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Part Three — Market volatility: Why and how to make it work for you

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In Part Two, I left off discussing benchmarks on investment returns.

Easy as ACB revisited

I stressed that such benchmarks only reveal how your investment would have done if you invested all of your funds at the beginning of the period. These benchmarks assume you were inactive during the time period you’re measuring, and you did zero rebalancing during 2008-2009 or other significant market corrections — exactly the periods of time when you should be (or should have been) more active.

While investors should have been rebalancing during 2009, research shows average investors freeze up during these times, or worse, sell.

The worst case scenario is that they sell heavily.

Let’s say you had a large cash position in your portfolio near the bottom in 2008-2009. New cash, profits you’d taken, whatever …

Now, let’s say you used that cash and bought equities around that time, which turned out to be the bottom or near the bottom of the correction. Your return would be considerably different. And this is why rebalancing is so important to the success of your investments, portfolio and retirement plan.

If you’d been following a sound rebalancing strategy, you would have bought during the downturn in 2008-2009 because your asset allocation would have drifted away from your plan.

Let’s use a simple illustration:

• You bought 50 shares (or units of a mutual fund ) at an average cost of $7

• Then you bought 10 shares at $5 (you were brave and when the market dropped 50 per cent in panic selling, you saw opportunity)

• You then continued to deploy your cash while the market was cheap and bought 10 shares at $6 (because of your rebalancing strategy, which you follow automatically. You bought while prices were cheap because your asset allocation had changed.)

• The market rose dramatically after this period and your asset allocation reached your target. You stopped buying.

So, your adjusted cost is:

50 @ 7= 350
10 @ 5 = 50
10 @ 6 = 60

Your total cost was $460. The price now is $7.
7 x 70 = $490

You now have profit of $30, called a capital gain.

In reality, your transactions will be more complicated, and there will be dividend payments in there somewhere. But the simplicity of this example shows us how following asset allocation strategies with your investments will help you lower your Average Cost Base (ACB).

Your equity component would have been, percentage-wise, less than it had been. Your allocation plan would have kicked in, and you would have bought the underperforming equity investments.

Even if you did this more gradually, before, during, and after the correction, it would have lowered your average cost.

One way for Joe and Josephine Average to get a leg up is to take advantage of what’s available to them. Tax-preferred or (deferred) investments and plans, and sound portfolio strategies included.

But research shows they don’t. Volatility spooks them, and sadly, this will cost the average investor over the long-term.

When I was a kid …

An older colleague I used to work with said the following, loosely paraphrased, about his lack of savings and investments in his youth: “When I was a kid, I was convinced I wouldn’t make it to forty.”

Heavy pause.

“I was wrong …”

I had asked him why he didn’t have an RRSP because I wanted to understand how he thought. He later added that he had lost a ton of money in real estate (Canadians seem to have forgotten the real estate crash that happened in 1989-1990 – Americans have had a harsh reminder).

Looking at real estate in this context reinforces my point of view on buying assets when they’re low. While it took residential real estate a long time to recover from ’89-’90, today’s real estate prices (supported by an extended period of low interest rates) prove that buying assets when they’re cheap is rewarding.

Yet nobody wanted residential real estate in ’89-’90, and many developers lost their livelihoods during that time.

Raising awareness, being startegic

Raising awareness about the investing habits of Joe and Josephine Average will help them over the long-term. They need to better educate themselves about market volatility and be more strategic in their approach to it.

While this is easier said than done, it is one of the reasons the Warren Buffetts do better than the Joe and Josephines when it comes to investing and financial planning.

Market volatility, understood properly, is your friend. Reminding yourself of this completely reframes the way you look at the market, your investments and corrections.

Maybe your friend goes a little berserk once in a while. Maybe he’s a little impatient or a little irrational at times, but he’s still your friend.

You know you can count on him when you’re down. Looking at market events this way, despite difficult times, puts you in control.

Just make sure the relationship is a long, diversified one.

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Part Two — Market volatility: Why and how to make it work for you

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In Part One, I discussed some differences between the 1 per cent and 99.

How do the 1 per cent differ from the 99 when it comes to market volatility? Is there something the average investor can learn?

I’m not trying to defend the 1 per cent. What I am trying to do is point out that the market is public and that market volatility leaves no one untouched. No stone unturned.

I’m not here to talk about tax inequality or to defend either side. People like Warren Buffett have done that. There have been arguments for and arguments against Buffett.

What I’d like to focus on is:

While the 1 per cent have better intelligence and more powerful networks when it comes to investing, there are strategies the 99 can use to get ahead. Strategies Warren Buffett and the 1 per cent have been using for a long time.

If you’re a long-term investor, you can own a lot of the same assets. Granted, you may not get these assets at the same transaction costs due to scale, but you can own assets that should enrich you over time.

