Australian investors were given a rude wake-up call on Monday when $24 billion was suddenly wiped from the ASX, punishing the portfolios of most unsuspecting investors.
The fact is, most investors simply are not prepared for volatility. For years, they've watched as the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has climbed to fresh heights, delivering enormous returns to investors through widely-held companies such as Commonwealth Bank of Australia (ASX: CBA) and Telstra Corporation Ltd (ASX: TLS). Unfortunately, it seems as though those enormous returns have become something of an expectation, and that could prove dangerous in the near future.
You see, most of the world is experiencing subdued levels of growth. Europe is still struggling to gain traction while countries like Russia are on the verge of recession; Chinese growth is diminishing at a rapid clip and central banks around the world are engaged in a currency war where interest rates are being cut left, right and centre. Locally, we're battling the commodities crisis, a high unemployment rate and lacklustre corporate spending.
At the same time however, the world's largest economy is set to throw a real spanner in the works. The United States is recovering, fast. Recent US jobs figures were stronger than expected, paving the way for the Federal Reserve to increase interest rates in the not-too-distant future. Foreign exchange markets are going crazy as a result and we could certainly experience a higher level of volatility in the share market, too.
Here's the problem…
Volatility can be a great thing for value investors. As high-quality businesses are sold off, long-term investors are given a perfect opportunity to buy at significantly discounted prices, increasing their ability to maximise their returns. However, very few investors are actually prepared for such volatility.
As Warren Buffett famously quipped, "You only find out who is swimming naked when the tide goes out." In a bull market, most people consider themselves to be investing geniuses for earning solid returns on their investments, but their Achilles heel is ultimately exposed when things start to turn sour.
Here's how you can prepare
Firstly, it's important to know that a market downturn is inevitable. Whether it happens in the next month or year is up for debate, but one will happen eventually, and there will be no avoiding it (unless you're content with stashing your money in low-interest bearing accounts or bonds).
Luckily, there are a number of things you can do to protect yourself from such an event. First and foremost, it is imperative that your portfolio maintains strong foundations, made up of companies that can survive through even the toughest economic conditions. It is also important that these companies are purchased at reasonable prices! Unfortunately, that rules the big four banks out but companies such as Woolworths Limited (ASX: WOW), CSL Limited (ASX: CSL) and Washington H. Soul Pattinson and Co. Ltd (ASX:SOL) are still looking attractive.
It's also important to ensure you maintain a decent cash balance. While this will ensure your entire wealth is not exposed to the downturn, it will also give you the ability to buy shares in high-quality companies when they are sold off.
Lastly, it is vital that you remain calm and remember that investing is a long-term game, where the biggest returns are made over years and decades, not weeks or months. That's why The Motley Fool's aim is to identify Australia's greatest buy-to-hold stocks capable of delivering market-smashing results in the long-term.
