Sector checkup can reveal weakness in your portfolio

Risk management is always an interesting topic, especially when it comes to the stock market.  There are many things an investor can do to help manage stock market risk.  Diversifying your investments by sector should be about lowering portfolio risk, and directing your funds to areas you feel will outperform.  Individual equities are typically classified under one of the following ten sectors:  financials, energy, materials, industrial, consumer discretionary, telecommunications, technology, consumer staples, utilities, and health care.

The S&P/TSX Composite Index (S&P/TSX) is one of the most commonly referred benchmarks for Canadian stocks.  In the United States, a popular index is the S&P 500.  The following chart compares both of these indices as of June 30, 2010.

 Weight By Sector

S&P/TSX (Canada)

S&P 500 (U.S.A.)













Consumer Discretionary









Consumer Staples






Health Care






The following are five steps to complete your sector check-up:

Step 1)  Obtain a consolidated statement of your investments sorted by the above ten sectors.   This list should be done at one point in time, such as quarter end or year end. This is a relatively straight forward exercise if you hold individual stocks.  This step becomes more difficult if you hold multiple mutual funds, exchange traded funds (ETFs), and other holdings.  Every fund has a sector break down disclosed on a monthly basis.  If you have a sector ETF then this is easy.  If the ETF is more broadly based then it is possible to obtain the above subsector breakdown.

Step 2)  From the above step compare your sector exposure percentages to both your desired goal and the indices above.  Your goals may be largely driven by both economic and financial conditions.  It is important to note that investors should not necessarily use the percentages of the indices to equal their own portfolio weighting.  As the S&P/TSX is a “weighted” index, there can be specific stocks that distort the numbers.  One example of this is when Nortel hit $124.50 on July 26, 2000, it represented 34.2 per cent of the TSE 300. During economic uncertainty, sectors such as telecommunications, consumer staples, and utilities are considered more defensive.  During periods of growth, an investor may choose to shift more towards cyclical sectors such as materials, energy and consumer discretionary.

Step 3)  Advisors should be able to provide you with their financial firm’s recommendation for each sector, along with their own opinion.  Most financial firms provide guidance on a sector basis by stating whether you should underweight, market weight, or overweight a sector.   As an example, if a sector represents 20 per cent of an index and a firm is recommending to market weight the sector then 20 per cent of your total equities should be invested in this sector.  If the guidance is to underweight the sector then less than 20 per cent should be within the sector, and vice-versa for overweight.

Step 4)  Once the three steps above have been completed this should reveal any necessary sector adjustments.  If you are over exposed to a sector then you should determine the weakest holdings in that sector.  Rebalancing sector weightings may take some time.  Limit sell orders work well to establish a sell discipline at the right price.

Step 5)  If you need to increase exposure to a sector then the process should be integrated into your geographic diversification.  The main reason for putting the S&P 500 in the above chart is to demonstrate how some countries dominate sectors where Canada has less representation.  Canada is strong in financials, energy, and materials.  The United States market is strong in technology, health care, and consumer staples.

Regular sector check ups will enable you to rebalance sectors.  If one sector has done particularly well during the year then this should be revealed in the above exercise.  Just as an investor should trim or sell a successful stock, the same applies to a sector.  Each check-up should focus first on the macro sector decision.  Making correct sector decisions are often more important than the individual stocks you select.


Just how liquid are your assets?

Liquidity is a term associated with the ease in which your assets may be converted into cash.  High interest savings accounts and money market investments are extremely liquid and can be sold and converted to cash within a day.  Holding a portion of your assets in cash is important for ongoing cash flow purposes and emergency reserves.

Fixed income investments, such as guaranteed investment certificates, are typically purchased for a period of time, but may be sold in a pinch with cash raised usually within three days.  Bonds can also be sold through a financial firm’s fixed income-trading desk.

Convertible debentures, also known as convertible bonds, are fixed income investments that trade on a stock exchange and have a three-day settlement timeline.

Equities that trade on a recognized stock exchange are typically classified as fairly liquid.  Cash can generally be raised within three days after the investment is sold.  Typically one could look at the number of shares trading each day to determine the volume.

We caution any investor buying too large of a position in a company, especially a small company with low trading volumes.  It may be easy to purchase the shares but selling is often a bigger challenge.

Equities that do not trade on a recognized exchange may or may not be liquid.  Most mutual funds is whether you purchased these on a deferred sales charge basis.  If a fee or penalty exists for selling an investment, then we would classify this as “liquid for a cost.”  Structured products such as principal protected notes, hedge funds, venture capital investments, may have restrictions with respect to liquidity.  If liquidity exists then you should understand the associated costs to sell the investment.