Have the wealthiest people sold all of their assets? Doubtful.

Do they sell them after market declines?

Well, let’s look at this rationally.

  • You need to find a buyer in order to sell your shares (the sheer scale of owning billions in assets means it’s harder to find a buyer when you sell)1
  • Liquidating such assets might cause some significant tax implications2
  • Because of professional counsel, the 1 per cent are exposed to more and better research than average investors, leading to fewer knee-jerk reactions in the face of market events

There would be barriers to the 1 per cent selling their assets.

Taxes …

You can see at least three articles above discussing whether taxes on investments and the 1 per cent are too low. There is definitely a movement afoot to examine these issues.

Let’s set the 1 per cent aside for a minute.

Remember, Joe Average gets a break on taxation for certain investments, too. So does his partner, Josephine. They may not get as big a break, but they do get a break.

They get a deduction for contributing to an RRSP. They get tax-free earnings in a TFSA. If they’re invested in dividend-paying equities outside of an RRSP or TFSA, they get tax-preferred income from those dividends.

Advice

Because the wealthy have the means to get good counsel when it comes to their investments and financial planning strategies, we can assume that those professionals counsel their clients:

  • To avoid panic selling
  • To rebalance regularly and systematically

Joe and Joe and Market Volatility

Now, what about Josephine and Joe Average? Are they taking advantage of the better prices presented through market volatility?

After the 2008-2009 correction, did the average investor take advantage of some of the cheapest prices we’ve seen in a generation? Is the average investor taking advantage of cheaper prices now?

Research says no. (Like to explore this idea further? I blogged about it in “Don’t Panic”.)

People concentrate on returns over a given period of time. But such assessments assume that you invested your money all at one time at the beginning of the period. How many investors do that?

Easy as ACB

Your Adjusted Cost Base (ACB), basically, how much you paid as you bought an investment, is a much more realistic measurement of how you’re doing.

If the broad market’s down 20 per cent, and you’re ACB is showing that your investment in a broad-based mutual fund or ETF has broken even, e.g. the investment’s price is 10 and your ACB is 10, you’ve done great.

Why? Because you’ve outperformed the market over the same period.

How did you accomplish this? By using excellent rebalancing strategies.

Of course, if you’ve had a more conservative position, you have to realize that when the market turns around, the broad index may start outperforming with respect to your investment. Your rebalancing plan will help with this, and sticking to that plan will help even more.

Figuring out who you are as an investor is important.

In Part Three, I’ll continue, focusing more on long-term strategy with a simple illustration of why that focus will make you a better investor.

Notes:

1The 1 per cent tend to buy shares of companies more than they buy mutual funds. Diversification isn’t as big a deal for them. They have the means to buy enough shares and still be adequately diversified. This isn’t true of the average investor. Some market experts say you should have at least a million dollars to invest to be adequately diversified when holding stocks. Others disagree. It’s true that the fewer companies you hold, the less diversified you are, and the more risk you’re taking on. Employees that held most of their investments in Enron or Nortel found this out the hard way when the stocks collapsed3.

2Taxation is another reason why the 1 per cent sell their holdings, e.g., experts have suggested Steve Jobs’ heirs sell their shares in Apple to avoid over $800 million in tax liabilities.

3More evidence for diversification comes by way of Bill Gates example. While he has significant wealth in Microsoft shares, he holds a lot of Berkshire Hathaway in order to further diversify his holdings. Forbes claims that more than half of Gates wealth is held outside Microsoft stock.

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Why you should consider new investments now

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Thinking about contributing to an RRSP, a TFSA, an RESP or other investment account? Now may be one of the best times since 2009 to fund any of these accounts, especially if you have over ten years for your investment to bear fruit.

Why?

Because, at the time of writing:

  • In Canada, the S&P/TSX Composite is down 20 per cent over six months
  • In the U.S., the S&P 500 is down about 17 per cent
  • Any good news out of Europe causes some nice upward movement on Canadian and U.S. equity prices, suggesting there may be some upward momentum if Europe gets its act together regarding a solution to the debt crisis
  • As the two most common areas for Canadian investors to put their money to work, Canada and the U.S. present compelling values for stock investors compared to six months ago
  • The S&P/TSX Composite is down about 10 per cent over one year
  • The S&P 500 is down about 5 per cent over one year
  • The iShares DEX Universe Bond Index is up over 7 per cent since its low within the last year

While nobody wants negative returns (unless you’re looking to buy at cheaper prices!), this current equity correction doesn’t look as bad over one year, and looking at returns over that time frame provides some perspective. Over one year, the declines don’t look as dramatic, and that takes some of the fear out of equities.

