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Investing in a toppy market
Toni Case - July 16, 2007

As the market continues its upward march, the question on everyone's lips is "Have we peaked?". Toni Case looks at investing in a toppy market

In every boom there’s always a moment when investors mull over the thought that the current boom will be stronger for longer this time around. But in every boom there’s also a moment when investors survey their surroundings and question: should I be selling out before it’s too late?

Today, as investors sit at the top of the curve – after almost four years of surging sharemarket conditions – the fear of losing gains is making it increasingly tough to sit still.

But easing concerns for many are the market fundamentals at play this time around. Investors are no doubt thinking: well, the fast-growing economies of China and India are fuelling demand for our coal, aluminum and iron ore exports, and this doesn’t seem to be petering out any time soon. There’s also the relentless surge in private equity, inflation is fairly benign, and lastly there’s the flood of super money and the Federal Government’s future fund - the largest pool of money ever created in Australia - spilling into the sharemarket on a regular basis. Understandably, investors considering these factors are fairly upbeat on how long the boom can last.

Indeed, many signals are pointing in favour of the argument for a stronger for longer boom. But a quick reminder of the history of boom and bust cycles will jog investors back to the realisation that sharemarket booms never continue indefinitely. Highs are followed by lows and it’s this ebb and flow that defines the cycle of life and the sharemarket.

So if the current boom will inevitably result in a market correction, should you sell out now – and shift your funds into cash - or hold on for the ride?

Investing is never black and white, and moving funds in and out of cash is rarely the best option for any investor regardless of the market cycle. Rather, maintaining a diversified portfolio and ensuring that the euphoria of the market is not unduly affecting your investing decisions is a good start.

For example, as the market steams ahead, investors can fall into the habit of buying stocks indiscriminately without weighing up the merits of one share over another and their respective risk levels. Indeed, while everyone is a successful investor during market booms – the true investor shines during less buoyant times.

While it could be premature to start building a bunker portfolio today in preparation for a large-scale market correction, investors may wish to look at measures to protect their portfolio in the event of more turbulent conditions ahead:

Diversification - don’t be too exposed to one share, sector or asset class. While commodities might be booming, for example, it’s not wise to have every penny riding on the fate of the resources sector.

Holdings of defensive stocks – should the market correct, do you hold sufficient defensive stocks in your portfolio? These are the stocks that will fare well regardless of economic conditions - such as food and beverage, banks and healthcare.

Hedging – sophisticated investors may look at opportunities to hedge their biggest share holdings or the broader market via CFDs or options. Hedging basically involves taking an equal and opposite view on a stock or index so that a negative market move leaves you in a neutral position.

It’s often said that when the great bulk of people think the boom will continue indefinitely, the peak of the cycle is nigh. The best preparation for investors is to keep in mind that booms don’t continue in finitum – and to be always prepared for the worst.

More articles from this week's newsletter:

Companies to benefit from the rise of the grey nomads
What is the ideal mix of companies?
Trading: is your bargain stock a lemon?
Will McFarlane's replacement sing in tune?
Are investment clubs good for your wealth?
Stock of the week: TPI
Inflation: when is 'core' not so core?
CFDs: the best time to trade
Analyst report: gold bull seasonals
Investing: Paying the cost of confidence

Whatever your views, you can discuss this article - or any of Nicholas's articles - on our message board Your 2 Cents.

Toni Case is the editor of CompareShares.com.au and is Australia’s first journalist to specialise on Contracts for Difference (CFDs). She was a staff writer for Shares, Personal Investor and Asset Magazines, and today is a regular columnist with the Australian Financial Review. She is a qualified financial adviser, and has an Economics (Honours) degree from Sydney University.