Rebalancing investments in two steps

A disciplined investment process begins with determining the asset mix that is right for you. By asset mix we refer to the portion you have in one of three broad categories of investments, including cash, fixed income and equities. Fixed income includes guaranteed investment certificates, term deposits, bonds, bond exchange traded funds, debentures, preferred shares, etc.. Equities are what many would refer to as the “stock market”. Life, markets and your asset mix all change with time. Decisions you made yesterday may not hold true with new information tomorrow. This is the reason that your investment strategy is not just about the markets. When you buy a house, have a child or approach retirement, your investment goals will change. As your goals change, so might your asset mix. For example, the asset mix of a very aggressive investor would not be suitable for someone who is retiring in the coming years. Just as major life events change us, we can also look at major market events as changing the way we look at our portfolio. For some investors this may be an opportunity for reflection. You may ask yourself if your “normal” asset allocation is still valid once you have considered any changes in your life. If that answer is yes, then when markets change as they do, it may also be time to consider rebalancing your portfolio back to its original mix.

Interest rate changes and market movement results in fluctuations between asset mix. From the day you begin investing, your asset mix is constantly changing. To illustrate, we will use Thomas and Heather Bennett who invested in a portfolio with the following asset mix: Cash 0 per cent, Fixed Income 40 per cent, and Equities 60 per cent. Asset classes do not change at the same rate. Over time, stocks may grow faster than bonds making the growth in your portfolio uneven. For example, the Bennett’s portfolio that started with 40 per cent bonds and 60 per cent equities could drift to 30 per cent bonds and 70 per cent equities if the stock markets rise, or alternatively the other way to 50 per cent bonds and 50 per cent equities if a stock market correction occurs. Regardless of the direction of the change in your portfolio, it is necessary to remember the importance of the reasoning behind your original asset allocation. Although it may seem counter intuitive to sell an asset class that is doing well or buy one that is not, however that is precisely what is required if the fundamental principle of “buy low – sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk.

Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counterintuitive. When markets are down, human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.

Although at times, the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit to doing so can be significant over the long run with compounding returns. It is important to talk to your advisor initially to determine your optimal asset mix that you are comfortable with, often documented in an Investment Policy Statement (IPS). Once you have a documented IPS then your advisor can establish a customized portfolio that matches your IPS.

Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review you IPS to ensure that you’re comfortable with the asset mix. Changes in market conditions and interest rate outlook are factors to discuss with your investment advisor when revising the asset mix within your IPS. Your personal goals, need for cash, and knowledge level may also result in your asset mix needing to be adjusted.

The asset mix is the macro decision within the IPS and is the first step in rebalancing. Step two of rebalancing is looking at the micro items, such as sector exposure and individual companies you have invested in. It also may involve looking at geographic exposure, credit quality and duration of fixed income, and mix between small, medium, and large capitalized companies. Up above, we noted that the Bennett’s initially wanted 60 per cent in equities and started with total investments of one million. The equity portion of $600,000 was divided into 30 companies with approximately $20,000 invested in each company. Over the last year, the Bennett’s now have a portfolio valued at $1,080,000 with 63 per cent in equities and 37 per cent in fixed income. Step one for the Bennett’s rebalancing of the asset mix would result in them selling three percent of equities, or $32,400, and allocating this to fixed income.

Step two in the rebalancing process highlighted that several stocks performed very well and are above the new individual recommended position size of $21,600 ($1,080,000 x 60 per cent divided by 30 companies). We also noted that stocks in two sectors performed very well and have resulted in the portfolio being too concentrated in those sectors. Step two of the rebalancing process resulted in the Bennett’s selling a portion of the star performers in the overweight sector.

When significant deposits and withdrawals are made then this is an ideal time to look at both macro (step one) and micro (step two) rebalancing. This could be when you are making an RRSP or TFSA contribution or when you have to decide what to sell to raise cash for your goals. If no deposits or withdrawals are made then periodic meetings with your investment advisor should have ‘rebalancing your portfolio’ as an agenda item. Some people may want to rebalance quarterly while others may feel an annual check up is sufficient.

Managing market volatility

Investors are often told not to consider investing in equity markets if they are not in it for the long term.  For some investors a year or two might seem like a long time but this should be considered the early stages of embarking upon exposure to the markets. The following should provide some perspective as to what the markets have done over the past couple of decades.

Over the ten-year period from January 1, 2002 to December 31, 2011 the S&P/TSX Composite Index returned a total 97.27%.  This may seem high given the nearly 50 per cent pull back in early 2009 and other volatility periods.  It does highlight the power of dividends and long term investing.

The actual annual percentage returns (losses) of the  total return for the S&P/TSX Composite Index were as follows:  2002 (-12.44), 2003 (26.72), 2004 (14.48), 2005 (24.13), 2006 (17.26), 2007 (9.83), 2008 (-33.00), 2009 (35.05), 2010 (17.61), and 2011 (-8.71).

