Managing market instability: Diversify - and rebalance

It was almost biblical the way the stock markets kept giving to investors and then taking away in the past decade.

The taking away part seems to have fried some nerves out there. After two epic boom-bust cycles in the past 10 years, Canadians are keeping historically high amounts of cash in safety-first investments like money market funds, savings accounts and short-term GICs.

Returns from these products are typically in the zero to 2 per cent range, which isn't going to allow many investors to realize their long-term financial goals. The alternative: include some exposure to stocks in a way that limits your vulnerability to the instability that defined the past decade.

People who are close to or in retirement are those who have the most to worry about in terms of stock market ups and downs.

"In retirement, you have to be prepared for a stock market correction every day," said Clay Gillespie, a financial planner at Rogers Group Financial in Vancouver.

Mr. Gillespie takes step to prepare his clients. Five years before they retire, he starts looking for an opportune time to buy bonds or guaranteed investment certificates that mature right around the time they'll be retiring and can be used to fund living expenses for three to five years.

A client retiring into the kind of stock market conditions we saw last winter could cash in some of his or her bond and GIC holdings and leave stocks or equity funds to benefit from a market rebound. In a bull market year, a retiree would keep his or her bonds and GICs intact and skim off some of stock market gains to pay for living expenses.

Mr. Gillespie's a lot less concerned about the impact of stock market ups and down on younger people who have decades to go before retirement, though he recognizes the psychological impact on them. "I always tell clients that over a 10-year period, on average, you're going to love me twice, you're going hate me twice and you're going to be indifferent to me six times."

Diversification is the most basic form of protection against market boom-bust cycles. It would have protected you nicely from the technology bubble that began the decade, and it would have worked in the most recent bear market if you had significant exposure to government bonds and Treasury Bills. They were the only safe haven when the stock markets began to plunge in September, 2008. You could have diversified across all stock market sectors and countries and not benefited one bit.

The reason why diversification doesn't work for some investors is that they fail to stick with it after setting up a portfolio designed with precise weightings in stocks and bonds.

"Over time, because of the movement of the markets, those weightings are going to change," said Gareth Watson, a senior equity adviser with ScotiaMcLeod. "If equities outperform bonds, all of a sudden your exposure to equities is going to be greater than fixed income. You've now veered away from your financial plan."

The next step? Get back to your plan. Sell some of your stocks and buy bonds to get back to the right mix.

The concept of rebalancing extends to individual stocks in your portfolio that have had big runups. Sheryl Purdy, vice-president at Leede Financial Markets in Calgary, said she recommends that clients sell half their holdings in a stock that doubles.

Some advisers say it's better to let your winners run, but Ms. Purdy likes the idea of clients taking their initial investment back and moving the money into something else. Recalling the market saying that "pigs get slaughtered," she's big on having discussions with clients about when to sell the entire position in a winning stock. Sometimes, clients fight her on this.

"It is so difficult to get them to lock in those profits," she said. "It's like their mind clouds over with greed."

Winning stocks and funds are what make investors feel successful. But as they grow in your portfolio, they increase your vulnerability to big losses in the next stock market decline.

To illustrate how this works, ScotiaMcLeod's Mr. Watson used the example of bank stocks. Say you bought them in 2002 to make up 5 per cent of your portfolio and by the middle of 2008, just before the market crashed, they were up to 20 per cent weighting. As it happened, the banks were easily down by approximately half in the worst of the bear market. A 5-per-cent weighting in banks would have set your portfolio back 2.5 per cent, then. With a 20-per-cent weighting, you would have lost 10 per cent.

Mr. Watson suggests rebalancing your portfolio every six months. If your weightings of stocks and bonds are skewed by a couple of percentage points, there's no urgency. If you're off by five percentage points or more, it's time to trim your winners and buy more of your losers. That's how you manage the give and take of investing in the stock markets.

Rebalancing 101

Here's how to rebalance the stocks and bonds in your portfolio in order to limit your vulnerability to the kind of big stock market ups and downs we have seen in the past decade.