Monday, 18 July 2016

Are you harming your portfolio by ‘buying the dips’?

Over the last year high looking valuations have led investors to pile into low-quality investments.
Piling into low-quality cyclical stocks just because a market correction has brought them down to more attractive valuations is one of the biggest mistakes investors can make in the current environment. The resources and energy sectors are prime examples of where investors need to be careful, as the bounce in these areas over recent weeks could be the result of overconfidence as economic data stabilises.

The growth versus value argument is often at the forefront of investors’ minds and recently, given that the FTSE World Growth index has continuously outperformed the FTSE World Value index over one, three, five, 10 years. While some investors believe this could continue, many others believe in the ‘mean reversion’ theory, which means it is only a matter of time before the scales rebalance and value starts to outperform.

Many investors are simply looking at a cheap valuation but perhaps haven’t analysed whether they’re buying good long-term value or whether they’re cheap for a very good reason. Although the concept of ‘buying the dips’ is often used as an investment thesis, I often caution against placing too much emphasis on this when building a portfolio. Instead, investors should hold a combination of value and momentum stocks in order to spread risk and maximise long-term returns in their portfolios.

Instead of buying based on market valuations relative to historical pricing, investors are better advised to establish an asset allocation strategy at outset which suits their long-term investing goals and then rebalance back to this position at set intervals, regarding of what the market is doing at that time. This removes the emotion and psychology from investment decisions.

Another danger related to impulse-buying deep value plays is that investors can find themselves enticed by the high yields they have on offer. For instance, more than 10 per cent of the FTSE 100 index – which is of course heavily weighted in mining and oil & gas stocks – is yielding upwards of 6 per cent.

However, yields increase if the value of the underlying holding falls as well as if the dividend payments simply rise. To avoid this risk investors need to keep thinking back to a stock’s cash flow and whether it’s sufficient to pay the dividend that is on offer. Perhaps the market should be sending a message to you as an investor that obviously if a dividend yield is high, it’s high for a reason because the return you’re getting is above-normal in terms of the dividend yield and so consequently you’re being paid because the risk is higher.

We believe the market areas that will continue to do well over the medium term are technology companies, telecom businesses and consumer stocks that are producing products people will want or need over a longer term time scale.

Too many investors place too much emphasis on short-term performance, whether it’s buying shares or funds because they are already delivering or strong performance or targeting those that are in doldrums but are cheaply-valued.

By adopting either of these approaches, investors are in danger of taking too much risk. They could buy shares or funds just as they peak or invest in areas which could be depressed for some time to come.

The reality is that nobody can consistently call short-term market movements. The best approach is therefore to take a long term perspective, try not to be too clever and try not to be overly influenced by short-term performance.

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