Posts Tagged ‘risk’
A question every investor should ask: What happens if the world doesn’t end?
Learn to harness your fear
Remember a few months ago when the economic news was so bad that optimism seemed naive?
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?
Click here for more about bonds and fixed income investments.
Click below for more about asset allocation and reallocation strategies:
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
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
Part Two — Bonds: Why you should love the unloved investment
Count bonds. Forget about sheep.
In the two years before the financial crisis, government bonds underperformed. Stock markets were hitting all-time highs and few investors were interested in bonds. However, as the risk premium for stocks was rising and stock indices in Canada and the U.S. were hitting highs, shrewd investors were reallocating their portfolios to include more bonds.
Bonds were unloved, but they were cheap, and when stock markets came down in a hurry, bonds acted like the buffers they are: they rose while stocks were coming down in portfolios.
The case for bonds in a portfolio as a permanent asset seems pretty solid. Let’s take a look at the last six months.
Over the last six months, stocks have finally gone into a correction. Stocks have been incredibly buoyant since the bottom of the 2009 crisis and have performed very well. But corrections are a normal part of the investing landscape. Corrections are healthy since they clean out the speculative element in the market periodically. Investors, on the other hand, especially average investors, aren’t huge fans of volatility.
Looking at the chart over the last six months, we can see that government bonds turned up as the markets headed down. Bonds are doing what they do, once again: smoothing out returns by acting like insurance in your portfolio.
Equities hit home runs, but bonds keep you from crashing into the catcher’s mitt and getting called out at the plate.
Equities should outperform bonds in the next few years because bonds have made out well recently, but good diversification together with prudent asset allocation suggest the average investor should have some bonds in the asset mix. Recent news has shown us how commodities and stock markets can change direction in a hurry.
The debt situations in Europe and the U.S. illustrate the importance of having Canadian bonds in a diversified portfolio. Canadian bonds are in a good place when it comes to quality these days. Just when many were saying Canadian bond returns had peaked and there was no future investing in them, boom, sovereign debt issues exploded in the media – again. Both recent history and the last few days are excellent reminders of why bonds have a place in the average investor’s portfolio.
Canadian government bonds may not work in a get-rich-quick scheme, yet when it comes to your portfolio, it pays to think. Think of bonds as insurance. Think of bonds before you go to sleep. In times of volatility, count bonds and forget about the sheep.
Part One is here.
Update: Foreign investors are also loving the unloved investment in Canada.
Bonds: Why you should love the unloved investment
Over the last couple of years bonds have been unloved. Interest rates have bottomed. Equities are historically cheap. The economy’s getting better.
Why debate any of the above? Surely, there’s some truth to these statements, and if you pay any attention to the financial news, you’ve heard them all.
Despite the lack of love for bonds, here are some reasons to hold bonds close to your heart through thick and thin, but especially through thin.
In 2009, when it seemed the earth had opened up and was swallowing investors and their portfolios whole, what did bonds do? They did what they’re supposed to do. Bonds acted like investment insurance. Bonds digested the increasingly bad news and turned that news into concrete returns. Interest rates plunged as governments moved to respond to economic fears, some rational, others less so.
Bonds or GICs?
The chart compares the Dex All Government Bond Index with 1-year GICs. Over three years, the bond index outperformed GICs by about 14 per cent. That’s roughly seven times the return. If you were invested in an ETF or a mutual fund holding Canadian government bonds, you would have made out well. And your investment would have been more liquid since GICs generally tie-up your money for the period you’ve agreed to invest for.
Stocks or bonds?
Over four years, if we compare bonds and stocks using the Dex Bond Index and the S&P TSX 60 Total Return Index, which includes dividends, we see that bonds outperformed. Of course, considering that the correction of 2009 was one of the deepest since the depression era, this isn’t much of a surprise. Bonds returned about 22 per cent while the S&P TSX 60 returned about three per cent over that period. It was an excellent period of outperformance for bonds.
The last few years, the financial media has been full of stories about why bonds won’t be the best of investments in the future. True. Bond prices are historically high at the moment, but every story should include that bonds tend to insure a portfolio – and they should always be part of a proper portfolio. Because they outperform, as demonstrated by the charts, when the stock market gets beaten down (see the financial crisis of 2009), bonds should always have their place in your portfolio.
No bonds? Your tolerance for risk had better be high. Bonds outperform when times are tough, and as bond assets rise they take some of the edge off the equities that are falling in your portfolio.
Why does this bond outperformance happen? Because during tough times, investors put their money in high quality investments like government bonds. Governments also tend to lower interest rates during times of financial turmoil. When interest rates go down, bonds become more valuable because the rates of interest they pay are more valuable when compared to new issues carrying lower interest rates. And that’s exactly what happened over the last four years. Bonds went from underperforming equities to outperforming them as jittery investors jumped into the asset class, and governments lowered interest rates in order to provide liquidity during the crisis.
Want to see a great infographic about bonds? (Somewhat U.S.-centric but still educational.)
Stay tuned for Part Two.
Infographic: mint.com
Success in succession planning
Planning is the key
There is no Superman.
If you’re in business, you need to plan for the worst. What would you do if your partner in business died or became disabled? Your business would feel it. A key player is gone or unable to contribute to the business. How might this affect your business, income, retirement?
Worth thinking about, isn’t it?
A thoughtful business
First of all, a well-crafted buy-sell agreement is crucial. You need a set of ground rules in case of conflict. You need a buy-sell agreement so that you can engage in a mutually beneficial relationship with your partner. You and your co-owner need to set down the rules of your business. That way there will be little to surprise you. Protected by identical rules in case of the unforeseen, you’ll both be secure in that eventualities will have been thought of, and a system will be in place to deal with them.
