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:
ASSET MIX IS KEY:
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.
AVOID MAKING TWO MISTAKES:
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.
SHORT VERSUS LONG TERM:
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.