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A question every investor should ask: What happens if the world doesn’t end?

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Learn to harness your fear

Remember a few months ago when the economic news was so bad that optimism seemed naive?

Well …

Markets the world over made solid gains in January.

Have a look at this recent article. Negative investor sentiment is occurring at the same time as the best January in the markets since 1987.

The markets often climb significant walls of worry. Sometimes, it pays to focus on bad investor sentiment and use it as a contrarian indicator.

In “Wait a minute. There’s some good news re the markets?” I blogged about how investors often miss the good news flying below the radar.

Many people have been burned by the excesses of credit mania, culminating in the market implosion of the financial crisis.

Humans in all walks of life sometimes give in to greed. Exuberance and fear are flip sides of a coin forged at the beginning of time.

I posted some stark stats in “Why you should consider new investments now”.

Why post negative stats? Because, while end-of-the-world scenarios might sell bytes of information in the short-term, they don’t do much for the average investor who’s trying to be strategic about long-term investing.

The starkness of information can be helpful.

Ask yourself a simple question:

When the market takes a substantial dip, generally, is there more chance that it’ll rise or keep falling on average?

Bad news gets the big, black ink (or bytes)

There are always going to be onslaughts of bad news. Good news rarely gets the big, black ink of the headlines until the story’s over. In between, you need to manage your fear.

You need to think strategically.

In “Don’t Panic”, I went into greater detail about managing fear while investing. Learning to harness your fear as an investor will go a long way toward helping you create an intelligent plan of action when it comes to investing and financial planning.

Again, in “The grand parade of future dividends “, I discussed how corporations were increasing dividends (good news for investors) and ended with the question:

“What happens if the world doesn’t end?”

While Canada is experiencing higher unemployment, the U.S., recently written-off as a basket case, just posted strong employment numbers.

What people keep forgetting, is that business, economic news, and the process of investing is fluid. Some get so used to bad news that they forget good news exists.

Until January, there wasn’t a big focus on the positive. But whispers of good news were there if you read between the lines (or read more than just the headlines).

Now, was it really a good idea to sit on the sidelines as an investor during all that bad news? And is the bad news over?

Well, here’s the thing:

We’ve come through a tough time. We’re not out of the woods yet, but if you’ve been sticking to a sound investing plan, you’ve taken advantage of the weakness in the market.

The bad news about being an inactive investor in 2011

If you’ve been sitting in cash only:

  • You’ve missed a very nice rise in the bond markets

and

  • A great opportunity to reallocate investments to stocks

Risk applies to low-paying GICs just as much as it does to equities or real estate.

In this case, low-paying GICs weren’t much of a safe haven when compared to the Altamira Income Fund, or even the broad Globe Fixed Income Peer Index.

Sitting in GICs can cost you.

So, when you consider the past year would’ve been:

  • A great time to buy equities at lower prices

and

  • That bond funds significantly outperformed the GIC index *

… it pays to ask this question again:

What happens if the world doesn’t end?

The case for bonds against ...

... GICs. (Over five years)

Click here for more about bonds and fixed income investments.

Click below for more about asset allocation and reallocation strategies:

Get the balance right

A simple way to arrive at the right asset allocation for your portfolio

Plan like a pension fund manager when it comes to your investment portfolio

Let’s think about assets

Asset allocation: Diversification is king

* Many criticize bond funds for their higher fees as compared to ETFs, but for many average investors they are the easiest way to get a diversified bond portfolio since not every investor has a trading account.
* You should also note that since bonds have significantly outperformed, they may not perform as well over the next few years. A balanced portfolio is the best way to ensure consistent outperformance while minimizing risk.
Note: Fund/funds used here are only for illustrative purposes.
Chart source: Globe Investor

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A simple way to arrive at the right asset allocation for your portfolio

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What’s your piece of the pie? 

 

Instant asset allocation

Asset allocation can be as complicated as you want to make it. But since many investors don’t have time to get overly complex about assets in their portfolios, here’s a simple look at how to allocate.

Financial planners used to say subtract your age from 100:

  • The remaining percentage is what you should have in stocks

So, if you’re 30, keep 70 per cent of your portfolio in stocks. If you’re 70, keep 30 per cent in stocks.

The best asset allocation for your age

Canadians can look forward to living longer. Because we’re living longer, we have to take this into consideration when it comes to our portfolios. Some recommendations are suggesting the number used should be increased to 110 or 120 minus your age reflecting our greater longevity.

If you’re living longer, you need to make your money last longer. You’ll need the extra growth that stocks can deliver.

Many experienced investors find that adjusting the number to suit their risk tolerance after a large correction, say, like 2008-2009, a good metric. Large corrections can get you in touch with your investor psyche pretty quickly. But be cautious about selling when the mood has reached maximum pessimism. It rarely turns out well.

