Resist the urge to “do something”
Unless you’ve been away on vacation in a secluded place, you’ll know that stock markets sank alarmingly earlier this month as the U.S. Treasury bond yield curve “inverted” – that is, the yield on short-term bonds climbed above the yield on long-term bonds, albeit only very briefly. Fearing that an inverted yield curve signals a recession (as it often has historically), traders went into full-on panic mode, dumping stocks and moving to “safe haven” investments, like gold and, yes, bonds. The big North American stock market indices consequently lost ground, some sinking by triple-digit amounts in a span of two days. So is it really time to panic, sell all your stocks, and hunker down with your piles of cash?
The short answer is “no.” Acting on short-term market swings can dampen your portfolio’s overall longer-term performance, skew your asset allocation model, and increase trading costs. Short-term market volatility like this is not unusual at this time of year. Trading volumes are lower in the summer as traders take vacations, so any kind of news – good or bad – tends to exaggerate market swings. Trying to guess when these market swings will start and stop is called “market timing,” and no one ever gets it right, except by sheer accident.
That’s why it’s important for you to have a planned investment strategy. (Certainly, your portfolio managers and investment advisors have such a strategy.) With this plan, the foundation of which is your broad asset allocation, you’ll feel a lot more comfortable during the inevitable stock market downturns. Yes, your stocks will decline along with the broader market. But your bond holdings are likely to soar, offsetting losses in equities. That’s called prudent asset diversification, and it can mitigate overall portfolio risk.
That’s why I tell clients they should be in stocks, bonds, and cash at all times, instead of switching in and out of assets at random based on the market moves of the day. Allocating your asset mix according to your objectives and tolerance for risk, and adjusting it only according to pre-defined conditions, will give you a much greater chance of success in the long term.
A growth-oriented investor with a more aggressive outlook and willingness to take on more risk (that is, you are truly comfortable if your equity portfolio drops 10% or more) might allocate, say, 10% to cash, 25% to fixed income, and 65% to stocks. And you’ll stick to roughly this allocation through thick and thin. You’ll always have a largeish portion of your holdings in equities, but you’ll also have bonds to dampen overall portfolio fluctuations and provide some income, while your cash gives you flexibility. A defensive investor, looking to minimize risk, could have the allocations reversed, with 65% to fixed income, 25% to equity, and 10% to cash. A variation on these tight allocations might be to set ranges for allocations, for example, 45% to 65% stocks for a growth portfolio, and perhaps 25% to 45% stocks for a defensive portfolio, with commensurately adjusted ranges for fixed income.
In any case, successful investors know that regardless of your allocation philosophy, the path to investment growth is guided by my three proven principles.
- Discipline. Sticking to your plan is critically important. If you succumb to the “fear” part of the fear/greed equation each time the market indices take a dip, you’ve made a fatal mistake in your financial planning. If your asset allocation was good before the selloff, and your security selections made sense then, what’s changed? Those big blue-chip companies aren’t on the verge of going out of business, and governments will not default on their bonds. The discipline lies in making sure you don’t blow up your portfolio at every turn – because you’ll almost certainly do it at the wrong time.
- Patience. The longer you stick with your plan, the more likely you are to achieve your wealth creation targets, regardless of market fluctuations. Stocks outperform virtually every other asset class over the long term. The S&P/TSX Composite Index, for example, has returned an average 7.39% compounded annually for 10 years, as of July 31. That means a $10,000 investment in the broad S&P/TSX Composite Index through a passive ETF 10 years ago, with only $100 added every month, would today be worth $38,000! The important principle here is that you’d have made this little pot of gold only if you’d stayed in the market. And you’d have done that only by exercising patience.
- Prudence. Selecting individual assets for a portfolio can also be a challenge. For example, if you’re a defensive investor, you won’t be devoting a lot of time to speculative junior stocks. You’ll want to do your research and know what you’re investing in, including the history and outlook of any company you want to own. You’ll need to look at the fundamentals of a company, including earnings growth, cash flow, dividend growth and history, management, and a host of other factors. If you’re not keen on that sort of financial analysis, ask your financial advisor who they use for asset management and what their financial management philosophy is. Get the facts and figures and proof of performance. If you’re satisfied, only then should you make a decision. It’s only prudent!