It's been nearly a decade since the worst global market meltdown after the Depression, and it seems the carnage is a fading memory for many investors.
In 2008, global equities – measured by the benchmark MSCI World Index – lost more than half of their value in less than a year. Yet, a recent Wells Fargo/Gallup poll finds only 54 per cent of Americans expect another meltdown – down from 58 per cent in 2014 and 62 per cent in 2013.
Global stocks have tripled in value since that 2009 low, but in the same poll only 18 per cent said they're selling stocks to cushion their portfolios from another selloff, and only one out of five said they were buying bonds to limit their exposure to the stock market.
As the fear-factor subsides, David Driscoll, president and CEO of Toronto-based Liberty International Investment Management, believes the risk of another pullback is actually growing. He says the rise in stock prices has far outpaced the true measure of value: corporate earnings.
"In 2009, I could buy a dollar of earnings for $6 to $10. Today, you're having to pay upwards of $50 for a dollar of earnings," he says.
His advice for investors is to lower risk without sacrificing further market gains by trimming stocks that have outgrown other holdings. "By having too much in one stock, you're subject to that one stock blowing up," he says. "In retirement, you can't rely on having too large a concentration because if one of them blows up, it could take away a quarter of your retirement savings."
Mr. Driscoll expects companies with heavy debt burdens to come under pressure as interest rates rise, and the cost of borrowing increases. He suggests investing in companies with a record of growing cash flows after expenses, and that have the financial flexibility to raise dividends. "All of our stocks pay dividends, but because of the free cash flow they tend to grow their dividends at a much faster rate," he says.
Another tried-and-true risk hedge he recommends is diversification. That means limiting holdings that correlate with each other, such as Canadian equities, which are heavily weighted in the finance and resource sectors.
"Often you will see in Canadians' portfolios they will own all the banks and utilities and telecoms when they should just have one and diversify away from that. In 2008, when the market fell 40 per cent, it wasn't just one Canadian bank that fell 40 per cent. All of them did," he says. "You can have a 30-stock portfolio in different industries and not have to worry about that correlation risk."
Mr. Driscoll says investors should further hedge Canadian market risk by diversifying on a global level, where returns are historically higher. "The Canadian-dollar returns for both the S&P 500 and TSX are close to zero. So if you're not invested globally this year, you're not making any money."
Other advice is as simple as reviewing investment fees, which are deducted each year from the total assets invested. "If you're paying a 2-per-cent fee in a mutual fund and you're making 7 per cent, 22-per-cent of your performance is disappearing in fees," he says.
Most do-it-yourself investors aren't able to access some of the more complicated hedges on the options market, so Mr. Driscoll suggests building up cash as a "synthetic short." Cash will hold its value if markets tank, and can be deployed to buy bargains when they bottom. "This is the best of both worlds. Even with 80 per cent invested, if the market continues higher, you will participate. If the market corrects, you never want to be fully invested selling into a falling market," he says.
Cameron Hurst, chief investment officer at Equium Capital Management, is more bullish on the broader equity markets, but is still advising clients to prepare their portfolios for a sudden market downturn.
"You just need to be able to get out of the way of the pain. If the pain is in risk assets, you need to be able to shift into bonds or bond proxies," he says.
Bond proxies are defined as defensive stocks that tend to pay bigger dividends than bonds, such as real estate, consumer staples, telecom and utilities. However, Mr. Hurst warns even bond proxies can be risky when interest rates rise.
"We don't think interest rates are going through the roof. Could they move in the direction of 3 per cent and put pressure on those bond proxies? Certainly," he says.
To manage risk, Mr. Hurst maintains a weighting in traditional fixed-income, such as bonds, but low yields have him pulling back from the portfolio benchmark 40 per cent to only 25 per cent. "We just think you're better off right now with more equity exposure than bonds," he says.
He considers bond proxies part of the remaining 75-per-cent equity portion and has boosted his exposure to a vast array of riskier global equity stocks to boost overall returns.
He says that level of diversification allows him to hedge risk and target overall annual returns of between 7 and 9 per cent.
"We run the mandate for total returns. We generate some of the return from yield, some of it from capital appreciation, some of it from dividends and some of it from income," he says. "Our job is to preserve and protect capital, but we have to get return for investors."