We noted that three years ended in negative territory, and seven years ended in positive territory.  We also noted the extremes of a loss of 33.00 per cent in 2008 and a gain of 35.05 per cent in 2009.  The above information reinforces something we already know – the stock market does not move in a straight line.

An important component to investing is having an Investment Policy Statement (IPS).   One component to an IPS is establishing your annual growth target to reach your objectives.  Do you need 8 per cent to reach your objective?  Possibly you only need to earn 6 per cent to reach your goal.

The higher annual growth you desire, the greater degree of risk you will have to assume.  Increasing risk in your portfolio does not always equate to higher returns.  High-risk portfolios run the possibility of experiencing a negative year (i.e. 2002, 2008 and 2011).

How does a negative year in the markets impact your portfolio? The table below shows how the first year investment returns affects the average annual returns required to reach respective targets of six and eight per cent.


First Year



Time horizon to meet your annual growth target *    



































































































* Required average annual return to reach stated annual growth target (with different outcomes)

An investor who began investing in early 2008  may have a significantly different outcome then an investor who began investing in mid 2009.  When we have new clients that have a lump sum to invest (i.e. selling a home, inheritance) we communicate the importance of reducing market risk.  Several simple strategies exist to reduce this risk.

To illustrate we will use Tom Henderson – a fifty year old man who plans to retire in five years.   Tom has determined that he requires annual growth of eight per cent each year to reach his retirement goals.

A positive outcome after year one would be growth of eight per cent or greater.  Assuming markets are good, let’s say Tom’s portfolio returns 15 per cent in the first year.  If we look at the table we see that Tom can now reach his objective by returning only 6.3 per cent for the remaining four years.  Tom should shift his portfolio to be more conservative based on the lower annual growth requirement to reach his goal and rebalance his portfolio.

The attached table is very effective in illustrating the impact of negative outcomes.   Instead of earning eight per cent in the first year, what if Tom’s portfolio declined 15 per cent?   In order for Tom to get back on track he would have to earn 14.7 per cent each year for the next four years.  Although this is achievable, it is significantly more difficult to achieve than eight per cent annually.

The key point to take away is that portfolios should be structured with the appropriate amount of risk.  As an example, if you only require a five per cent return per year then you should have a greater allocation to fixed income, such as bonds, GICs, and preferred shares.  It would be prudent to lower the percentage exposed to the stock market.

As your return expectations increase, so does your exposure to the stock market.  Although the stock market is biased in the long run to increase, there will likely be both positive years and negative years over your time horizon.

Energy investments have risks

Energy stocks represent approximately one quarter of the weighting within the TSX/S&P Composite Index, which isn’t surprising given the rich resources available in Canada and high demand world wide.  Everyone needs energy and power, unless you’re living in a cabin in the wilderness.  Let’s take a look at the energy sector in three categories:


If investors are looking for lower-risk options in the energy sector, the first place to look is often within infrastructure.  Two names in this category that are hitting the media in 2011 are TransCanada Corporation (controversy over Keystone pipeline through US to the GulfCoast) and Enbridge Inc. (controversy over pipeline to Kitimat).  These two stocks are considered lower risk within equities.  There are numerous pipeline and infrastructure type energy investments; many of these same stocks pay a good dividend.  In our opinion, stocks within infrastructure can be traded but many are also good long term holds.  Risks within this sector are:  interest rates, power prices, age of infrastructure, natural disasters, accidents, poor maintenance, commodity volumes, regulatory approvals, and environmental legislation.

Equipment and Services

The equipment and services stocks within energy are typically higher risk.  Servicing wells and drilling can be a very profitable area when times are good.  When energy commodities decline below certain thresholds, many of these companies go into survival mode.  As an example, if the price of a barrel of oil declines below $68, many companies may stop drilling until the commodity rises in value which would hurt the equipment and services side of energy.   If an equipment and services company pays a dividend, it is often on the lower end and can fluctuate based on conditions.  In our opinion, stocks within equipment and services should be monitored continuously and traded.  Risks within this sector are:  commodity prices, labour supply, access to supplies, weather, contract risk, foreign exchange, customer concentration, political risk, and technological acceptance.

Oil and Gas

Oil and gas are perhaps the first two things that people will think of when we talk about energy.   Another term for upstream is exploration and production which essentially means that a company specializes in finding oil and gas fields under the ground or under water.  E&P also includes drilling of exploratory wells, and operating the wells to bring crude oil and natural gas to the surface.  Getting it up and out of the ground is essentially upstream. Downstream is when a company is dealing with the oil and gas once it is out of the ground.  An example of this is crude oil being refined.  Converting the raw material into products such as gasoline, diesel, natural gas, propane, heating oil, etc. are all examples of downstream activities.  The distribution and retailing of these products to the consumer is also an example of downstream.