Non-registered investment accounts should be considered more liquid than RRSP investment accounts.  Withdrawals from an RRSP account are considered taxable.  We prefer planned RRSP withdrawals rather then required withdrawals due to emergency cash requirements.  Some registered investment accounts are considered “locked-in” and have restrictions with respect to withdrawals.

There are several categories of illiquid assets, which cannot be converted into cash quickly.  In most cases, it is a result of not having a market in which it regularly trades.  An asset is usually illiquid when the valuation is uncertain.   Two common types of illiquid assets are shares of a private company and real estate.

Retirement plans are more complicated when illiquid assets are meant to fund retirement cash flows.  In some cases, these assets generate net cash flow, such as rental income.

But what happens if a roof needs to be replaced, or you have tenant vacancies?  If the real estate is financed, how will a rise in interest rates impact you?

If the majority of assets are considered illiquid, this will cause cash flow pressures at retirement.  Planning should look at the different options, including selling assets.  By planning in advance, you should be able to factor in the most tax efficient option.  It may take longer to sell an illiquid asset.  We recommend that our clients plan ahead to ensure they do not find themselves stuck, having to sell an asset at the wrong time.

To illustrate our point we will use Norman and Pauline Baker.  Norman is 66 years old and Pauline is 70.  The Bakers have a personal residence valued at $750,000 and an 18 acre parcel of land valued at over $1 million.  They have registered investments valued at $250,000.  Annually they have been living off of CPP, OAS and small registered account withdrawals.

Pauline would like to sell the 18 acre parcel of land and enjoy retirement while they can.  She knows that if they sold the property that they would never have cash flow problems again.  Norman is a retired realtor, and feels that they should hold onto the land for a couple more years so that they will get a greater value. 

The above situation highlights that the Bakers failed to factor in liquidity as part of their retirement plan.  Waiting too long to sell an illiquid asset could result in unfavourable timing, such as a depressed real estate market.  Although the Bakers have a good net worth, this has not translated to cash flow at retirement for them. 

In order for the Bakers to begin enjoying their net worth to the fullest extent they will need to sell their 18 acre parcel of land.  With the proceeds we will assist them in developing a liquid portfolio that generates the cash flow they require.

Balance risk against return

One concern worth discussing is the degree of risk within your registered accounts.  Registered Retirement Savings Plans are typically designed to fund your retirement.

It’s not a question of how to invest your hard-earned dollars, but more specifically, how much risk should you take within your RRSP account?

Tom and Linda Green both have RRSPs.  Tom, 46, is an engineer and Linda, 45, is a teacher.  They have been married for 11 years.  Tom is not interested in fixed income as he considers the rates too low.  Tom would like his RRSP to be 100 per cent equities.  Linda had a bad investing experience two years ago and prefers 100 per cent fixed income.

The following summarizes some of our discussion points we had with both Tom and Linda.

Household Investments:  The first question that we asked was whether or not they viewed their investments individually or as a household.  Both said household.   After that response we went on to explain how most of the portfolios we design have a balance of fixed income and equities.  The way the portfolios were currently structured, one portfolio would likely be outperforming the other in any given year.

Fixed Income:  We asked Tom why he objected to fixed income in his portfolio.  He responded by saying that a three per cent GIC doesn’t earn anything after taxes and inflation are factored in.  We explained to Tom that over the last year we were able to purchase fixed income for our clients with yields of up to ten per cent.  We discussed corporate bonds, debentures, and other fixed income options that provide a better return, with a little risk.  Tom was open to adding a fixed income component to his portfolio.  There are times in the market cycle when there are growth opportunities in the fixed income markets.

Equities:  We asked Linda why she was so cautious about equities.  She had invested in some technology stocks and sold all of her equities after a one-year period at a significant loss.  We explained to Linda that equities are typically classified as low, medium and high risk.  The stocks she had invested in were all “high beta” or “high risk.”   We also noted that she had some bad timing when she bought the investments initially.  We outlined a few low risk, high dividend paying stocks.  We also reviewed market cycles and the importance of focusing longer term when equity investing.  Linda was open to adding a few low risk equities to her portfolio.

 Time Horizon:  Tom and Linda both plan on working another 15 years each.  We talked about how the overall asset mix should become more conservative as they approach retirement.  We refer to the five-year period before retirement as the “risk zone.”   We discussed a disciplined approach and documented this through an Investment Policy Statement.  The statement covered their investments as a “household.”

