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.

Annual

First Year

                 
Growth  

Actual

Time horizon to meet your annual growth target *    
Target

Returns

         1

         2

         3

         4

         5

         6

         7

         8

         9

                 

 

15%

    (2.3)

      1.8

      3.2

      3.9

      4.3

      4.6

      4.8

      4.9

      5.0

6%

5%

      7.0

      6.5

      6.3

      6.3

      6.2

      6.2

      6.1

      6.1

      6.1

-5%

   18.3

   12.0

      9.9

      8.9

      8.3

      8.0

      7.7

      7.5

      7.3

 

-15%

   32.2

   18.4

   14.1

   12.0

   10.8

   10.0

      9.4

      9.0

      8.6

 

15%

      1.4

      4.7

      5.8

      6.3

      6.7

      6.9

      7.0

      7.2

      7.2

8%

5%

   11.9

      9.5

      9.0

      8.8

      8.6

      8.5

      8.4

      8.4

      8.3

-5%

   22.8

   15.2

   12.7

   11.5

   10.8

   10.3

   10.0

      9.7

      9.6

 

-15%

   37.2

   21.7

   17.0

   14.7

   13.3

   12.4

   11.8

   11.3

   10.9

 

                 
* 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.