Integrated Company

Some of Canada’s largest energy companies are considered integrated.  This essentially means that it does both upstream and downstream activities.   A company like Suncor would essentially buy land, explore it, drill it, extract the oil, refine it, ship it, and retail it.  Integrated oil companies generally have a risk classification between medium and high.   Risks include drilling program success, commodity prices, estimated reserve life, method of extraction, project execution, weather, and political and regulatory risk.

Geographic Diversification

Although Canada is rich in oil and gas many of the world’s largest fields are outside of North America.  Many Canadian oil and gas companies have operations purely within Canada.  Some concentrate within one province, while others have operations in four or more provinces.  Many energy companies listed on the Toronto Stock Exchange have operations outside of Canada.   Many investors bullish on the energy sector diversify by geographic region.  Additional risks exist for companies with operations outside Canada including political interference, foreign currency, agreements being changed or cancelled, and unfavourable changes in taxation.

Operational Mix

If a company has just oil, it would be considered a pure play oil company and it’s the same for gas.  Most energy companies are not pure play because most have fields with both oil and gas.  Depending on the prices, a company may choose to focus on one or the other.   It is possible to look at the operational mix of a company to see what assets it owns and the percentage weighting between oil and gas.

Supply and Demand

The peak oil theory is often referred to when investors are bullish on the energy sector.  With a limited supply, this theory supports that prices should rise over time.  New technologies of extraction and massive discoveries in the short term can impact this theory.  Individuals bullish on this sector also have done analysis on the growing population and the rising demand for oil and gas in emerging markets such as China and India which supports energy prices rising over time.  Over the years, fears of global economic slow downs have resulted in significant corrections to energy commodities.

Unlike material stocks, many oil and gas stocks have a decent dividend yield.  We encourage growth oriented investors to look at the dividend reinvestment plan on the energy stocks they own, as many offer discounts for participation.


Diversify materials to reduce volatility

The materials sector is one of 10 on the Toronto Stock Exchange and a way to diversify your investment dollars.  Materials represent nearly a quarter of the value within the TSX/S&P Composite Index and these hard assets are viewed as valuable because most have a limited supply.  When meeting with a new client, the best way we can begin explaining the materials sector is to break t down into four baskets.  We do this because even within the materials sector, the individual baskets can react considerably different during changing conditions.

Basket One: Precious Metals

The greatest weighting within the materials sector is precious metals, including gold and silver, and diamonds.  Most precious metals shares that trade on a stock exchange have more than one metal.  As an example, gold companies often end up with silver, or some other material, during the mining process.   However, it is possible to look at a company that is focused primarily on one material.   Most companies break down the percentage of each metal as a percentage of its operations.   People who focus on this basket are generally bearish on the markets.

Basket Two: Growth Materials

If you’re bullish on the markets, then your underlying belief may be that the economy will continue to grow.  You may see growth continuing either domestically or in other regions, such as emerging markets.  If the economy is expanding then various materials are needed, such as coal, nickel, cobalt, molybdenum, iron ore, zinc, and copper.  Like precious metals, there is a limited supply – as demand increases so should the price of the underlying material.  On the flip side, if global growth is expected to slow then you would expect these types of materials to decline in price.

Basket Three:  Agriculture and Fertilizer

Agriculture and fertilizer stocks have been growing in popularity in recent years.  A growing population and shrinking agricultural land space gives a good argument to have exposure to this area.  Rising food costs are one area that is consistently linked to higher inflation.  Extreme weather patterns, quality of crops, and economic conditions will play an important role in this basket.

Basket Four:  Other Materials

Forestry products are an example of a renewable material.   Foreign exchange rates, housing, and general economic conditions will have a direct impact on this material.  Uranium is used for power, medical devices, and other various industrial uses.  Uranium is also linked to nuclear weapons and has some groups strongly opposing its use, especially after some recent disasters.  Attitude towards the use of uranium and other costs of energy are key risks for this material.  There are also materials used in products such as cellphones and televisions, referred to as rare earth metals with names ranging from cerium and dysprosium to Thulium and Ytterbium.

Diversify Materials

Depending on which advisor you speak with, some may like to concentrate on materials from a specific basket noted above.  An example of this is a person who really feels negative about the economy and chooses to overweight gold.  This would be a targeted approach to materials and one would be speculating to some extent.  A diversified approach is to purchase materials stocks in more than one basket.