In “Plan like a pension fund manager when it comes to your investment portfolio”, I discussed the benchmark for the average diversified fund manager. The important thing is to choose an asset allocation you think you can be comfortable with.

For example, if you had a 50/50 portfolio split, you could expect that your stock holdings would move a lot less than a broad index like the S&P/TSX 60 in Canada, or the S&P 500 in the U.S. While you may be tempted to think it’ll move half of one of these indices, it will depend on how close the equity component of your portfolio correlates to either of these indices. If your stock allocation is geographically diversified, this will also change things.

When you compare the S&P/TSX 60 (60 of the biggest companies in Canada) with a balanced fund that is geographically diversified, we’d expect, generally, to see:

  • Less volatility because of the fixed income component in the balanced fund
  • Less volatility because of the geographic diversification in stocks and bonds in the balanced fund

This is exactly what happens when you graph the S&P/TSX 60 and the Claymore Balanced Growth Core Portfolio (TSX:CBN). The Claymore portfolio is based on the Sabrient Global Balanced Growth Index. Roughly an 80/20 balance between growth and income-oriented ETFs holding stocks and bonds.

Diversification reduces volatility

The S&P/TSX 60 shows more volatility than the Claymore ETF. There are reasons for this.

The S&P/TSX 60 is made up of sixty of the biggest stocks in Canada – one country with a big presence in financials, energy and materials.

The Claymore ETF is geographically diversified. It holds stocks from all over the world. It also has a fixed income component. Its equity and fixed income allocations are further diversified. They hold different investments that perform somewhat differently depending on market/economic conditions.

What investors have to remember is that while volatility is reduced when fixed income products are added to a portfolio, it also reduces the upside of the portfolio when markets turn around. A geographically diversified portfolio with fixed income products added into the mix isn’t going to perform as aggressively as the broader stock market.

Most investors can tolerate less upside for less downside. As we’ve recently seen, it’s the drops that make people a little shaky in the knees.

Remember, should you want even less exposure to stock, there are plenty of products out there that are closer to a 60/40 split between equities and fixed income.

Asset allocation is going to affect performance and risk. You can always use systems (like the simple ones above) to come up with a benchmark for your portfolio, but in the end, your portfolio’s going to be slightly different because it won’t have exactly the same investments.

Opportunity abounds in down markets. Part of the opportunity of market volatility is figuring out your risk tolerance. If this last correction gave you palpitations, maybe you have too much stock.

But consider:

  • The markets have corrected. This graph is from September 2010 to September 2011. If you sell investments now, you may be selling near the bottom.
  • Having an asset allocation system in place is going to be the best benchmark for rebalancing your portfolio. If you haven’t had such a system in place, think, and act now.

There may be opportunity out there. In fact, the last few days in the markets have seen some extraordinary upward movements in equities. September is often the cruelest month in markets, but October has ended a lot of bear markets historically. Bad news travels fast and furious, yet the sounds of optimism often appear within the pessimism and noise.

*ETFs used here are for illustrative purposes

Get the balance right

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Can we simplify asset allocation?

Yes, we can.

While there may be more to asset allocation than just stocks and bonds, stocks and bonds are the best starting points for most investors. Anyone can become an investor through mutual funds or ETFs.

What have most investors heard about stocks?

• Stocks usually outperform bonds over long periods of time

Ok, now, in this hypothetical, let’s imagine that stocks take longer than average for that outperformance to take place. What can we do to bolster our portfolios?

If we find ourselves in a period where equities take longer to outperform than average, we can arrive at two conclusions:

• Fixed income positions (bonds) are even more important

• Rebalancing is even more important

Why?

Because, although a 100 per cent portfolio of stocks should statistically outperform over the long-term, most investors are more human than they are instruments of logic. People are emotional.  Since they’re emotional, what is theoretically true about investing may not hold true in real life.

Volatility takes its toll. Big market drops herald big investor reactions. When bad news reaches a fever pitch about stock markets, many investors start to feel ill. Investors start abandoning strategy and discipline.

After all, there’s Europe, a potential recession, inflated house prices in Canada, and a blue sky that’s sure to fall. (Never mind that equities haven’t been this cheap in quite a while.)

The only things that have really changed are the names of the crises. Not to belittle the difficulties we face economically – these are challenging times – but we’ve always faced difficulties economically. With market corrections, and, with prudent planning, difficulties become opportunities.

Seeing the opportunity in today’s markets may be better than running around screaming the sky is falling.

If your portfolio has a good allocation to fixed income products – if you have a mix you’re comfortable with – and you have a disciplined rebalancing strategy, you should benefit. There are times when stocks and bonds move up or down at the same time, but usually, stocks and bonds move in opposite directions.

If your allocation is 65 per cent equity (stocks) and 35 per cent fixed income (bonds), then when your allocation drifts, let’s say to 70 per cent equity and 30 per cent fixed income, it’s time to rebalance.

