How to stress test your investment portfolio

Financial experts say the best way to combat market volatility is to invest for the long term

Now is a good time to stress test your investment portfolio to ensure it is as diversified as possible and reflects your financial goals. Getty Images

Investors have plenty of reasons to feel edgy right now, with stagflation, stock bubbles, potential market crashes, supply chain shortages, oil shocks and climate change all threatening disaster.

Throw in growing US-China tensions, scattered Covid-19 outbreaks and a feeling that the 12-year stock market bull run cannot last for ever, and it is amazing that investors do not sell every asset they own and bolt for the hills.

You could call it post-pandemic stress disorder.

Yet stock markets have held firm. In fact, the S&P 500 has just hit an all-time high by closing above 36,000 for the first time.

The bond market has not crashed – yet. Bitcoin is enjoying another purple patch. Safe-haven gold remains out of favour. Risk is still on.

Yet still the anxiety persists. How worried should we be?

Nobody can accurately predict when the next crisis will happen, so do not believe anybody who claims they can, says Chaddy Kirbaj, vice director at Swissquote Bank.

“That said, there is a consensus that we are living in a bubble, with stock prices and indexes at historical levels, massive amounts of cheap money still available, property prices ballooning in major cities, and abnormal scenarios becoming new economic realities,” Mr Kirbaj says.

As central banks prepare to withdraw Covid-19 stimulus measure and policymakers battle climate change, Mr Kirbaj is in a defensive mood and suggests stress testing your portfolio before the storm strikes.

But resist the temptation to panic. “We don't expect a crisis this year, but the second half of 2022 may be challenging due to record global inflation, high production costs, booming energy prices and potential mistakes in monetary policies or the green energy transformation process,” Mr Kirbaj says.

Uncertainty is rife, says Lorenzo La Posta, senior analyst at Momentum Global Investment Management (MGIM). “Is the current bout of inflation transitory? How will central banks respond? When will disruptions to global trade end? Will labour shortages and raw material supplies return to normal? Is there such a thing as ‘normal’ any more?”

He says the biggest threat right now is stagflation – that nasty blend of rising inflation and slowing economic growth.

That could force central bankers to raise interest rates, slowing the economy further, which would hit stock markets and bonds.

There will still be winners among the losers, Mr La Posta says. “Commodities and mining stocks would benefit from rising prices, while inflation-linked government bonds would also outperform.”

Since nobody can say for sure what will happen next, the best way to protect yourself is to diversify your portfolio across a spread of assets, he says.

“We own commodities and inflation-linked bonds, in case of stagflation. We also hold emerging market equities and bonds, as well as real estate, for a high-growth, high-inflation world. Also government bonds in case of stagnation, and developed market equities for continued strong and steady growth.”

Investors cannot avoid uncertainty, Mr La Posta says, and need to embrace it instead.

US tech companies such as Apple, Amazon, Facebook and Tesla have dominated the past decade, but many investors may now be over exposed to these growth stocks, says Mark Leale, head of Quilter Cheviot’s Dubai office.

He suggests they should rebalance their portfolios in favour of areas that have underperformed, such as value stocks. These are larger, established blue-chip companies that pay regular dividends and are typically found in sectors such as utilities, health care and consumer staples.

Banking stocks may also benefit as inflation and interest rates rise. This allows them to boost net lending margins, which is the difference between what they pay savers and charge borrowers.

So it may be worth taking some of your tech growth and shifting it into value. While you're at it, check your bond fund exposure, because that sector may also struggle, Mr Leale says.

Bonds pay a fixed rate of income, but this is less attractive as interest rates rise and investors can get a better return elsewhere. The subsequent sell-off could hit bond prices. “This is making ownership of bond funds increasingly unattractive. We have seen a few difficult days for bond markets. There could be more,” Mr Leale says.

Like Mr La Posta, Mr Leale also favours commodities, not just as an inflation hedge but also because they will play an increasingly important role in the energy transition. “Materials are needed for the production of green infrastructure, batteries and electric motors,” he says.

Gold is another traditional inflation hedge but recent performance has been poor. Most advisers still recommend holding some as the price tends to hold firm or rise when shares are crashing,, but no more than 5 per cent or 10 per cent of your total portfolio. Cryptocurrencies such as Bitcoin are often touted as an inflation hedge but are prone to wild price swings, so, again, limit your exposure.

The best way to combat volatility is to invest for the long term because inflation will not soar for ever, Mr Leale says. Keeping some cash to hand is also advised. “That will allow you to take advantage of any volatility and purchase assets at a reduced price.”

Your investment decisions should be guided by four basic principles, says Mark Fitzgerald, head of product specialism at Vanguard Europe. “Start with your goals, shape an investment strategy around those goals, keep your costs low and remain disciplined. Whatever happens in the markets, think long term and tune out the noise.”

It is also worth checking whether your portfolio is appropriate for meeting your long-term goals within your risk level, he says. “Check if your plan has changed over time. If not, stick to it. Remember that more return equals more risk, up to a point. If you take on too much risk, you may not receive those higher returns.”

If investing for the long term, you can afford to look past short-term troubles, Mr Fitzgerald says. “Remain patient and stick to your guns.”

If you need to access your funds soon, shift into lower-risk investments to help preserve their capital value. “The longer your time frame, the more risks you should be able to take,” Mr Fitzgerald says.

Investing has always been uncertain but the old mantra “never put all your eggs in one basket” holds true.

Diversification is often called “the only free lunch in investing”, says Chris Davies, a chartered financial planner at The Fry Group. “If part of your portfolio underperforms, other assets will protect you as they react differently.”

Diversification also protects you against the temptation to second-guess the future. “It is difficult to predict which sectors or regions will be the winner each year, so diversification allows you to capture the broad market return, year after year,” Mr Davies says.

You must also understand the long-term risk-and-return profile of the assets you hold, he says. “This can be hard for DIY investors, so seek advice from a financial planner if unsure.”

But it is important not be too negative because winter is traditionally a “sweet spot” for stock markets, says Lee Wild, head of equity strategy at Interactive Investor. “With luck, investors with a well balanced and diversified portfolio should be able to switch off and enjoy the festive period, which often brings a ‘Santa rally’.”

Let’s hope he’s right. We need a break from all this stress.