Volatility and Risk Tolerance

Prior to investing in any materials stocks we caution investors to understand that these stocks will be more volatile than other sectors.  People should have a medium to high risk tolerance prior to investing in materials stocks.   The TSX/S&P Composite Index is currently comprised of approximately 24 per cent in materials stocks.  We recommend you speak with your advisor about beta risk, and other potential risks prior to obtaining any significant weighting in this sector.

Producing Versus Development

One area that should be looked at from a risk stand point is whether the materials stock is producing or is in the development stage.  Companies that are in the development stage are higher risk.  As inflation rises, so do the costs of getting a start up mine to the completion, or development stage.  A huge amount of capital is required to develop a mine.  Looking at the current level of cash and the overall economy is essential to determine if the company could survive if times got difficult or the material being mined suddenly declined in value.

Small Cap Versus Large Cap

Nearly all materials stocks start out as small capitalized companies.  Getting the company to the stage that it can be publicly traded is the first hurdle.  On the opposite side, some of Canada’s largest companies are in this category.  The top ten large capitalized materials names in Canada are:  Barrick Gold, Goldcorp, Potash Corp of Saskatchewan, Teck Resources, Kinross Gold Corp, Ivanhoe Mines, Silver Wheaton,  Agrium, Yamana Gold, and First Quantum Minerals.

Growth Stocks

Most material stocks are considered growth stocks.  Developing companies and smaller producing companies do not typically pay dividends.   Some of the largest producing companies may pay a small dividend.  The underlying reason to purchase these types of stock is to obtain growth in the underlying share price.  In our opinion, investors who purchase materials (growth stocks) must periodically trade them in order to obtain profits.  This is even more important if the underlying company is cyclical.

Investment Options

Investors have various options when it comes to obtaining materials exposure.  Using gold as an example, one could purchase any of the following:  physical bullion, gold Exchange Traded Fund (ETF), gold Exchange Traded Receipt (ETR), gold closed end fund, materials mutual fund, or gold common shares.  An advisor can assist you with understanding the pros and cons of each approach.

Balancing income, growth in volatile market cycles

There are good reasons to work with a qualified investment advisor when the markets are so volatile.  The ups and downs of investments are not only time consuming, but also emotional draining.

It is essential to design a tax-efficient income portfolio to generate investment income, which helps with cash flow needs to work through market cycles.

GICs, term deposits, and bonds pay interest income.  Preferred shares pay dividend income.  Many common shares also pay dividend income.  Creating the right balance of investments that generate both growth and income comes down to risk tolerance.

Looking for investments that pay income – rather than just growth alone – is a successful approach.

Income is often a key component for the decision to invest.  If a $500,000 portfolio is generating $20,000 of interest and dividends, this provides a buffer, even if markets are flat or decline slightly in the short term.

Periods when investments are generating income and the markets are doing well reward patient investors.  When your portfolio has hit a new high, it is natural to mentally calculate this as part of your overall net worth.  This maximum value is known as the high-water mark.  But it is health to remember the dollar amount you started with initial to avoid th emotions when values drop from the highest market value.

If you have given an advisor a lump sum several years ago and have made no withdrawals or deposits, then keeping track of overall returns is straight forward.  It gets a little more complicated if you have deposited funds or withdrawn funds over the years.

Many people have purchased investments either to create long term growth (during working years) or for the income component they generate (during retirement).   The term “unrealized” refers to investments that you have purchased and you continue to own.  Investment statements often have a term unrealized gain or loss, which is the difference between what you originally paid for the investment and the current market value.

Until investments are sold they are not “realized”.  Positions that have been sold are removed from the statement, making recalling what you started with more difficult.

Investors who have investments that generate investment income should factor this into the total return for an investment.

Let’s assume a year ago you purchased $10,000 of a large company paying a five per cent dividend.  Today the position on your statement is showing a book value of $10,000, which represents your original cost.  The market value is showing $9,840 and the unrealized loss amount is $160.  However, this $160 amount is not the total return on an investment.

During the year, you received $500 in dividend income from this investment which does not change the original cost or the current market value.  The total return (before tax) on this investment is really $340, not an unrealized loss of $160.

The above example is quite simple because we have used an investor who has held an investment for exactly one year and the dividend was constant for the period.  What happens if you have held an investment for many years?  What happens if the dividend rate has changed or you have set up the dividend reinvestment plan (DRIP)?  Some people have kept track of the total income paid to them for each investment on an annual basis.  This will assist investors in calculating the true return on an investment during the total holding period before tax.

The next challenging part to the above is that some investors will have to factor in the tax component if the investment is held in a taxable account.  For investments paying income report taxable distributions on T3 and T5 slips in which you pay tax on even if you have not sold the investment.  Tax from T3 and T5 income has to be paid even if the underlying investment has declined in value from your original cost.

If you hold foreign investments then you may also have to factor in a currency gain (loss) once the investment is sold.  This becomes more complicated if dividends have been paid, especially if withholding tax has been applied.

