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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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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

Part Two of RESPs for the educated mind

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If you missed the first part of this article, please go here to see it.  

  • Organize your books Get the required documentation from the post-secondary institution your child’s going to be attending. RESP carriers need proof of enrollment. Make sure you’re going to have the cash when your child needs it. Get the needed documentation to the plan carrier as early as possible.
  • Leftovers can be better than an apple a day Should you find yourself in the position at the end of your child’s post-secondary education where you have contributions left in the plan, do a little dance. You can use that cash any way you want. Transfer the money to another child’s plan, or withdraw it and use it yourself.
  • Do your homework on tax savings If you withdraw earnings from the RESP, it’ll be taxed as a portion of your child’s income. But your child’s income is likely to be low. In fact, children’s incomes are often effectively tax-free because their income is usually very low.

An RESP is an enormous benefit for those using the plan. It’s the correct answer when it comes to the cost of education, and the government helps you with education expenses. A better educated workforce and a helping hand go a long way toward helping parents and society in general – let the government help you keep your kids in school. With inflation once again looking like it may rear its head, an RESP is a significant tool when used intelligently. Financial security and a paid post-secondary education give kids, and parents, a hand up when they need it most.

RESPs for the educated mind

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The kids are all right

Strategy. Strategy. Strategy.

You have watched your child grow and develop. You can’t believe it, but your little bundle of joy has grown up, has her own opinions and philosophies and is now ready to embark on one of her greatest adventures. Higher education. Goodbye high school. Hello post-secondary education.

Remember your own first year in university or college? Everything looked so big … How could you possibly get from one end of the campus to the other in five minutes? The excitement … The feeling of learning and collaborating … And now, it’s your own child ready to swing the door open to a whole world of possibilities. Immensely proud, you have some small, nagging worries about your child getting a great education and a smooth path into the future.

You have planned for this, though. Long ago, you established a Registered Education Savings Plan (RESP). And now, that long-term thinking is about to pay off. You might think your financial planning and strategy for you child’s education is done …

Think again.

Did you know that the way money is withdrawn from an RESP is enormously important? Strategizing doesn’t end now – it evolves.

Just like that little baby that grew into a teenager ready to take on the world.

  • Limit withdrawals – Remember the government … The government limits the withdrawal of RESP income and Canada Education Savings Grant funds including the CES Grant. Government restrictions on a maximum of $5,000 in the first 13 weeks of your child’s program, might leave you searching for extra funds, tempting you to grab some extra cash from the RESP to add to the $5,000. Avoid this redemption, if possible. Think long-term. Investing is often about deferring tax. Redeeming early undermines a registered plan’s tax-deferred growth potential just as leaving college or university early may limit your child’s future possibilities. Even worse, if the program doesn’t qualify, you’ll have to repay a portion or the entire CES grant!

Wait a minute … Didn’t you start this plan to give your child an advantage?

Yes. And knowledge will help you graduate RESP complexities with honours.

  • Get permission for an early withdrawal – And get it in writing. You can exceed the $5,000 limit on the withdrawal of RESP earnings by requesting permission in writing from the Minister of Human Resources. Avoid withdrawing plan capital (and a repayment of CESG funds), but make your request early. By making the request as soon as you can, you’ll get a timely response and be able to determine if this plan works for you before school begins.

The government could request a payback …

  • Strategic withdrawals avoid paybacks The government may ask you to pay them back the CESG grant money if they see earnings remaining in the plan after your child graduates or leaves school. Avoid the potential CESG payback, be sure to use the plan’s earnings before withdrawing contributions.

Part Two is here.

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