Other Accounts:  The only accounts that Tom and Linda currently have are registered (both have an RRSP and TFSA).  Tom and Linda are nearly debt free.  They have been aggressively paying down their mortgage.  In about three years time they will be debt free and plan on directing excess cash to a joint with right of survivorship (JTWROS) non-registered investment account.  We explained that once they begin saving outside of registered accounts they should consider shifting the higher risk equities out of their RRSP into the JTWROS account.  We explained that losses within an RRSP are wasted.  A loss within a non-registered account may be carried back three years or forward indefinitely.

Return versus Risk

It was obvious in our initial conversation with Tom and Linda that they both viewed investing from different angles.  Tom looked at returns first, where Linda looked at risk first.  Together they compromised on a balanced portfolio with a moderate level of risk.

How to manage market uncertainty

One sure thing of the stock market is uncertainty.  It never goes away.  But, there are ways to reduce risk and to manage this uncertainty.  Some points to consider:


Every investor should set up an investment policy statement (IPS) that outlines specific percentages for cash equivalents, fixed income (bonds, GICs, debentures, coupons), and equities.  We will use Sandra Anderson’s portfolio as an example in this article. Sandra’s portfolio has 10 per cent cash, 30 per cent bonds, and 60 per cent equities.  Only the 60 per cent allocated to equities is exposed to market risk.  Over the last couple of years, Sandra had modified her asset mix when opportunities were available.  The best way to determine if you have the right asset mix is to assess how you felt over the last couple of years.  If you felt an unusual amount of anxiety then you should talk to your advisor and reassess your IPS.


Some investors may attempt to time the market through buying and selling stocks by predicting future stock prices.  There has been much debate about whether market timing is a valid strategy.  Consistently buying at an absolute low and selling at an absolute high is impossible.  Having said that, we feel there are times when the probability of success increases.  As an example, when the S&P/TSX Composite Index was crossing through the 15,000 level (in 2008) it became easier to predict that a decline, also known as a correction, was likely.  After all, we had just finished five consecutive years of stock market increases.  Every decade on average has three negative years.  After the Index had declined nearly 50 per cent, below 7,500 (in 2009), it became easier to predict that an increase was likely.  In our opinion, people should consider market timing, especially after extreme changes.


Market timing could also be compared with an active investment approach.  Actively monitoring company specific news and predicting the future direction of the markets is part of investing.  This includes determining the extent economic news will ultimately trickle into the stock market.  Some stocks or sectors are better for active trading than others, especially those that are considered cyclical in nature.


Opposite to an active strategy is a buy and hold approach.  In non-registered accounts there are some distinct advantages to this type of strategy.  Capital gains are not taxed unless the investment is sold.  This allows investors to create deferral opportunities, provided they do not sell.


Most portfolios should have a combination of active and passive investments.  We will illustrate using Sandra Anderson’s portfolio of 30 individual stocks.  Sandra has ten stocks that we classify as longer term (hold longer than five years), ten are medium term (hold two to five years), and ten are shorter term (hold less than two years).  We have communicated to Sandra that the ten shorter-term stocks will have more active trading associated with them and may be replaced from time to time.  Another term that may be associated with active trading may be short-term capital appreciation where investors aim for short-term profits.  The ten stocks Sandra owns that are long-term could also be classified as “buy and hold.”  This may be associated with primarily blue chip equities where long-term capital appreciation is the primary objective (we call these growing wealthy slowly stocks).  For Sandra, we have set the dividend reinvestment plan on these ten long-term hold investments.  Every investor should customize the type of investments and determine the right balance of active versus passive.


All plans need to be flexible and change with conditions as you find them.  From time to time, one of our buy and hold stocks may be removed from our portfolio.  This can be for a number of reasons, such as the position reaching our target price.  When we sell a passive or active part to our portfolio it is because we are either raising cash or looking for what we feel is a better alternative.


Markets become overvalued at times, and the same applies to good companies.  A market correction can cause all stocks to decline.  One could say that paying too much for a stock, or buying right before a correction, is the first mistake.  Every equity investor makes this mistake from time to time.  Before we do any investing for our clients we always outline the cycles the markets have always gone through.  No investor can control the direction of the markets but can control how they react to it.  Selling investments at a low is the second mistake and one more likely to cause permanent damage.


The markets are extremely unpredictable in the short term.  In the long term markets have historically had an upward bias.  We also know that the stock market has always recovered fully from corrections in the past.

Watch interest rate risk

Most people benefit if they make a correct projection with respect to the direction of interest rates.  This is easily illustrated when you are deciding on the type of mortgage.