Another important point to review is that realized capital losses can generally only be applied against realized capital gains (not interest income or dividends).

You are permitted to carry net capital losses back three years and forward indefinitely.  Upon death, net capital losses convert to non-capital losses and can be applied against all sources of income.  If a person passes away with both unrealized losses and realized losses, there likely is some tax planning that should be considered, especially if the deceased had a registered account.

If you have a non-registered account, it is important to understand the tax differences between interest income, dividend income, capital gains, and deferred growth/return of capital.  Total return should factor in the change in underlying market value of the investment, income received, foreign exchange gain or loss, transactions charges, and tax consequences.


Managing emotions, money during volatility

Financial planning would be easier if markets returned a steady percentage each year.  Unfortunately this has never been the case for the stock market – and never will be.

The Elliott Wave Principle reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific and measurable patterns.

Illustrating how the markets have had their ups and downs can easily be looked at by summarizing the year-to-year returns for the S&P/TSX Composite Index for the last ten years:

2001 -13.9% 2006 14.5%
2002 -14.0% 2007 7.2%
2003 24.3% 2008 -35.0%
2004 12.5% 2009 30.7%
2005 21.9% 2010 14.5%

Even within the current year we have experienced a bit of a roller-coaster ride in the stock market.  To deal with these bumps, it comes down to your underlying belief about the current economic conditions and your long-term outlook.  Some people may feel that the current times are difficult and they do not see investment opportunity.  The other extreme is that any market pull back is an opportunity for long term investors. Having both bears (sellers) and bulls (buyers) really is the essence of what creates a market.

After nearly every period of volatility we read about how the wealthy are getting wealthier and the poor are getting poorer.  Some of the reports can be read through the economic data on the Conference Board of Canada website.   Historically the stock market has recovered from the problems of the day.  Knowing the history of the stock market and reading some of these reports, makes us reflect that it generally pays to be on the optimistic side when times get rough.

A lot is riding on a stable stock market.  Government bodies require returns on their investments and benefit from stable and growing markets.  Pension plans require returns on their investments to pay out benefits to retired employees.  Insurance companies collect premiums that must generate a return to fund future payouts (annuities, death benefits on life insurance).  Companies require stable markets to raise both debt and equity.

People who are able to survive best during periods of market volatility are those who have saved a little extra for retirement.  This buffer is becoming increasingly important during periods of volatility.  Some people are simply not saving enough for retirement.   Compounding the problem is that many of these same people have to take on too much market risk to generate the retirement income they need.  When times are challenging, the lack of proper retirement planning means some people are going to feel more anxious about their financial situation.

Being aware that the markets are volatile, and interest rates are low, means that investors are best advised to factor this into their financial plans.  Ensuring that you have a balanced portfolio with cash, fixed income, and equity investments at retirement is a critical step.  An example of a balanced portfolio at retirement is 10 per cent in cash, 30 per cent in fixed income, and 60 per cent in equities.  If you are able to generate sufficient income at retirement with this asset mix then weathering volatility should be easier.

Prior to retiring I feel it is critical to know how much income you require from your investment portfolio.  Knowing this in advance and communicating this to your financial advisor should enable them to map out the right asset mix.  Ensuring cash is available at the right times, will ensure that you are not selling equities at the wrong time in the market cycle.  Cash will protect you against bad timing in the short term to fund your cash flow needs.

There are different rules of thumb regarding how much cash you should have at retirement.   As a guideline, one year should be used as the minimum. Some investors are more comfortable with two years.  This cash component can give you the reassurance that investments do not need to be sold at the wrong time.

Purchasing fixed income investments that are laddered – like a bond maturing yearly for the next 10 – can assist in replenishing cash when needed.  With a laddered bond strategy it may be necessary to periodically rebalance asset categories of cash, fixed income, and equities.

As an example, we will use a couple who have income from pensions, CPP, and OAS.   In addition to this income they feel they will need to generate $30,000 per year from their $600,000 portfolio.  The cash flow needed for this couple is five per cent of their portfolio.  At a minimum they should have five per cent in cash at the beginning of the year, possibly up to ten per cent if they want to have extra security.

A downside to having this cash component is that the return on this portion in the long term is lower than other asset classes.  This is one of those sacrifices we feel investors should factor in to their retirement plans to protect against volatility.


Monitoring market caps helps with risk management

Market capitalization is defined as the price of the company’s stock multiplied by the total number of shares outstanding.  As stock values change, so does a company’s market capitalization.

It can be argued that a well-diversified portfolio should have holding of different market capitalizations, and there are some distinct advantages and disadvantages to holding a mixture of small and large capitalization holdings.

Some indices and mutual funds attempt to categorize stocks into three broad categories – small cap, mid cap, and large cap.   There is no universally accepted definition of these categories.

