When volatility knocks

Have financial markets learned to expect the unexpected? The sanguine reaction of the UK stock market to Theresa May’s surprise loss of a working Parliamentary majority seems peculiar, particularly given the potential for the Brexit process, now just days away, to slide into chaos without a strong government handling negotiations. But as the UK election result was only the latest in a series of political shocks, maybe investors have just learned to shrug their shoulders.

In fact, the becalmed nature of the UK market reflects a similar picture in developed markets all around the world, where volatility has been extraordinarily low in recent times. That’s extraordinarily low by historical standards, by the way – let alone in the context of the ostensibly difficult market environment, where there is potential for shock ranging from the Trump effect in the US to runaway debt in China.

There are two ways to look at this lack of volatility. One option is simply to enjoy the calm while it lasts, as markets continue to perform strongly. The alternative is to be more fearful – to worry that too little volatility is as concerning as too much, particularly if other investors appear to be complacent about the risks that lie ahead.

The second mindset is more rational. The idea of calm before the storm may be clichéd, but it’s not unreasonable to fear that when market setbacks do come, they will be all the more serious given the preceding period of denial.

In which case, how should advisers and investors be preparing for the worst, short of moving into cash and risking missing out on further gains?

It was certainly interesting to see a Financial Times article this week on post-election planning in which a series of experts tipped the investment companies sector as a good option for investors worried about what lies ahead.

In particular, these experts suggested well-diversified global and flexible funds that offer exposure to stock markets all around the world, different investment styles and non-stock market assets too, including fixed-income holdings and property. Some of these funds take a more defensive view than others – advisers and investors will need to cut their cloth according to their own attitude to risk and financial objectives – but it’s the diversification that is crucial right now.

Investment companies offer another advantage to those concerned about potential volatility to come. The low-cost regular savings schemes most funds offer provide an opportunity to drip-feed money into the markets – and therefore to benefit from pound-cost averaging. This statistical quirk, to remind you, smooths out volatility because investors’ fixed monthly contributions buy more shares during periods when markets are falling.

Bear in mind too that the closed-ended structure of investment companies comes into its own during periods of market stress, particularly in more specialist asset classes or sectors, where liquidity can be a problem. While shares in closed-ended funds may fall to a wide discount to the value of the underlying assets during such times, the managers aren’t forced to make disposals to fund redemptions, however many investors may head for the exit.

Closed-ended funds, in other words, may be your best option right now. It’s almost impossible to predict when volatility might rear its head once again, but anyone who thinks it’s gone for good is in for an unpleasant surprise. Now is the time to prepare for what lies ahead.