Preparing for stock market volatility

It’s become almost impossible to switch on the TV or open a newspaper without some mention of political issues or trade wars. Given the many potential outcomes, it makes good financial sense to understand the impact these uncertain times could have on your money.

Stock and bond markets have been volatile throughout 2018 – particularly since October. There are many reasons why markets have become less stable and it’s wrong to blame volatility on one sole issue. For example, since 2009 we’ve experienced one of the longest stock market bull runs in history. On top of that, there are worries that some major world economies are beginning to slow – not to mention the current US/China trade war.

Financial markets hate uncertainty and there are currently more unknowns than usual. Some of these will hopefully soon be resolved, such as the US/China agreement on trade. But the resolution of these issues doesn’t mean that markets will automatically recover. They could do the opposite depending upon the outcome.

Saving for the future

Most defined contribution pensions are invested in stocks and shares, so you may have seen the value of your pension fund fall over the last few months. If you’re still some way from retirement, don’t be too concerned about these sort of falls in value. Stock markets are volatile in nature but tend to produce the best returns over longer periods (5 to 10+ years).

In fact, if you’re still saving for retirement, a fall in value means your regular contributions will buy more new units each month. That means if stock prices recover, you’ll have more units that will benefit.

No one knows whether stock markets will start to recover or whether they’ll continue to fall. What we do know is that UK stock markets have fallen about 15% from their high point in May 2018. That means shares are currently 15% cheaper than they were just a few months ago.

Buying anything when the price is lower – including shares – is the best time to buy. Rather than seeing stock market falls as a disaster, take the opposite view and see them as an opportunity to buy at a discount.

In or approaching retirement?

If you’re drawing income from a fund rather than investing for the future, actively managing your money during times of market turbulence is vital.

To get the most out of your pension when drawing income directly from the fund (rather than buying an annuity), you ideally need to take investment risk. However, this is a double-edged sword. You need to take the risk to potentially get better returns. But if markets fall, you can’t afford to keep taking income from investments that are falling in value.

Holding cash is a good solution and if you’re a regular reader of Thinking Ahead, you’ll know that we recommend you hold two to three years’ worth of income in cash. Although cash doesn’t historically produce the best returns – holding too much will also create a ‘drag’ on your overall returns – the nominal value of cash doesn’t fall, even if stock and bond markets do.

This means that during turbulent times, you can start drawing income from your cash instead of your invested pension fund. This gives the invested part of your fund time to recover. Keep drawing from cash until your investments recover or your cash runs out.

When your investments are doing well, make sure you replenish your cash so that you have two to three years’ income in reserve again.

Staying on top of your savings

It doesn’t matter whether the cash is held within your pension, an ISA or a normal bank account. Be sure you review your cash savings regularly to make sure you’re getting a decent rate of interest and that interest is received tax-free.

These rules can also be followed by people approaching retirement.

Planning on taking income directly from your pension? Rather than buying a guaranteed lifetime income from an insurance company, you need to actively manage your retirement pot.

In the three to five years running up to your expected retirement date, you should start building up cash within your pension.

  1. You can take one-quarter (25%) of your pension pot as a tax-free lump sum and it makes good financial sense to do so in most circumstances
  2. If you’re planning to spend your tax-free lump sum on other things – such as paying off debt or buying a car – you should aim to build up cash equal to two or three years’ worth of income to draw on if or when investment markets are falling

By thinking about retirement in advance, you can ensure your plans aren’t blown off course by turbulent markets. If you’ve already prepared your pension savings in advance, you won’t have to delay retirement – even if investment markets are depressed. This is because you’ll have two or three years’ worth of income held in cash to draw upon while your other investments recover their value.