How to manage your wealth through the market cycle

Tim Bennett, a partner at broker Killik & Co, explains that while equity markets will deliver the best long-term returns, investors need a strategy for shorter-term cash-flow.

One of the biggest issues for long-term savers is understanding and managing market cycles so that they can preserve and grow their lifetime savings. The specific challenge is how to successfully juggle two opposing forces: the desire for safety and the need to earn inflation-beating returns.

Cash - not as safe as it seems

Most people’s natural and understandable instinct is not to lose money, which tends to drive them towards the safety of cash. But while cash certainly has its place in an overall investment strategy, its biggest drawback is that inflation erodes capital such that your purchasing power – your ability to pay for the things you want – is reduced.

So, while cash might appear to be a safe option, and in the short term certainly has its place, longer-term it isn’t ever likely to offer a good way to build and preserve wealth.

It’s true that inflation has been relatively subdued for a while (remaining at a three-year high in March of just 2.3 per cent), but even at these low levels someone sitting in cash, earning perhaps 1 per cent, is still losing money in real terms.

And remember that inflation has a habit of kicking up quite quickly and usually faster than interest rates (at the end of the 1970s it peaked at well over 20 per cent). Should it start to rise again in the future, those stuck in the ‘safe haven’ of cash could see their purchasing power shrink even more quickly.

Shares – volatile but not necessarily risky

So where can the investor turn for inflation-beating returns? Whilst the past can never be guaranteed to repeat itself, over the past half-century, shares have demonstrated their worth.

According to the Barclays Equity Gilt Study, a basket of UK equities could have returned an annual average post-inflation return of over 5 per cent, making the stock market one of the best and arguably lowest-risk places to put long-term capital to work. However, over the short term, stock market investing isn’t always plain sailing, thanks to volatility.

Whilst a broad index of UK stocks, such as the FTSE All-Share, has tended to rise over long time horizons, big bouts of short-term volatility – sometimes involving drops of 50 per cent or more – have been seen over the past few decades. And although volatility is low now and has been for some time, it could return anytime. The important thing is to be properly prepared.

Understanding market cycles

Recent UK stock market history reveals that peak-to-peak stock market cycles have tended to last between five and seven years. This is important: as a long-term equity investor you have to be ready to manage these dips.

This means avoiding panic-selling, and planning your future cash requirements in such a way that you never have to liquidate shares at just the wrong time to meet a short-term call on capital.

An active approach to asset allocation

To help you to make the long-term investment commitment that is needed to manage and ride out stock market cycles, you should consider a three-pronged approach. First, set up a ‘rainy day fund’. Ideally, this should be three to six month’s salary kept in cash (or something close to cash) to cover an emergency - be that a leaky roof, short-term illness, or redundancy.

Next, identify and quantify big future foreseeable calls on capital and when they will crystallise – for example, a property deposit or the cost of a wedding. Start to move funds into cash (or short duration bonds) to cover these foreseeable calls on capital, particularly once they fall within the next five to seven years.

The bulk of your remaining funds, i.e. those that will not be required within that sort of timeframe, will usually be better off invested in the equity market as, for example, you build the level of lifetime savings that many of us will need to pay for retirement.

Simple though this approach may sound, never take your eye off the ball - you should continuously monitor the timing and size of future calls on capital, especially as they move into the five- to seven-year range, whilst making informed judgements about the level of the stock market. That’s the key to not being blown off course by its inevitable gyrations.


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