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How investors can deal with stock market dips

Paloma Kubiak
Written By:
Paloma Kubiak

Last week’s global market sell-off was a clear reminder of the volatility investors may experience. But how should you react to these dips?

Stock markets fall every year but most years they bounce back to deliver positive returns for the year as a whole.

Selling on the dips is therefore not normally a sensible investment strategy. But very occasionally, what starts off as a dip turns into a much more significant sell-off. These bigger declines (greater than a 20% fall in equities) are nearly always caused by the market realising that one of the world’s major economies will have a recession within the next year.

If we could predict precisely when the next recession will happen we would generally know whether or not to add to equities on small market dips.

With the unemployment rate in the UK and US at the lowest levels in over 40 years, history suggests that the probability of a downturn, sometime in the next few years is rising. But even professional economists are notoriously bad at predicting precisely when recessions will happen.

So how should investors react to stock market dips as this economic expansion ages?

Investors should accept that they won’t be able to time the top or bottom for equity markets. The key is to build in some resilience to portfolios so that you’re comfortable with the level of risk both if the market falls or rises sharply.

A well-diversified and balanced portfolio can help investors avoid panicking if one part of the portfolio falls, which can prevent selling out at the bottom.

What are some of the options available to investors looking to balance equity exposure in a portfolio?

First, an investor could consider absolute return global fixed income funds with a focus on protecting on the downside rather than those that always own the riskiest types of corporate debt or the riskiest government bonds.

Second, absolute return alternative funds – with the ability to reduce their exposure to equity market moves to zero when they are concerned about the outlook – may be of interest. These include some but not all macro funds and equity long-short funds.

Finally, if there are parts of a portfolio where investors aren’t willing to take any risk at all, other than the risk of inflation, holding some cash or liquidity funds to balance out riskier investments could also be considered.

Ultimately, having a well-diversified portfolio is particularly important as the expansion ages.

Mike Bell is global market strategist at JPMorgan Asset Management