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Portfolio Strategy

Ignore the headlines, plan for the long haul Add to ...

No one outsmarts the financial markets.

So stick to the basic rules of portfolio building and fight the urge to make fine adjustments. Overweighting this, underweighting that and fiddling with your holdings in stocks and bonds to suit your expectations of what's to come are just guesswork for most investors.

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The Japan catastrophe proves this. All the talk about the dangers of government bonds, the wonders of commodities, the bright outlook for the Canadian dollar and the tenacity of the two-year stock market rally went out the window - at least temporarily - this week.

Let's review some portfolio-building ideas that will allow your portfolio to prosper in good times and limit the damage in down markets.

First, it's the correct mix of investments for you personally that rules how much exposure you have to stocks and bonds, not your market outlook for the year or your response to events like the disaster in Japan.

Review your mix once or twice a year. If your stock or bond holdings are below your target - 50:50 for example - then sell some of what's been rising and buy more of what has fallen. The process is called rebalancing and it's the best way to avoid reacting to emotions that tell you to avoid stocks when they're down and jump in when they're up. In fact, that's the opposite of what you should do.

"People who were focused on their asset mix and their long-term plan would have been adding to their stock position last summer, when markets were correcting," said Murray Leith, vice-president and director of investment research at Odlum Brown in Vancouver. "And, if anything, they should have treated the recent market rally as an opportunity to rebalance out of stocks and into cash or fixed income."

But, wait, aren't bonds vulnerable to the rise in interest rates we've long been expecting? True, but you still need bonds, notably government bonds, as portfolio insurance. In times of high stress for the stock markets, money flows into the safety of government bonds. We saw that in 2008-09, and we've seen that as stocks tanked on the news out of Japan.

If you're worried about your bonds or bond funds falling in price as interest rates rise, play it conservative by holding only bonds that mature in five years or less. On the chance that global economic growth disappoints, maybe because of Japan's troubles, Mr. Leith suggests you keep some longer-term bonds around as well.

For the portion of your investments made up of stocks, put strict limits on your exposure to any one company or sector. While it's tempting to let your winners ride, you can be vulnerable to the kind of sharp, sudden setbacks that uranium stocks experienced on Monday as investors began to appreciate the risk of nuclear power-plant meltdowns in Japan. Shares of Cameco Corp., the world's largest publicly owned uranium company, fell almost 13 per cent that day alone.

"Obviously, if you had 25 per cent of your holdings in uranium stocks on Monday, you were in worse shape than someone who had 3 per cent in uranium stocks," said David Baskin, president of Baskin Financial Services. "Our rule of thumb is not to have more than 5 per cent in any one name, and no more than 15 per cent in one sector."

If you've taken a look lately at the sector weightings of the S&P/TSX composite index, you'll find that energy and materials (mostly mining) add up to about 50 per cent of the total and financial stocks add another 29 per cent. Exchange-traded funds that track the Canadian market will be similarly dominated by these sectors, and many mutual funds will be as well.

"I think your average conservative investor should not be benchmarking the TSX," Mr. Leith said. "It's a very risky index. It has a very cyclical bias to it, which exposes investors to a lot of volatility. We're seeing some of that now."

One way to build a portfolio that is more diversified than the index is by finding contrarian fund managers who have de-emphasized energy and materials stocks. Mr. Leith's suggestion is to seek out foreign companies in sectors such as consumer products, health care and technology that are barely represented in the Canadian market.

An example is Coca-Cola, which he describes as having a solid balance sheet, a reasonably cheap share price and a resilient franchise. "When the world starts to blow up, you don't lose a lot of sleep wondering whether or not Coca-Cola is going to survive."

Coca-Cola is also an example of the quality global stocks Mr. Leith encourages investors to consider right now. For one thing, companies with low debt, strong balance sheets and reasonable valuations would be much more comfortable to hold, if there was a global stock market correction, than the typical resource company.

Quality stocks are also cheap, Mr. Leith argues. "Unusually, quality trades at a discount in this market. Normally, there's a tradeoff - you either pay a premium for quality, or you buy lower quality for a discount."

One more portfolio-building strategy to remember in these uncertain times is to take the long view and not get caught up in the news for any one day or week. The 2008-09 crash was brutal while it was happening, but results for investors who have held for the long term are excellent. For the 10 years to the end of last month, the S&P/TSX composite total return index (includes dividends) made an average annual 8.2 per cent.

Five years qualifies as long term for Mr. Baskin. His firm recently studied returns for the composite index over the past decade, and it found that you would have made money over any five-year period within those 10 years.

How do you stick it out for five years, even during events like the global financial crisis and now the disaster in Japan? By building a portfolio that anticipates the unexpected.

"In the life of an investor, you never know what's going to happen next, and that's reality," Mr. Baskin said. "You're going to be taken by surprise."



Going Their Own Way

One way to curb risk as an investor is to own mutual funds run by independent thinking managers who have much less exposure to volatile energy and mining stocks than you'll find in the S&P/TSX composite index and, as a result, most Canadian equity funds and exchange-traded funds. Here are a few funds that have made solid returns despite having less than half the 50-per-cent exposure the index has to the hot-performing energy and metals sectors. Exposure to financial stocks was limited to no more than 30 per cent, which is roughly the same as the index.

Fund

MER

Assets ($-mil)

YTD % rtn

3-Yr % rtn

Top Three Holdings

Investors Quebec Enterprise A

2.65%

$244

3.9%

6.2%

Financials: 21.6%

Cons. Discret.: 19%

Industrials: 18.4%

Mackenzie Cundill Canadian Security C

2.38%

$1,611

8.3%

10.0%

Financials: 30%

Tech: 19.7%

Materials: 12.9%

Manulife Dividend

2.32%

$688

2.2%

5.3%

Financials: 18.5%

Other: 17.6%

Consumer Staples: 13.2%

RBC North American Value

2.05%

$373

3.7%

8.3%

Financials: 26%

Cash: 17.2%

Energy: 15.5%

Trimark Cdn Plus Dividend Class A

2.46%

$45

2.7%

5.1%

Financials: 24.2%

Energy: 16.9%

Industrials: 13.2%

S&P/TSX Composite Total Return Index

1.8%

4.4%

Financials: 29.2%

Energy: 26.9%

Materials: 22.2%

Notes:

Year to date returns are to mid-week

3-year returns are to the end of February

Top three holdings are according to each firm's most recent report to Globeinvestor

Source: Globeinvestor Gold



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