An accord
Within a buy-sell agreement, there are clear rules for succession whether due to death or other events. The agreement will benefit the interests of all shareholders. Without a buy-sell, your business, your income and your family could face difficult circumstances. A buy-sell establishes secure commitments and responsibilities for buyers, sellers and heirs. With a proper agreement, you can feel secure that provisions have been made for triggering events.
Death, disability, divorce, retirement, bankruptcy or discord between co-owners are all critical life events affecting a business. Plan and you will grow.
Insure there are no “what ifs”
Your partner dies. Now where do you get the funds to acquire his part of the business? What if there are many partners? You may have enough money to buy the outstanding shares, but is your money liquid? What if you had to sell assets at a bad time?
As you can see, it’s important to have options. Borrowing money is a possibility, but you’ve got to pay the loan back with interest. After tax dollars that can’t be deducted are rarely the best way to go.
Insurance policies provide many empowering options. They are a fairly inexpensive way to have the funds on hand. The policy will guarantee that there is cash available in a lump sum when the triggering event occurs.
Assuring continuity
If your buy-sell agreement is funded by insurance, you will be liquid at the exact time you need to be. Your business survives the loss that can occur due to forced liquidation, death or disability.
The buy-sell provides direction to remove the risk of friction from surviving owner(s) or heirs, and provides for continuity in the operation of the business. Furnishing life insurance to diminish business debt or offsetting a shortage in sales because of the death of a co-owner or other key person in the business can be structured into the agreement.
Planning is fundamental. Why wait for a catastrophe? Get effective insurance protection. Eliminate insecurity.
There is nothing to fear, but the lack of planning and preparation.
Asset allocation: Diversification is king
The king and you
Invest in different asset classes, across geographies, sectors and styles, and the impact of any one investment on your portfolio is diminished. Most investors, especially new investors, worry about poor performance but forget about the importance of diversification.
For example, if your only investment is your house, then you’re not very diversified. Ask anyone who was overloaded in U.S. residential real estate about how lack of diversification can negatively affect your portfolio.
These days diversifying is easier than ever. You can invest in real estate, international stock and bond markets, emerging markets and commodities. You don’t have to simply depend on domestic stock and bond markets as much as investors once did.
But what is important is considering the risk/reward features of these asset classes. You don’t want to invest too little or too much in any one asset.
The challenge of asset selection
The number of investments available today is truly staggering. Individual stocks and bonds, mutual funds, ETFs and managed accounts are only a few of the types of investment options. If you want to manage risk well, you have to evaluate how each investment will impact your portfolio.
Benchmark indices help financial professionals gauge the performance of their assets under management. Some investments are designed to very nearly track these indices. Many exchange-traded funds seek to offer investors nearly the same performance as indices.
Individual securities or actively managed funds hold out the potential to outperform the indices they are based on. However, these investments rarely do outperform. And they often carry higher risk and higher management fees that are a detriment to an investor’s overall portfolio depending on the extent of an investors understanding of markets, and the level of advice she may need.
Determining the level of risk you are comfortable with is crucial. Mixing index and active investments into your portfolio will benefit you when it comes to the end result of achieving your objectives.
Rebalancing
Rebalancing your investments is key. Periodically, investors should review their portfolios and re-assess their investments and long-term goals. Often, this requires selling your best-performing investments along with the discipline to execute your plan.
“Buy low and sell high” may be the mantra investors want to follow, but for many, it’s easier said than done. Risk management best practices suggest that an investor must pay just as much attention to selling high as buying low. Getting overly greedy after a good run in the markets is dangerous to your portfolio.
By rebalancing, you can stay on track. Proper asset allocation helps you stick to your risk/return objectives. Although this sounds easy on paper, it’s not. Systematizing the rebalancing process is one of the most important processes of a sound investment plan.
How to be a smarter investor
Most people obsess about investment performance. While tracking the performance of your investments is without a doubt important, are you considering risk?
Investors generally understand risk. For example, not meeting investment goals stands out as a hazard when it comes to portfolios. But without risk, there is no return. You have to take some risk to earn better-than-average returns.
So, how should you consider risk? How does risk fit into your portfolio? If risk and reward are so heavily correlated, how much should you be taking? How can you manage risk properly?
Understand risk
What is risk, anyway?
You can’t control everything. The recent market meltdown was out of investors’ control. But how you organize your portfolio is within your control. And that’s empowering.
Most Americans investing in residential real estate didn’t think they were taking on a lot of risk. Yet U.S. residential real estate dropped by about 50 per cent from its peak. You definitely increase your risk with all your eggs in one basket. But you can manage risk. You can create less uncertainty and the stronger probability of meeting your investment goals.
Are you taking on too much risk? Is there overlap in the securities or funds you hold? You think you’re well-diversified, but are you really? On the other hand, if you’ve been holding only low-risk, low-return investments like GICs over the last ten years, you might feel sorry. Why? Because if you held a basket of Canadian financials (even with two major stock market corrections), you would still come out ahead. Yes, risk offers the potential for higher returns. However, you need to determine what the appropriate amount of risk in your portfolio is.
In order to create an intelligent investment plan, you need to evaluate your risk tolerance. You need to ask yourself questions like … How much risk are you willing to take? Is a very conservative strategy going to allow you to achieve your investment goals? Research shows that being too conservative also entails risk when it comes to achieving portfolio goals. Risk is not only about aggressive investments. Conservative investments carry risk, too.
Risk, by any other name, is still risk
Risk can take many shapes and forms. Do you have the right investments? Are you being too aggressive? Or maybe you’re not being aggressive enough? The best way to consider risk is by having a sound investment plan.
Considerations for your investment plan
• Asset allocation
• Choosing assets that will make up your allocation
• Rebalancing your portfolio
In an upcoming post, I will discuss the above fundamentals.