The recent market collapse of BP PIc shares also highlights the need for investments to be diversified as even blue-chip shares can fail. “Investors need to invest wisely in the good times to avoid huge losses when things go bad. They need to make sure they make investment decisions with which they can live.”

The following guidelines will help ensure investors don’t crash and burn during a financial downturn.

Foster says a portfolio of deep value shares, or defensive shares, is one of the best ways to own equities.

“Those are companies whose earnings are higher than average relative to their share price. You need to invest in companies that have low debt and have a strong market position so they will continue to have customers even in tough times. They are more likely to meet their debts and continue paying dividends which you can live on until the market improves.”

Defensive or deep-value shares need to have the following three characteristics:

1. Low debt-to-equity ratio. As at 30 April 2010, the average debt-to-equity ratio was 32.7% across all Australian listed companies. Cut this in half as a guide to how much debt the companies should have.
2. High levels of free cash flow (FCF). High FCF means a company’s income not only covers all expenses but also all debts and depreciation amounts. The company should also have enough left over to pay dividends and grow their business.
3. An advantage. This might be high barriers of entry to competitors or managerial edge. Whatever it is, it means that the company’s revenue will be the least affected by a downturn.

Don’t be lured by a company with a good name and stick all your money behind that stock, says Foster.

“Keep your investments diversified among different asset classes. Within asset classes, you also need to be diversified. The lessons are obvious. Many UK investors may not have gone past British Petroleum, with its profitable history and huge cash reserves. Well, even a company such as BP can have a disaster and lose much of its value in a short period of time.”

“If your investments are doing better than you expected, take some profits and put them into cash,” says Foster. “If you already have more cash than your need for the five years, or if investment markets fall, then consider reinvesting that cash in other shares.”

If you really don’t understand what could happen next in financial markets and no one else seems to have much idea either, then cash might be a good option, says Foster. “You should only have in growth assets like shares or property what you can afford to lose half of. Everybody should have some part of their portfolio invested in cash so they can ride out a market downturn if it happens”

But Foster warns investors against selling out when the market is falling. “If you are thinking of going into cash, it should be when the market is overpriced and not when the market is falling.”

“Some people will tell you that an index share fund is the best protection because of the diversity, as you effectively hold the whole market. However this means you own the worst half of companies, the ones most likely to go broke if times get really tough.

“But you should focus on deep value shares or defensive shares which can ride out most markets. These companies can continue to make a profit even in the toughest times and, as a consequence, can also manage their debt obligations. Shares in this type of company are usually the first to bounce back in price after a large share market price plunge.”

Global economic instability means that understanding currency and hedging is going to become more and more important for investors, according to Foster.

“Currency is the dog that wags the tail and at the end of that wagging tail are the share and property markets. Hedging can allow you to profit when share markets fall but if you don’ have the time or inclination to become adept in these areas (and it isn’t a hobby) then you must find someone who can manage this for you.”

For most investors, cash and fixed interest returns won’t be enough to allow them to accumulate enough to help them grow wealth for retirement. “You need to hold some of your investments in growth assets, which over time will give you a return greater than inflation,” says Foster.

The allocation to growth assets such as shares and property is client specific. “Investors must ask themselves what level of volatility they can stand before wanting to sell everything to cash. Most people can stand a 20% or greater reduction in their portfolio value if they have an adviser who can talk them through the bad times and coaches them to hold on to good quality assets.”

“However, it is client specific and the allocation to growth assets will depend on an investor’s risk level and age, with the allocation to fixed income and cash rising with age.”

Addwealth is a financial planning and funds management company based in Western Australia. Addwealth offers its international client base investments, insurance, tax management, property development, cash management, superannuation and estate planning. It’s advisers and support teams have significant expertise and experience in managing the tax and investment affairs for those who have achieved financial independence or are determined to do so. Addwealth’s visions is “to be the world’s best at creating and delivering financial services with honesty, integrity and inspiration – ALWAYS.”

Addwealth is a Corporate Authorised Representative of Choice Future Planning Pty Ltd, an Australian Financial Services Licensee.

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