If you feel interest rates are going down, or are staying close to current levels, then the best option is likely a variable rate mortgage.  If you feel interest rates are going up in the near term, then locking in with a fixed rate mortgage may save you interest costs over the term.

Central banks in the United States and Canada announce changes to interest rates on predetermined dates.  In Canada, there are eight specified dates during the year.  Central banks also retain the option of taking action between fixed dates, although they would exercise this option only in the event of extraordinary circumstances.

By the time the predetermined dates arrive, most economists have a pretty good idea what the current change will be.  What is really important is listening to the words of the U.S. chairman or Canada’s governor say with respect to economic conditions and the outlook for future interest rate changes.

One of the most interesting components of macro-economics deals with monetary policy, inflation, and interest rates.  When central banks are looking to stimulate the economy, interest rates are lowered.  This should encourage more borrowing and spending.  When the economy is growing too quickly, or inflation concerns are rising, raising interest rates helps slow down the growth.  Interest rate changes are generally tied to economic conditions.  If conditions are improving, interest rate increases are more likely.  If deteriorating then interest rate cuts (if possible) are more likely.

So how does all this economic jargon impact investors?  Some investments are more likely to fluctuate in value than others as interest rates change.   We have illustrated a few scenarios below:

Bonds versus Equities

Bond prices change inversely to fluctuations in interest rates.  If rates go down, existing bond prices rise.  If rates go up, bond prices decline.  Interest rates are at historic lows now.  As rates go up, the price of your existing bonds may decline in value.   If interest rates are increasing, that is generally a sign that the economy is improving.  If the economy is improving then investors are generally better off in equity investments.

Short Term versus Long Term

Investors with low tolerance for risk should always hold a majority percentage of fixed income type investments (bonds, Guaranteed Investment Certificates, term deposits, deposit notes).  What should fixed income investors do if they feel interest rates are likely to change?  If you feel interest rates are likely to increase then the focus should be on short-term maturities, being five years and under.  If you feel interest rates will decline over the long term then you may profit from extending your maturity dates beyond five years.  All investors should look at the maturity dates of their bonds.  If all of your bonds are long term and interest rates begin increasing, then you will likely see a decline in the value of your long-term bonds.  The benefit of bonds is that they may be sold at anytime and the proceeds used to purchase other bonds with different maturity dates.  The number one thing to note is that the longer the duration (time to maturity) the greater the volatility when rates change.

Preferred Shares

If you own preferred shares, determine what type you own.  Not all preferred shares are created equal.  Hard retractable preferred shares have a set maturity date and fluctuate less with changes in interest rates.  Perpetual preferred shares mean they have no legal maturity date and are very susceptible to changes in interest rates.  If interest rates begin to climb then you should expect the value of this type of preferred share to decline in value.  The higher the coupon on the perpetual preferred the less volatile it will be to changes in interest rates.

Call Features

Unfortunately most call features benefit the issuer, rather then you, the investor.  When an investment has a call feature you should monitor the call dates and the likelihood of it being called.  Structured products, fixed income (Tier 1 and Tier 2), and preferred shares are examples of investments with call features.  In some cases, the market anticipates the investment to be called.  It is best to speak with your advisor about whether your investments have call features.

Timing and Magnitude

Interest rates are currently at historic lows in the United States and Canada.  Timing of course is the toughest part when it comes to projecting interest rate changes.  Even if one is confident in the direction of interest rates, it really comes down to further projections.  When will they change?  How fast will the change occur?  What will be the magnitude of the changes?

We recommend you discuss how your portfolio may fluctuate with changes in interest rates.  By looking at the probability of different outcomes you will be able to map out a plan to minimize interest rate risk.

Protecting your money against inflation

We are often asked our opinion on inflation and inflation protection products.  And as with most economic related questions, timing is really the key.   Is now a good or bad time to look at adding inflation protection products to your portfolio? Before we answer, let’s  look at what inflation is, and a few different investment options.

Inflation in Canada is based on the Consumer Price Index which has eight categories:

  • Food
  • Shelter
  • Household operations, furnishings and equipment
  • Clothing and footwear
  • Transportation
  • Health and personal care
  • Recreation, education and reading
  • Alcoholic beverages, and tobacco products.

Each of the above categories has a different weighting within the CPI.  As a simple illustration, food has a greater weighting over clothing and footwear, because most people spend more on food.

Let’s say in 2006 that Jack goes shopping for the day.  He picks up groceries, fills his truck up with gas, gets a haircut, and buys a new pair of shoes.  The entire shopping experience cost him $374.