Fixed income has outperformed. Looking at this outperformance in a rebalancing context, shows stock is currently cheaper.

No one is sure what the future holds, but what is sure is that stocks are a better deal than they were, and bonds aren’t as attractive.

Do yourself a favour: If you’re nervous about markets do some gradual, strategic buying. If you don’t have a plan regarding your asset allocation, get one.

Fear of losing may keep you from winning. Fear is a motivator, so if fear is keeping you from being a strategic investor, consider that fear should also keep you focused on your plan.

Investors have to accept that they will never know exactly what the market is going to do — and then plan accordingly.

Take comfort in the fact that someone like Warren Buffett recently invested $4 billion in the stock market.

Markets will either go up, down (or sideways) in the short-term. If you stay with a balanced portfolio, you have limited downside risk. But if you stay completely out of the market, expecting the four horsemen of the apocalypse, you may be disappointed if the horsemen don’t arrive.

A good long look at a stock chart after the 2009 market bottom (and such a chart can be found in one of the above links), might help you steel yourself, too. Markets had quite an increase until the latest correction began.

The planning you do now will serve you well when the market next moves into a bull phase and increases.

Related:

Feeling some panic?

What’s a TFSA?

In times of volatility, you might want to focus on conservative dividend-paying investments

Cash, corrections, the end and feeling fine

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 It’s all about the cash (and being able to sleep at night) when it comes to the stock market correction: Finding optimism in the insomnia of the moment

Didn’t the Twist go out a long time ago?

Somebody should tell the U.S. government that half-measures hardly ever satisfy anyone. Doing the Twist may be the middle ground, but now is the time for leadership and focusing on one’s convictions.

Is the glass still half-full?

Cash on Corporate Balance Sheets

In “Too much cash on corporate balance sheets: So, does this mean we can expect higher payouts?”, I wrote about the Everest of cash sitting on balance sheets. Today, Thursday, September 22, as I write, markets are moving down aggressively suggesting the Fed’s doing the Twist wasn’t what the markets wanted. There’s still one overwhelming fact that we shouldn’t overlook:

• Corporations are sitting on mountains of cash

What are they going to do?

Since they’re not in the business of becoming money market funds, (though some companies are starting to look like balanced funds by the mounds of cash they’re hording [more on this in a moment], these corporations need to do something with all this cash. After all, just like investors sitting on GICs, corporations sitting on cash aren’t going to get much of a return on it.

Now, let’s Think Apple, for example.

Seems the apple’s full of cash. But Apple’s not a balanced fund. It’s a company. Not everyone’s enamoured of Apple’s strategy.

While a lot of this cash hording relates directly to our current economic times, it still raises the ire of many people. High unemployment, especially amongst students, doesn’t make people rejoice when they hear you’re sitting on $76 billion.

With that amount of cash on the balance sheet, it seems management at Apple’s got the Mayan calendar out and are waiting for the end of the world. If that’s their forward-looking scenario, an iPhone or iPad won’t be much use …

“Hi … Mom, dad, I just thought I’d say bye … The end is coming …”

Perhaps investors in Apple have more confidence in Apple’s future than Apple management does?

But let’s revisit what’s most important to remember:

• Corporations have to do something with all this cash
• And some are

Microsoft recently raised its dividend: One of many companies to do this. It’s about sharing the wealth.

The fact that Apple hasn’t issued a dividend seems like a strategic mistake. It will be interesting to see how long investors will tolerate so much cash on Apple’s books.

Since opportunity appears in times of crisis, it’d be foolish to forget that all this cash has to go somewhere eventually.

Where?

  • Dividends
  • Mergers, acquisitions
  • Buying back shares
  • Towards hiring the most important resource, people, as the economy improves

Part Two is here.

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.

Don’t panic

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In the face of the typhoon (market correction), bend like bamboo

What is it about market corrections? Wise, rational people can become wide-eyed pessimists and conduits of fear in the face of steep market drops. Can you remember a time when you sold investments during a market correction and it turned out to be a wise move?

Investors ruled by a forest fire of emotions, fanned by the media looking to report the latest, most sensational story, rarely make wise decisions. Often, when the market is hitting new record after new record, they’re buying. But when the market turns the other way, and suddenly high quality companies are on sale and can be bought at excellent discounts, emotion-ridden investors are running for the hills or putting their heads in the sand.

Here are some facts that you’d do well to pay attention to. The study tells the sad tale of how investors, suffering from a bad dose of “Oh, no! The world’s going to end!”, make some classic mistakes while investing. In fact, what may be the most important aspect of your investment plan, after asset allocation, is dealing with the forces of rampant negativity that rear their ugly heads every time there’s a market correction.