What do you need to do? Sell some stocks and buy some bonds. Sell the asset class that has outperformed, and buy the asset class that has underperformed.

Sell high. Buy low.

Everyone knows that, right? But it takes great discipline to do. You have to automate the process.

Some investors worry that they’ll impede portfolio performance by selling stocks when they seem to be doing nothing but going up. True. This happens. Your allocation may change early in a bull market. But many investors struggle seeing future benefit in the face of the madness of crowds. The “noise” affects their focus and their resolve. It can make investors buy at the wrong time or sell at the wrong time. In down markets, too many investors only see current losses or declines.

What might be the best rebalancing schedule theoretically, may not work for the average investor struggling to cope with “noise” during a market correction, especially, if it’s a severe correction like 2008-2009.

While the financial crisis may have caused some grey hair, it was one of the best times in recent memory to test out your portfolio. Recent weeks also put some pressure on investor nerves while squeezing portfolio integrity.

It’s times like 2008 – 2009 that make people happy to own bonds. Bonds performed very well as stocks declined.  Stocks usually outperform bonds over the long-term, but bonds add some insurance to your portfolio.

As the market began the steepest part of its recent decline, we can see that bonds once again outperformed as investors positioned themselves for safety. The steady income from bonds and the hedge they provide against market drops often make them fund manager favourites.

Why should the average investor be any different?

Bonds providing a hedge during recent market correction

Part Two is here.

Plan like a pension fund manager when it comes to your investment portfolio

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GICs, bonds or stocks? What would you have rather held for the last two years?

GICs, bonds or stocks? What would you have rather held for the last two years?

Employees have paid more attention to their pension plans in the last few years due to the financial crisis and volatility in markets. However, volatility made even the brave flinch during 2009. So, just what’s the situation in Canada? And what’s an employee to think these days?

Think sound planning

Careful planning is what drives investments and pension plans forward. When the market dropped in 2009, it rattled a lot of investors, and, of course, we’re all pension holders whether it is through the company we work for or the Canada Pension Plan.

Make volatility your friend

Volatility works for you in the markets if you have a plan. It’s part of investing. Ask any fund manager.

Equity and bond markets can’t go up in a straight line because there are too many interconnected parts to the economy, business and world events. News, especially in an increasingly digitized society moves at light speed, and news impacts on investments. In order to achieve the goals we set for retirement, exposure to the equity markets is necessary. Equities provide the added growth and performance few other assets do. After all, if you held a lot of cash since March 2009 or invested new cash into GICs rather than equities, you’d have gotten simply anemic returns.

Have a look at historical charts

If you pulled your money out of the markets in May 2009 and kept it out, you would have missed out on a 40 per cent return on the S&P TSX 60 Index at its recent peak. On the other hand, pension managers, as markets stabilized, began reinvesting new money into equities at bargain prices. Meanwhile, bond holdings that should be part of every balanced portfolio, accelerated through the market turmoil providing a buffer. The DEX Universe Bond Index returned about 16 per cent from the time the equity markets began correcting to now. Compare that to the average 1-Year GIC returns shown in the chart above – they’re barely recognizable during that time.

The picture I’m painting is your pension’s doing what it should be as the manager sticks to his plan.

What lesson can the average investor learn?

  •  Get a plan
  • Stick to your plan
  • Remember to reallocate investments

Remember to diversify

Proper asset reallocation on the part of managers forces them to buy assets when they are cheaper, rather than when prices are steep. The average diversified fund manager measures himself against a benchmark that is 55 per cent equity and 45 per cent fixed income. These percentages are reallocated as the portfolio weightings and market conditions change.

The average investor would do well to remember the fixed income component of their plan. A short while ago nobody had anything good to say about bonds but since commodities and the markets have started backing up recently, fixed income is showing us, once again, why it belongs in our portfolios. There’s nothing like some income and fixed income investments that generally rise when equities go down to stabilize a portfolio.

The bottom line is that performance has been excellent since 2009 and in the first quarter of 2011. How would you feel right now if your pension fund manager had been holding a portfolio of GICs exclusively during that period?

Probably, a little sick …

Contrast the 1-Year Average GIC Index return of slightly more than 1 per cent with the above returns on the iShares S&P/TSX 60 Index and the iShares DEX Universe Bond Index since May 09.

While returns are never guaranteed for any asset class, you can bet that over the long-term, stocks and bonds will beat out GICs.

*Note iShares S&P/TSX 60 Index and iShares DEX Universe Bond Index used only for illustrative purposes

Update: The Canada Pension Plan has hit a record, largely by scooping up bargains in the equity markets after the financial crisis and resulting market correction. For more details.

Update: I was gratified to see that a connection of mine, Adrian Mastracci was thinking similarly about investing like a pension fund manager! See article here.

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