In 2009 he went out and bought the identical groceries, put the same amount of litres in his gas tank, got another haircut, and another pair of shoes.  This time the total bill came to $412.

The change in the price of these goods can be boiled down to inflation.

In 2006 Jack was earning $63,200 annually, and in 2009 his income is expected to be $69,621.  In Jack’s case, his income kept pace with inflation.

Another case:

Charlie retired at age 65 in 2006 with a government pension and all of his savings in a simple savings account at the bank.  Overall inflation has been relatively low since he retired.  Recently he has been hearing a lot about inflation and is getting worried.  We explained to Charlie that CPI is used to index his company pension, CPP and OAS.  These parts of his income flow are protected.  The portion of his financial situation, exposed to inflation, is the $400,000 he has in the bank earning little to no interest.

If costs rise significantly in the future, the amount he has in the bank will purchase less than what it could purchase now.  One option Charlie has is to look at purchasing some investments that may better protect him, if he is willing to assume a little risk.

Charlie has specifically asked us about Real Return Bonds.  After all, he has read that bonds are less risky and RRBs protect against inflation.  In our opinion we do not feel RRB will be the best option for Charlie over the short term.  With the absence of inflation, RRBs function similarly and are influenced by the market very similar to long-term bonds.  In our last article, we discussed what happens to long-term bonds when yields rise – they decline in value.

If yields do rise as forecasted over the next year, we feel it will not be solely because of inflation.  We feel that if real yields rise, part of this will simply be based on the fact that we are at 50-year lows and the economy is recovering.  RRBs will likely trade similar to extremely long duration bonds and will be quite volatile.  Many investors are being told to buy RRBs because inflation will rise.  Sure, it will rise eventually, but we feel the potential for large losses exist based on the long duration associated with most of these investments.

Another possible outcome is that yields rise as a component of both inflation and real yields.  In this particular outcome, RRBs will likely outperform the nominal long bond of comparable term.  But it is also likely in that scenario that short-term bonds would outperform both!

To illustrate our point, one only has to look at some of the Real Return Bond products available.  In December 2008, many of these products hit a low and have posted nice returns since that date.  The returns have been positive although inflation has been negative.

What has caused the positive returns?  Interest rates have declined since last December causing a profit in most RRB products plus the demand for inflation protection products.

It would be extremely hard for the average retail investor to diversify by purchasing individual real return bonds.  These bonds are generally picked up in the institutional market.  A more practical way to obtain exposure to Real Return Bonds is to look at an investment such as iShares CDN Real Return Bond Index Fund (XRB).  This fund holds a basket of real return bonds and has a low management expense ratio (0.35%).

XRB has a current yield of 2.7 per cent.  To illustrate our point with long-term bonds, 98 per cent of the holdings within XRB have a maturity of ten years or greater.  The weighted average term is 21.23 years with a weighted average coupon of 3.62%.  We are at fifty-year lows when it comes to interest rates – they can only move up from current levels. If you have a short-term time horizon and an active strategy, we do not feel now is a good time for RRBs.

If an investor has a long-term time horizon and wishes to use a passive strategy (buy and hold) then RRBs generally make sense for a portion of a portfolio.  Typically, this type of portfolio would hold a flat percentage of their holdings within RRBs, such as five per cent.  In Jack’s case, with a $400,000 portfolio he would hold approximately $20,000.  We would not encourage overweighting RRBs.  As with other bonds, they are generally best held in a registered account, such as an RRSP or RRIF.   RRBs may help protect the purchasing power of a portion of your portfolio.  The key component that will impact performance is the change in interest rates.

For protection within non-registered accounts, we prefer holding a small portion in gold, agriculture, and energy common shares.  Several types of preferred shares also provide some inflation protection along with tax efficient dividend income suitable for taxable accounts.


Stop-loss orders can be beneficial

A “stop-loss” sell order is an industry term, used to trigger an automatic sell of an investment once it reaches a specified price.  A stop-loss sell order is below the current market price.  Why would anyone set an order to sell a stock for lower than the current market value?

Stop-loss orders are entered to either protect profits or limit losses for investors who want to continue holding equity investments.  No one enters a stop-loss order hoping it gets filled; rather, they hope the stock continues to increase in value.

This type of order allows investors to gain more comfort that losses are limited and profits can be protected, while at the same time continuing to own the stock in the event it increases in value.

We will explain stop-loss orders through two investors, Mr. Cooper who finds they assist him in protecting profits, and Mrs. Davis who uses them to limit losses.