Glued to the media, wide-eyed and beset with your worst fears for the economic future? It’s time to go for a walk. Fund managers wait for corrections to go out bargain hunting. Wouldn’t you be happy if the suit or new pair of shoes you wanted to buy were now on sale? Because that’s exactly what’s going on now: high quality, dividend-paying companies are on sale.

Investors need to do themselves a favour:

  • Develop a thicker skin
  • Stop dwelling on the investment media during corrections
  • Stop chasing investment returns
  • Ask yourself: since everybody’s talking about gold bullion (or whatever the flavour of the month is) right now, do I really want to buy it?
  • Get a sound investment plan
  • Stick to your plan
  • Buy or sell investments when your asset allocation veers away from your planned allocation, and do it regularly
  • Remind yourself that great, stable companies are not going to disappear

Further considerations that you should bear in mind:

  • Remind yourself that Warren Buffett (and other smart money managers) are looking for bargains rather than making rash, panic-fuelled decisions
  • Aren’t all the companies you wanted to buy when they were more expensive, cheaper now?
  • The economy’s gone through corrections dozens of times before – this won’t be the last time (e.g., Latin American bonds, the Asian Crisis, the Tech bubble, 9/11, [Remember when people were talking about the Canadian peso?], the financial crisis, etc.)
  • If you’re buying in the midst of this correction, or any, remember, you don’t need to throw all your money in at one time – you can also buy gradually, giving you a cushion and better prices should the market go down further
  • There’s a place in your portfolio for bonds – do you have any?
  • Revisit your plan yearly

If you’re still spooked after a hard, meditative look at your investments, maybe your asset allocation is too aggressive. Should you reduce your equity holdings somewhat? Reducing stock holdings amidst any correction is tricky. You’re probably going to be selling at the worst of possible times – maybe you should revisit your asset allocation model when things calm down a bit? (Have I mentioned stick with your plan and re-evaluate your plan regularly?)

The time for strategic thinking is before a correction and during one. When it seems that investment losses are falling out of the sky, too many investors forget their planning. Many have heard Warren Buffett’s “Be greedy when others are fearful” philosophy – slowing down and taking a breath during the bad news feeding frenzy will help give you some perspective on where you’ve been, where you’re at now and where you want to be.

Let’s think about assets

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The beauty of asset allocation

Asset allocation is basically how your assets are invested. About 90 per cent of portfolio volatility occurs due to the strategic allocation of your assets according to studies.

Sadly, most investors either lose control of their asset allocation through an overabundance of mutual funds, or they pay too much attention to the selection of their securities and market timing. While all aspects of investing are important, good asset allocation will help you sleep at night.

A careful combination of assets

Different assets will have different reactions to economic conditions. At different points in time, different assets will perform.

Equities, bonds and cash when invested prudently help soothe the impact of market volatility. An investor must determine what range of returns he or she is comfortable with. Speaking to an advisor can help you determine the asset mix for your individual investment goals.

The sound principle of rebalancing your asset mix

As all investors learn, over time investments perform differently. Those that grow quickly will soon be a greater percentage of your portfolio than originally invested.

If your objectives and tolerance for risk haven’t changed, your asset mix could become inappropriate. Your asset mix could prevent your achieving your long-term financial plan. For example, as your life changes, you may be more aggressive or more conservative as an investor; correspondingly, your asset mix should meet these important life events.

Having children is an event that might cause you to rethink your portfolio.

Rebalancing explained

Since managing risk is so important to investors, investors need to stick to their plan. Good diversification maintains a portfolio’s ability to grow, as well as an investor’s calm in the face of scary market events. Unfortunately, investors who are not privy to sage advice will often react hastily in the face of turbulent markets.

You should review, and when needed, rebalance your portfolio, either annually, or bi-annually, whichever is most suitable to each individual investor’s situation. Another possibility, in the face of wildly gyrating markets is to rebalance if any one asset moves notably from your set target.

A good rule of thumb to avoid an asset group’s drifting too far is to rejig one’s allocation if part of your portfolio has moved 5 – 10 per cent or more. While this can act as a target, many investors will reallocate using different metrics. What’s important is choosing a realizable goal, sticking to it, and making it work.

The secret is automating the process. When you make asset allocation automatic upon reaching a target, you take emotion out of the equation. And that’s exactly what you want to do. You may give up some gains in a rising market, but you’ll also give up catastrophic losses in a serious down market.

Preserving capital goes a long way toward realizing your portfolio goals.

An effective way to rebalance your investment portfolio is to sell some of an asset that has done well and reinvest your profits in investments that have lagged. As a result, if your equity component was 50 per cent and it increases to become 60 per cent, it may be wise to return it to its original amount and invest the rest in the fixed income component.

An advisor will definitely be helpful in aiding you in your goal of rebalancing your portfolio in an effectual manner.

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