Navigating Difficult Markets

 

One of the questions we’re often asked, in the middle of a period of market volatility, is how are we planning to protect portfolios.    Our response is usually that we’ve taken numerous steps before the arrival of volatility to protect the portfolio and that in the midst of a market correction, we’re more often taking advantage of opportunity rather than being protective.

 

When we review the chart below we’re reminded that stock market corrections (-10% or more) and bear markets (-20% or more) come along with a level of frequency that should result in most investors being unsurprised by their arrival.   Nearly annually for corrections and every 4 years for full blown bear markets.

 

The reality is that after helping our clients navigate capital markets for over 50 years, the volatility always seems to catch clients by surprise.  Perhaps that is because the circumstances that triggered the correction are often unique, inspiring the old adage “this time it’s different”.  This has been described by legendary investor Sir John Templeton as the four most dangerous words in investing.   The danger in those four words is that an investor will convince themselves to take action and protect their money – often resulting in an untimely sell decision near the bottom of the decline. 

 

Reality is that while it might feel unique ‘this time’, enduring market volatility is the price of admission for the premium returns that equity investing delivers over the long term - a price too dear to pay for most investors, especially those operating without advice or guidance. 

 

That aforementioned preparation for volatility in our portfolio construction can be boiled down to a few key concepts:

 

Owning Quality – every component of our portfolio is high quality, ensuring we’re not owning anything speculative or too weak to endure a period of protracted economic difficulty.  Quality gives us the confidence to hold or add to our position through periods of volatility.

 

Being Conscious About Price/Value – understanding how to value an investment and then ensuring we’re paying a fair or preferably discounted price is a key determinant of our future success.  If we overpay for an investment we are now beholden to hope – either the hope that we find someone willing to overpay even further to give us a positive return, or the hope that our investment suddenly sees accelerated positive change.  We’d rather target good value.  Coupled with owning quality, owning value also bolsters our confidence in negative markets and allows us in good conscience to add to our holdings.

 

Diversification – holding a well-diversified portfolio that gives us exposure to multiple asset classes (cash, fixed income, domestic stocks, global stocks, alternatives) and is then further diversified within each asset class ensures that we’re not overexposed to a particular investment at an inopportune time.  Ensuring that we are regularly rebalancing our portfolio to a client’s target asset allocation is an important step to prevent concentration from creeping into the portfolio. 

 

Even having ‘diversified’ exposure by owning something like a stock market index ETF doesn’t guarantee you’re truly diversified – there may be concentration issues within the index itself.  Consider the S&P500, the 500 largest companies in the US market.   As we write this note, the S&P500 index is down about -13% year to date, driven largely by the poor performance of the top 10 stocks in the index.   These ten companies represent 38% of the entire US index.  Here at home, the TSX60 index of the largest Canadian stocks often suffers from concentration issues lurking within. No time was this more evident than in the year 2000 when Nortel grew to represent over 45% of the entire index.  Within two years Nortel was worthless, taking TSX ETF investors for a devastating ride that cost them nearly half of their original index investment.