Protecting Profits

Mr. Cooper uses stop-loss orders to protect profits.  He has several stocks in his portfolio of 25 companies where the current market price is significantly higher than what he originally paid.  He would like to protect the profits he has earned but at the same time participate if the stocks continue to increase in value.  We discussed stop-loss orders with him and entered these on a few stocks to protect the profits that he has earned.

Several years ago he purchased 500 shares of ABC Company Ltd at $20 per share (total purchase price $10,000).  ABC is currently at $40 per share; Mr. Cooper still likes the company and feels there is further upside.

One concern we expressed to Mr. Cooper is that the shares in ABC had become overweight in his portfolio.  To reduce risk, and protect profits at the same time, we mapped out a plan using two stop-loss orders.

For ABC we recommended he set a stop-loss order at 10 per cent below where the stock is currently trading on 250 shares, or $36 per share.  For the other 250 shares, we recommended setting a stop-loss order at 20 per cent below where the stock is currently trading, or $32 per shares.

By setting the first stop-loss order closer to the market price (only 10 per cent) it has a higher likelihood of being filled.  If filled, a portion of the profits would be locked-in and at the same time he would be reducing his overall portfolio risk.

If the first stop-loss order is filled, then the remaining number of shares will be closer to the recommended position size for Mr. Cooper.

The second stop-loss order remains in place for the period of time selected.  Of course, the shares of ABC could continue to increase and neither is filled.  If ABC continues to increase in value we would recommend Mr. Cooper increase his stop-loss prices accordingly to keep the same 10 and 20 per cent ranges.

Limit Losses

Mrs. Davis uses stop-loss sell orders to limit the risk of losses.  Most of her portfolio is corporate bonds, but has recently purchased several high quality dividend paying common shares.  Prior to purchasing these investments she mentioned that the maximum she would be willing to lose on her equity holdings is 20 per cent on any one investment.   We reviewed stop-loss orders with her and entered these on every investment she purchased to limit the downside.

As an example, she purchased 200 shares of DEF Company Ltd. for $40 per share (total purchase price $8,000).  At the same time we entered a stop-loss order to DEF if the share price drops to $32 per share.  If the share price increases in value we discussed increasing the stop price on a quarterly basis during our meetings.

Mrs. Davis does not want her stop prices to ever be decreased, even if the market value declines after rising.  After the first quarter the share price has increased to $42 and the stop-loss order increased to $33.50.  Stop-loss orders allow Mrs. Davis to participate in the equity market knowing that potential losses are limited.

Other Important Points

It is important to note that a stop-loss order to sell GHI Company Ltd at $45 per share does not guarantee that the minimum price is $45.  If the price drops to $45 or below, the order converts to a market sell order, which may be different then the stop-loss price.  Most companies releasing important information do so after market trading hours.

If GHI has a current market price of $47, but releases negative news after market hours it is possible that the stock will begin trading the next business day at a significantly lower market price, say $42.  In this case, the shares would have been sold at $42, rather than $45.

The challenge every investor has with stop-loss orders focuses around timing and at what price to put the stop-loss at.   It is important to balance your intention to sell the position with a price that allows for a reasonable level of fluctuation.

The term “whipsawed” is a frustrating situation where a stock declines temporarily to the stop-loss price, even within one trading day, and then increases above the stop-loss price.

Stop-loss orders should not be used for thinly traded positions.  Thinly traded positions refer to those equities having low trading volumes.  When volumes are low, price fluctuations can be magnified.  Stop-loss orders are generally set for a period of up to three months.

This type of order may also be useful if you are planning an extended holiday and want to protect some profits or limit losses while you are away.  These orders may be changed or cancelled if they have not been filled.

We encourage anyone considering stop-loss orders to monitor outstanding orders carefully, especially around earnings announcements and press release dates.  Prior to entering any stop-loss orders you should estimate the tax consequence if filled.

Financial plans provide some clarity

We’re told over the course of our entire lives about the importance of saving to reach other goals, especially when it comes to retirement.   Most people agree that having a financial plan is important to provide clarity.

Unfortunately most people have never had a properly prepared financial plan.  For those who have a plan, few stick to it over time – especially during the down-turn we’ve all witnessed lately.

Most plans require you to gather both personal and financial information.  Your financial planner is able to input this information and generate a variety of documents ranging from a simple concept to a comprehensive financial plan.

The information you gather is mostly concrete and is based on actual amounts as of a certain date.  As well, you will have to make some projections as to the level of income you would like at retirement.  Your financial planner will also establish various assumptions or estimates (inflation rates, life expectancy, investment returns).