To provide some examples, we have noted three methodologies below:

  • BMO Nesbitt Burns Canadian Small Cap Index: This Index is intended to represent the Canadian small capitalization equity market and includes approximately 400 stocks trading on the TSX.  This Index is comprised of stocks with a market capitalization of less than 0.1 per cent of the total capitalization of the S&P/TSX Composite Index.  This is an example of a “floating” index and the value would change daily.
  • Canadian Investment Funds Standards Committee:  The categories are determined by allocation, geography and cap size and are set quarterly.  As of December 31, 2010 the thresholds are:   Small/Mid Cap Equity:  $2.6 billion (CAD), Canadian Focused Small/Mid Cap Equity $3.5 billion (CAD), U.S. Small/Mid Cap Equity $5.5 billion (CAD), Global Small/Mid Cap Equity $4.7 billion (CAD).
  • Morningstar US Categories:  Giant cap stocks comprise the top 40 per cent of total US market capitalization.  Large cap stocks make up the next 30 per cent. Mid-cap stocks are defined as being part of the next 20 per cent while small and micro-cap stocks comprise the smallest 10 per cent of the total US market.  The absolute breakpoints are updated periodically to ensure the definitions of each capitalization range fluctuate appropriately with the market. Generally though, market cap breakpoints will be as follows in the US:  Giant $40 billion plus; Large $8 to $40 billion; Mid: $1 to $8 billion; Small $500 million to $1 billion; and Micro less than $500 million.

The following are the largest ten companies in the world by market capitalization as of market close on April 21, 2011 (in USD$ billions):

Exxon Mobil Corp 425.9
Petrochina Co. 330.2
Apple Inc. 324.4
BHB Billiton Ltd. 262.0
Industrial & Commercial Bank of China 259.8
China Const BA – H 239.3
Petrobras 237.4
Royal Dutch Shell 235.6
Chevron 216.6
Microsoft 214.1

The following are the largest ten companies in Canada by market capitalization as of market close on April 21, 2011 (stated in CAD$ billions):

Royal Bank of Canada 89.5
Toronto-Dominion Bank 76.8
Suncor Energy Inc. 70.7
Bank of Nova Scotia 65.3
Barrick Gold Corp. 55.0
Canadian Natural Resources 50.9
Potash Corp of Saskatchewan 49.9
Imperial Oil Ltd. 44.9
Goldcorp Inc. 44.3
Bank of Montreal 37.4

Our largest Canadian companies are well down the list when looking at the world.  Many companies that we consider large here at home would be small when looking at the total universe of stocks.

There are several benefits to investing in large capitalization stocks.  The stocks are often classified as “blue chip” and should provide a combination of growth and income through dividends.

Most large companies in Canada have several research analysts that cover the stocks, which provides greater transparency and different opinions.  In declining markets, large companies should exhibit less downside than smaller companies.

Purchasing small capitalization companies can be rewarding in up markets, especially in certain sectors.  On the other hand they come with several challenges.  Most small companies have either few, or no analysts covering the stock.  If only analyst is covering the stock, it’s important to determine if that person is truly an unbiased analyst.

Many pension funds and institutions have investment policy statements in place that state that they can not invest in companies below a certain size.  This is for many reasons, including the lack of transparency and liquidity that comes with buying and selling small companies.

If you want small-cap exposure, then purchasing a mutual fund with this mandate may be the best risk adjusted approach.  Investors should use caution prior to purchasing small cap companies.

Tracking your risk, optimizing your reward

A financial advisor is required to document risk tolerance and how much you are willing to assume.

Every investment account should have set percentages for low, medium, and high risk.  Your RRSPs, for example, may have the following percentages:  25 low, 50 medium, and 25 high.  Note every account has to add up to 100 per cent.  It is important for you to know what your percentages are and that they accurately reflect your risk tolerance.

One of the ways to look at risk is to look at the mirror reflection of reward.  The greater the risk you take, typically the greater reward (but not always) if markets are positive.  If the markets are negative, then high risk investments will typically decline more than medium risk investments.   Any investor who has medium and high risk investments should be comfortable to withstand negative returns and the volatility of the markets.

Investment firms typically classify the equity investments they have coverage on by assigning a low, medium, or high risk rating.  When looking at these “equity” ratings it is within the equity category only.  A low risk common share is riskier than a term deposit.  If on the account opening forms your stated risk tolerance is 100 per cent low risk then your advisor is limited to recommending low risk investments only.   If you have a medium and high risk component then your choice of investment options increases significantly.

The account risk percentages set the framework for investment recommendations from your advisor.  When we are reviewing these percentages with new clients we provide an example of what types of investments would typically be classified into the three areas.

