advocate diversification into other assets – advice which I respect, but have only limited experience of doing, except for diversification into cash.

Diversify into cash

Diversification into cash means selling one’s shares.  I have learned this is something many private investors find difficult to do.  My experience tells me, though, that it is an essential tool for achieving the best out of any portfolio, whether run for dividend income (see “A rewarding strategy” 31st Aug 2016) or for capital gain and growth.  To assist a novice investor, I once likened portfolio management to maintaining a garden: left to its own devices, a well-planted garden will give pleasure even if it is untended, but as time goes by, if left unweeded and decaying plants are not replaced, the pleasure will be less.  So it is with company shares.

So even in the best of times, consideration should be given to selling shares that have passed their prime, or whose value has slipped and seems unlikely to recover within an acceptable period, or perhaps not at all.  This happens and it is naïve to think otherwise.  Money should be made to work, so why hold onto shares that are neither producing a satisfactory dividend nor growing in value?  Would one buy this share at this price and at this time?  The PE ratio may show a company is highly regarded, but that won’t prevent investors losing interest and buyers dropping away, thus causing the price to drop too.

When it seems that we may be approaching anything but the best of times, these considerations become more general.  Tougher tests should be applied to see if a company is overvalued and, if it is, its shares will probably be available at a much cheaper price in due course.  Can shares under water realistically be expected to recover any time soon?  When markets fall heavily, it is better to have cash available to seize the opportunities that eventually present themselves, than feel wholly impotent as a buttoned-up portfolio sinks further in value.

Disciplining oneself to sell

By nature, I am a contrarian, so I find it relatively easy to sell shares which seem at their zenith and to buy shares that nobody else wants.  Of course I don’t do this blindly (well, at least I try not to), but it does take a certain self-discipline, especially when selling.  Such discipline becomes more necessary if one fears a widespread loss of value, such as I do now.  Then at least look for shares which have plateaued, whether at a gain or loss in the portfolio, to ask why keep the value there instead of in cash?  Some will take more dramatic action, but most private investors – including me – will want to keep shares that are delivering good and reliable dividend yields and those which seem unlikely to be much affected by a general market fall (such as currently undervalued shares).

Selling shares at a time like this is principally a defensive measure.  This protects the downside, but if too much cash is taken out it leaves the investor too exposed to the upside risk – that the market continues rising, which it may do and for some time yet.  But the latter risk is of not making money, whereas the risk of not acting is that of losing money.  Cash can always be reinvested and there will be opportunities to do so.