The best part of a financial plan is the list of savings required to meet your goal.  As an example, a typical financial plan may recommend that a couple each maximize RRSP contributions and save $500 per month in non-registered savings.   These savings are required whether we are experiencing good times or bad.

Unfortunately when markets decline, many people stop investing.  This often has a bigger long-term impact on your financial situation then for someone who continues to save.  By continuing to invest during difficult times people are essentially dollar cost averaging.  By dollar cost averaging we mean that some investments are purchased at higher amounts and others are purchased at lower amounts.

Rather than stopping the amount you save, consider saving more.  By saving more, at any time, you increase your chances of reaching your goals.

After a financial plan is prepared, it is important to update your financial planner with details of any significant changes in your life.  Significant changes may include family death, marriage, birth of child, inheritance, sale or purchase of a property, significant raise, job loss or health issues.

A typical financial plan may have an investment return assumption of 7 per cent annually.  It would be unrealistic for returns to be exactly 7 per cent each year.  On average, over time this is what is used as an estimate.  When investment returns are significantly different – that is a one-year deviation of 20 per cent or more – we recommend updating the financial plan.

When returns are greater than expectations then three things can be discussed.  Consideration should be given to shifting the investment portfolio more conservative as the required returns are now lower.  Another discussion point would be lowering the required amount of periodic savings.  The last item to discuss is the possibility of either retiring younger or having more funds available at retirement.

When returns are lower than expected it is important to assess how this will impact your financial situation.  For some people it may involve saving a little more or working a little longer.  We would prefer these two options rather than encouraging people to take more investment risk.

For younger people, a negative year in the markets has minimal impact to long-term financial plans.  The older a person is, the more the stock market may have an impact on your financial situation.  This is the reason why a person’s investments should shift towards fixed income (bonds, GICs, term deposits) the older one becomes.

The best part about a financial plan is that it provides some clarity relating to savings and long-term goals.  The conclusion after a significant decline or increase in the stock market is a change in the required periodic savings.  The most important component to long-term success is to continue saving during all market conditions.

Timeline shrinks entering risk zone

Stock markets are unpredictable and at times completely irrational – at least in the short term.  By short term we mean five years or less.  Investing can be a very frustrating experience for people seeking instant gratification or short-term results when markets decline.

Prior to any investing with our clients we ask a series of questions to obtain an understanding of risk tolerance, time horizon, and cash flow needs.  We have listed three of these questions below and outline the reasons why we ask these questions.

Question 1:  What is your investment time horizon in years?

A)    1 to 2 years

B)    3 to 5 years

C)    6 to 10 years

D)    More than 10 years

The main reason why we ask the above question relates to how conservative our recommendations will be.   If someone has a time horizon of one to two years our recommendations will focus on cash equivalents and bond type investments.  If someone says more than ten years, then a portfolio could have a balanced approach with a greater percentage in equities.  As time horizon decreases so should the percentage in equities.

An interesting exercise for investors is to go through and look up the worst one-year returns in the stock markets.  One would discover many negative one-year periods in the markets.  Significant one-year declines would have seriously impacted someone that was incurring too much risk based on their time horizon.  By looking at the worst ten-year historical period of returns in the Canadian stock market, investors would realize that these longer periods are actually positive.  History may provide some comfort for people who are holding high quality investments and feel they will recover over their time horizon.

Question 2:  As a percentage, what is your household’s annual income requirement from your investment portfolio?

A)    10 per cent

B)    7 – 9 per cent

C)    4 – 6 per cent

D)    1 – 3 per cent

E)     0 per cent

We receive a variety of responses when we ask this question.  Some people are fortunate not to need any income from their investments because of age or other sources, such as pensions or rental income.  Most retired people require some form of income from their investments.  If investment income is the only source of income it becomes important to balance capital preservation with income.  If income needs are five per cent or less then the portfolio should be heavily weighted towards bonds, GICs, and other lower risk investment options.

Question 3:  Will you need to liquidate a portion of your investment portfolio over the next five years?

A)    More than 20 per cent

B)     11 to 20 per cent

C)     zero to ten per cent

D)    No requirement

The reason we ask this question is to get an understanding of significant purchases that are planned.  This may be a personal residence, vacation home, vehicle, boat, motor home, travel costs, renovation, etc.   These one-time items should be itemized and timing should be noted.  We recommend keeping an amount equal to these costs liquid and secure.  This ensures that specific goals can be met and that short-term equity markets do not impact plans.  The remaining assets can then be looked at for a longer-term strategy.