  • Low risk investments are treasury bills, money market investments, guaranteed investment certificates, term deposits, investment grade bonds, some debentures, and certain types of preferred shares.  
  • Medium risk investments may be most debentures, certain types of preferred shares, and common shares with up to a medium risk classification. 
  • High-risk include commodities, precious metals, initial public offerings, flow through investments, and common shares with a high risk classification.

One error we occasionally see is that all investment accounts have exactly the same risk tolerance.  Each account should have customized risk percentages.

To illustrate we will use Mr. Warren who has the following accounts:  Tax Free Savings Account (TFSA), Registered Education Savings Plan (RESP), Registered Retirement Savings Plan (RRSP), and a Joint With Right of Survivorship Account (JTWROS) cash account with his wife.

With the TFSA, Mr. Warren would like one blue chip dividend paying equity with the dividend reinvestment plan (DRIP).  The risk percentages for the TFSA are:  0 Low, 100 Medium, and 0 High.

With the RESP, both Mr. Warren’s children are under five years old.  He would like to see some growth for the next five years at least.  We discussed how the RESP risk tolerance could be initially set for 0 Low, 0 Medium, and 100 High.  In five years time we could look at shifting the portfolio more conservative (time horizon shrinks) to 0 Low, 50 Medium, and 50 High.  When the children are within five years of going to school then the risk tolerance could be shifted to 50 Low, 50 Medium, and 0 High.

For Mr. Warren’s RRSP we have a ten year laddered corporate bond portfolio with a few convertible debentures.  Based on the current holdings the recommended percentages are:  75 Low, 25 Medium, and 0 High.

Mr. Warren’s JTWROS is where they hold a mixture of longer term hold medium risk common shares and high risk common shares.  The percentages are 0 Low, 25 Medium, and 75 High.

The following are a few steps to complete to ensure your investments are suitable given your risk tolerance:

Step 1:  List all of the investment accounts that you own on a sheet of paper.  Beside each one of these you should write down how much low, medium and high you are willing to assume given the type of account (i.e. taxable, registered), time horizon, and your risk tolerance.

Step 2:  For each of your investment accounts obtain the current risk percentages listed on each account.  Your original account opening documents would have these percentages.  If you have signed any documents changing these percentages you should obtain a copy of this for your file.  Compare the percentages from Step 1 and Step 2.

Determine if the percentages on your accounts are still accurate.  Often at times with age and time these percentages may need to be updated.

Step 3:   The last step involves you looking at each individual holding you own and determining the risk of each.  This exercise is worth doing with your advisor at least annually, or more frequently if you are making investment changes.  Beside each investment write low, medium or high risk.  This exercise is a little more difficult when you have investments that are in the “grey area”, such as preferred shares and convertible debentures that have features of more than one risk category.  For investments that have characteristics of both categories, allocate an amount equal to half for this exercise.  Add up the total market value of the lows, mediums and highs.  Once you have these totals, divide by the total account value to obtain an approximate percentage in each risk classification.

Step 4:  Compare the estimated percentages determined in Step 3 with both the percentages in Step 1 and Step 2.  The outcome from this exercise may result in either a change in account documentation (updating risk tolerance) and/or making appropriate changes to the investments.

Markets can be as varied as the ocean

Whether you’re an avid sailor, boater, fisherman, or beachcomber, the ocean waters provide a great gateway to experience some of the best of British Columbia.  Anyone who has spent any time on the West Coast can appreciate how powerful and complex the ocean can be – it is part of the mystique that makes it so fascinating.

Why are we talking about the ocean?  Before we do any investing with a new client we feel it is important to first talk about stock market risk.  One of the best ways we can visually illustrate this is to compare the stock market to the ocean.   The oceans have periods where they are calm, and others that are rough.  Tides fluctuate daily; they can be mild, or at times more extreme.  Like the ocean, markets can be extremely unpredictable.

Market Cycles

Some investors may get emotional when it comes to riding through market cycles.  Buying when markets are over valued or selling after market corrections, can negatively impact long term investment performance.  Before investing in equities, we feel it is important to understand that the stock market will have both good and bad periods in the years ahead.

Crystal Ball

We feel it is important to discuss risk with people before they invest.  New investors may feel anxious about their investments at some point in the future, these feelings are normal.  Some advisors may have told their clients that they do not have a crystal ball to predict market changes.

Changing Tides

One way to describe market behaviour is to compare it to the ocean tides.  For example, on an extreme low tide, it may be like all stocks are declining.  Stock market risk is not company specific – a really low tide will typically take good companies down too, even if it is only temporary.   When the tide is high, it seems like every investment advances – and the current is behind you.

Efficient Markets

Fear has always been part of the markets – this will never go away.  Current fears may not be talked about in a few years.  New concerns will arise and they will appear to be “different”.   It is often said that stocks are the one thing many people do not purchase when they go on sale.  What is the reason for this?  Possibly some people may believe that the current problems are so different or extreme that we may not get through them.

