When markets drop as they have this month, there is a natural inclination to want to sell.
Investors are wondering whether the TSX will in the next month shoot right back above14,000 or if this is the early stage of a much bigger drop?
The answer is that nobody knows for sure. What we do know is that unlike gambling in a casino, where the odds are tilted against you, the stock market has gone up over time. If you had put $100 in the TSX in 1950, it would now be worth moer than $33,000. Over the past century, North American markets have risen in roughly seven out of 10 years.
Because of this historic upwards trend, to be out of the market or to bet against the market is like betting against the odds. That does not mean that there aren't times to consider doing so, but it is important to understand that the odds are stacked against you.
For the nervous investors that want to focus on capital preservation, here are five strategies to consider:
1) Find the most volatile investments in your portfolio and sell a portion of those. Investments with a high 'beta' tend to grow the most when markets are rising and fall the most in a down market. Simply switching some assets from these holdings to cash can take some risk off the table. You do not need to sell everything to lower your risk profile.
2) Increase your weighting in bonds and consumer staples, like grocery and discount retail. These areas tend to be more stable and sometimes rise in down markets. This was particularly evident in 2008 and early 2009.
3) Don't change anything - assuming that you have the proper asset mix for your personal goals and risk tolerance. I put this on the list because over time, it is likely one of the better capital preservation strategies. I have already talked about how taking meaningful risk off the table or betting against the market has a lower chance of being successful, all things being equal.
4) Sell everything and put it in money markets. This is an extreme solution. It ensures full capital preservation but raises several issues. The first is that there is usually some costs associated with selling everything in your portfolio and then for buying it back. The second is that you are guaranteed not to earn very much in this interest rate environment. The third is that people often stay in money markets too long and only decide to reinvest after some of the best market gains in the cycle have been achieved.
5) Add some 'short' to your investments. Today, with ETFs you can easily buy an investment that bets against the market. To own some of these investments does not mean you believe the market will fall, although it might. The value of holding this is to protect capital without having to turn over a large part of your portfolio. For example, if you had $100,000 in stocks, $10,000 in each holding, you could sell two holdings and buy an inverse ETF. You would then own $80,000 in stocks but have $20,000 invested as a short on the market. Overall, you would be 80 per cent long (hoping the market goes up) and 20 per cent short (hoping the market goes down), leaving you net 60 per cent exposed to market gains and losses. In this way, you could still hold 8 of the same stocks you had before, but you have dropped your exposure from 100 per cent to 60 per cent. There are also ways to buy double inverse ETFs. These investments essentially give you twice the investment impact for each dollar. The idea being you could buy a double inverse ETF with a $1 and if the TSX goes down 1 per cent, the ETF will actually go up 2 per cent. Unfortunately, the actual experience with these types of ETFs is that unless you are buying and selling over a very short period of time, they don't really achieve their purpose.
Whether you choose to stick it out over the long haul without major portfolio shifts, or you choose to use some capital preservation strategies, it is important to remember that the bigger picture of the markets is upwards. If you aggressively take risk off the table, it is very important to have the strategy in place now for when you put the risk back.
Ted is doing a live web chat on retirement income strategies on Friday, June 24th at 12 PM ET. To join the conversation, sign up here.
Ted Rechtshaffen is president and CEO of TriDelta Financial Partners, a firm that provides independent financial planning advice. He has an MBA from the Schulich School of Business and is a certified financial planner. He was vice-president of business strategy at a major Canadian brokerage firm.
Follow Ted on his blog at The Canadian Financial Planner.