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Time to take the emergency exit?

An investor is concerned that equity markets might be heading for a correction.

I have an extensive equity based portfolio and recent stockmarket volatility has caused me great concern. I have seen my investments recover well since March 2003 but in the past few weeks I have lost 5 per cent. I do not need the money for any particular purpose but I am deeply concerned that the recent fall could be the start of a bigger slide and I really do not want to find myself back where I was a few years ago. Should I get out of the market before it collapses?

If you knew that the market was going to collapse, then, yes, you should get out and buy back in at the bottom. The trouble is that you do not know whether it is going to collapse or, if it does, where the bottom is.

You are invested in equities with a view to achieving better returns than you could elsewhere. It might be hard to comprehend after the last few years but few professional investors can dispute the fact that, over the longer term, stockmarket investments have outperformed bank and building society deposit accounts significantly or that, in the longer term, this is likely to continue. On the other hand, it is equally true that stockmarkets are susceptible to periods of underperformance which, not unnaturally, investors would prefer to do without.

But I am sure your portfolio will not consist only of equity investments. You, no doubt, hold other asset classes such as corporate bonds and possibly property which, like the equity element of your portfolio, should not be seen in isolation as all the assets together will provide a diversified portfolio.

With equity markets now into the third year of recovery from the bear market, a correction greater than that already seen cannot be discounted. In fact, I believe that a further correction should be expected although when it will happen and to what extent no one knows for certain.

Until October, equity market movements suggested that investors remain relatively positive despite being offered excuses to step on to the sidelines, including the rise in the oil price, the deteriorating situation in Iraq, the terrorist attacks on London, Hurricane Katrina and, most recently, Hurricane Rita. Katrina, in particular, illustrates the apparent indifference to bad news although its impact on US petroleum refining capacity at a time when supplies were already under pressure might have been expected to lead to markets falling but the actual impact has been more or less nil.

The lack of market response to a series of apparently very bearish events confirms my belief that second-guessing the markets on a consistent basis is impossible.

I believe that a correction at some point is inevitable, deciding on what should instigate a market exit relies more on luck than skill. This view is supported by research earlier this year by Fidelity International which showed that returns from the FTSE All Share index from December 31, 1989 to December 31, 2004 averaged 8.6 per cent a year if you had remained fully invested but would have been an average of 1.3 per cent less a year if you had missed the best 30 days of that period.

In short, there is always the possibility of an abrupt market correction but my belief is that to make gains you have to be prepared to take risks. By that, I mean you need to be invested.

Furthermore, while I anticipate a correction of up to half of the rise since March 2003, I believe it will be short-lived and anyone who does time an exit correctly could find that they miss out on a subsequent rise that would take the market way above the pre-correction price.

It is not possible to eliminate risks completely but they can be reduced by investing in a diversified portfolio of funds invested across a range of assets appropriate to your attitude to risk and managed by experts who have demonstrated their ability to meet their objectives.

On the assumption that you have such a portfolio, given that you are unlikely to require your capital in the immediately foreseeable future, the best strategy is probably to stop watching and worrying about every market movement. Over the years, your portfolio will suffer periods where its value falls but it is the long-term performance which will ultimately count.

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