How to prepare for the next stock market crash

Given that the future cannot be predicted, the next best strategy for a pension scheme is to be prepared for what might lie ahead.

Bring it back to basics

A value-led investment approach can help to maintain long-term discipline. It ensures that you buy assets when they are cheap, relative to their fundamental value, so that you do not overpay for an investment, and that you get sufficiently compensated for the risk you are taking.

Building in a sizeable value buffer that can act as a ‘shock absorber’ to protect and preserve capital in adverse scenarios can help mitigate the impact of a market crash on portfolio valuations.

It might also be prudent to reduce risk when valuations are high in order to preserve capital, rather than chase less compelling opportunities.

Investors would be better served to focus on fundamentals as drivers of long-term stock market returns

The textbook assumption is that prices respond to news. Even in an efficient market, price responses to news can be exaggerated or muted by the distribution of investor beliefs and the nature of competing models of how the world works. Investors would be better served to focus on fundamentals as drivers of long-term stock market returns.

Take advantage of volatility to generate returns

Volatility is a normal part of investing, but giving up return in order to achieve lower volatility can hamper your ability to generate sufficient risk-adjusted returns required over the long term.

There are many investment strategies designed for schemes looking to reduce their risk exposure. These include low-volatility and total return strategies, which can help insulate during times of crises and market downturns.

Diversified growth funds aim to deliver stable returns to investors across all market conditions. However, macroeconomic and market developments in 2016 meant that it was a testing time for many of these strategies, as not all approaches were equally effective, resulting in the most divergent DGF returns since 2008.

This divergence in returns highlights the need for a dynamic investment process that can deliver pension scheme objectives in all environments.

While it is important to be adequately protected against market volatility, schemes also need to be nimble and able to take advantage of falling prices.

The benefits of a flexible mandate

Relationships between assets change over time, and correlations can spike in periods of stress, so investors might need to revise their assumptions to take advantage of new opportunities.

In volatile markets, liquidity can rapidly dry up, as we have seen in the past, so having a certain degree of flexibility that an unconstrained approach offers can be beneficial.

Giving your managers a flexible investment mandate can allow them to dial up and dial down asset class exposures; and the ability to build up cash or liquid asset reserves can give them the capital to put to work when prices fall and opportunities arise.

Timing markets with precision is challenging

Stock market crashes — as the name would suggest — can come with speed, depth and breadth.

Even if you could predict a crash with perfect foresight and take profits in advance, you would also be faced with the question of when to reinvest.

Should you wait until market volatility has started to subside? If so, how quickly will this happen? Again, this is almost impossible to forecast. Sitting out of markets for too long can be just as detrimental to returns as the destruction of value a crash can cause.

Building flexibility into a mandate and adopting a value-orientated investment approach allows managers to accommodate rapidly changing market conditions.

Ominder Dhillon is global head of institutional distribution at M&G Investments