Too many people wait until the markets stabilize fully before gaining the comfort to invest.  It is this behaviour that causes some people to be their own worst enemy.  If you believe that markets are efficient, then the markets should be at the level that reflects the risk at that point in time.

Riding the Storm

Current and future world events can cause economic instability and concern over near term growth.  At times these could be compared to a storm out at sea.  Stormy periods do take down unstable boats, just as market corrections impact some companies more than others.  Difficult times in the markets help differentiate the well managed companies from those taking on too much risk.  Companies with cash on their balance sheets, good cash flow, and solid earnings are typically better equipped to ride through the bumps compared to a company with a lot of debt and negative cash flow.

When you’re on a boat and the weather is rough, it is common to feel a little ill.  The best advice is to look out into distance, rather than to keep your head down.  Establishing a financial plan and focusing longer term helps keep any short term volatility into perspective.


Investing in uncertain times

The markets can be completely irrational.  Anyone who has invested for any length of time knows this.  Economic data could be pointing in one direction with the markets reacting in an opposite way.  At times investor emotions of fear and greed dictate more of what they actually do versus what they should do.  We will call this the psychology factor.

There is so much free financial information available that it can be overwhelming.  It is not just that there is a lot of information – so much of it is contradictory.  This increases anxiety for many when making investment decisions.


Over time the markets have always gone up and down, but have maintained an upward bias over the longer term.  Regardless of the short term prediction we are more confident in the longer term that the S&P/TSX Composite Index will be higher than it being lower.  Taking a longer term view of your investments should help reduce the stress of attempting to predict short term performance.

Instant Gratification

Value investing often involves attempting to pick up companies you feel are undervalued in relation to the current stock price.  Value investors feel that if they purchase undervalued stocks, and wait a period a period of time, that the stock will deviate back towards fair value.  The main problem that exists today is that so many investors are looking for instant gratification, or quick returns.  A value investor may have to develop the patience to wait two or more years for some stocks.


Some people are better able to deal with the ups and downs of the markets.  When the markets decline some people view this as a buying opportunity while others fear the worst and look at selling.  This is what creates the market.  If everyone believed the same thing then there really wouldn’t be a market.  There has to be both buyers and sellers to make a market.   Investors who are able to handle risk and volatility are typically further ahead.  Getting too emotional with your investments can be damaging if you sell quality investments at market lows.  In some cases the biggest advantage of dealing with a financial advisor is to ability to reduce the “psychology factor”.  If you choose to do it on your own then you are far more likely to get emotional in your decision making.

Coin Toss

If someone were to propose a little bet, based on a coin toss.  If it’s heads you win $10,000, if it’s tails you lose $5,000.  Some people would take this bet, but most people would not, even though they have the chance to win twice the amount that they could lose.  We are not trying to compare the stock market to a coin toss, but rather trying to illustrate that everyone has a different risk tolerance.  All investments have risk and that ultimately investors have to choose the best educated risk-reward trade off.


Most people who are successful have taken significant personal and business risks.   In some cases, there has been failure before successes.  The ability to cope with risk is ultimately the largest component of the psychology factor.  People who have invested for a longer period of time are typically able to manage the psychology factor better.

Time Horizon

If you are in the growth stage of saving for retirement, you may not require funds from your investment accounts to live off of immediately.  When you do picture yourself in the near future (five years or less) having to live off of your savings then it is critical that your investments match your time horizon.  Stress can be significantly reduced if you ensure that you have invested based on your time horizon.


Not all people are meant to invest in the stock market.  Knowing your own comfort level is important, as well as communicating this to your financial advisor.

Managing Volatility

We feel it is very important for all new investors to discuss risk thoroughly with their financial advisor.  How would you react to certain market conditions (overall markets declines 10, 20 or 30 per cent)?  We go through a series of questions with all new clients and document our plan, called an Investment Policy Statement.  By going through this exercise we hope that new investors will establish a disciplined approach and the investments will reflect their risk tolerance.

Here is an example of one of the questions we ask:

Assume you have just invested $1,000,000 and intend to leave the money where it is for ten years.  When you review your first quarterly statement, you see that the value of your investment has dropped to $900,000.  What would you do?

  1. Take advantage of the lower prices and invest more money, if possible, since I am interested in the long term value of my investment and I’m confident that I have made the right choice.
  2. Leave my money where it is, since some changes in value are a normal part of investing.
  3. Monitor my investment closely and sell if the value has not recovered in three to four months.
  4. Sell my investment immediately, since I’m not comfortable with any decline in value.

No one can control the markets but you can control how you react to it.   Managing risk and emotions are two important components of successful investing.