While many investors may be feeling optimistic at the start of 2018, there could be significant risks ahead. Certainly, last year was a positive year for the stock market. The FTSE 100 delivered a total return of around 11%, which is well ahead of its expected annual returns.
However, there are significant risks facing the global economy. This could mean that 2018 is a more difficult year than many investors are anticipating. And a range of companies could deliver disappointing share price performance. Here’s how Foolish investors could avoid losing money this year.
While interest rates in the UK remain near historic lows, the general trend is set to be an upward one. Higher inflation could prompt the Bank of England to follow the Federal Reserve and deliver a steady stream of interest rates rises over the medium term. While this may not be a problem for most companies, some businesses continue to run high levels of leverage in the search for the maximisation of profit.
In a period of low interest rates, high leverage can lead to greater profitability. However, such stocks could see their bottom lines squeezed by higher interest costs in a period of monetary policy tightening. As such, avoiding highly-indebted companies could be a shrewd move in 2018.
Although the FTSE 100 may still have a dividend yield of 4% even after reaching a record high, some companies may now be overvalued. This is not particularly surprising, since the index has enjoyed a multi-year Bull Run, with investor confidence improving year-on-year. Today, many investors think less about risk and more about potential returns, which means that the challenges which many companies face may not be factored into their share prices.
Therefore, valuations could be an even more important aspect of investing this year. Although it may be more difficult than it has been for a number of years to find wide margins of safety, doing so could prove to be worthwhile in the long run.
In any bull market it is usually cyclical stocks that gain the most. They are most dependent upon the performance of the wider economy out of all stocks, and a Bull Run usually coincides with a period of improving economic performance. While it is tempting to buy such stocks at a time when they are delivering rising levels of profitability, the reality is that their financial performance can be highly volatile. As such, assuming that last year’s performance will be replicated each year could be a major mistake for investors to make.
Defensive shares could therefore be a better buy for the long term. At the present time, they seem to offer lower valuations than their cyclical peers, while also having the potential to outperform the market in a period of falling share prices. They may offer less excitement this year, but could be more profitable than riskier stocks in future years.
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