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.