The risk zone that all investors face is the period immediately before retirement.  As an example, this may be the five-year period before you begin living off of your investments.

A typical investor may have been focused on growth for 30 years or more.  As an investor enters the risk zone it is important to look at shifting your portfolio to provide a future income need and capital preservation.

All equities have some degree of risk

The most important investment decision people make is where to sock away their money.

So how much do you squirrel away in:

  • Cash equivalent, which could be cash, money markets, cashable GICs, and high interest savings accounts
  • Fixed income, such as GICs, term deposits, bonds or coupons
  • Or equities

The second most important decision relates to the types of equities to buy.

Risk could be defined as the possibility of losing money.  And all equities have a degree of risk.

You only have to look at the TSX/S&P Composite Index this year to see that 229 of the 244 stocks comprising the Index are in negative territory year to date.  Some stocks have declined much more than others year-to-date, highlighting that not all equities are of the same risk level.  Beta is a financial term associated with equity investing and measuring risk.  More specifically it relates to the volatility of a stock in relation to a specific market.  For purposes of this column we will use the TSX/S&P Composite Index, which comprises 244 of Canada’s largest companies.  The Index has a beta of 1.0.

Before we get into the details about beta, most of us should agree that penny stocks, small-capitalized companies, and those with no analyst coverage generally have more investment risk than large established companies with a history of paying dividends (also known as “blue chips”).

What some investors might not know is that many large established companies that are household names have more risk and volatility associated with them than the general market.

Mutual funds and exchange-traded funds that carefully track the Index will have a beta close to 1.0.  Beta is more important for people investing in individual stocks.  Individual stocks can be compared to each other using beta.  Ranking stocks according to how much they deviate from the Index is an easy exercise. A stock that has more volatility than the market over time has a beta above 1.0. A stock that is less volatile than the market has a beta of less than 1.0.  If a stock has a beta below 1.0 then it will have less dramatic movements than the market.

Let’s use a stock with a beta of .5 as an example.  If the Index were to increase 20 per cent then we would anticipate this stock to increase ten per cent.  What if the market declines 20 per cent?  A stock with a beta of .5 would historically decline by 10 per cent, even though the index has declined by 20 per cent.

Let’s use a stock with a beta of 1.6 as another example.  If the Index were to increase 20 per cent then we would anticipate this stock to increase 32 per cent.   If the market declines 20 per cent we would anticipate this stock to decrease 32 per cent.

To illustrate we will look at two portfolios, A and B, each comprised of 20 stocks taken from the Index.  The beta for the portfolio is the weighted average of the betas for the individual stocks.  We have assumed that each position is equally weighted.  Portfolio A will have the 20 stocks with the lowest beta on the Index.  Portfolio B will have the 20 stocks with the highest beta on the Index.

  • Portfolio A (lower risk and lower reward):  The sum of the twenty lowest beta stocks on the Index is 10.46.  If we divide this number by 20 we have an average beta of .52.  Based on historical changes in values and a 10 per cent change in the Index we can estimate possible outcomes.  If the Index increases 20 per cent, the historical upside return would be approximately 10.4 per cent.  If the Index declines 20 per cent, the historical loss on this portfolio would be approximately 10.4 per cent.
  • Portfolio B (higher risk and higher reward):  The sum of the 20 highest beta stocks on the Index is 35.62.  If we divide this number by 20 we have an average beta of 1.78.   Based on historical changes in values and a 10 per cent change in the Index we can estimate the possible outcomes.  If the Index increases 20 per cent, the historical upside return would be approximately 35.6 per cent.  If the Index declines 20 per cent, the historical loss on this portfolio would be approximately loss of 35.6 per cent.

The above shows a rough illustration of how a portfolio can be structured to reduce risk on the equity side.  Reducing risk in a portfolio reduces the potential for large losses and large gains.  Portfolio B has significantly more risk than Portfolio A, and it also has the potential for greater gains and losses.

Beta should not be entirely relied upon because of its historical basis of measurement.  If new information becomes available this is not immediately reflected in the beta.  As we have seen during the past year, often at times the markets become irrational and fundamentals mean little in the short run.  Some investors feeling bullish may sell the lower beta names and buy higher beta names if they feel the markets are at a low and conditions are improving.  Beta is not an indicator of how a stock will perform, only a reflection of what has happened.

It is an interesting exercise to determine the overall beta of your portfolio.  Despite its shortcomings, beta provides one way to measure individual stocks amongst each other.  If you have a portfolio weighted towards high beta names, you will likely see more ups and downs.