Given Donald Trump's recent behaviour, I've concluded the U.S. market has probably run up as far as it's likely to go, and I've been selling off some of my U.S. stocks that are overbought to prepare for a buying opportunity I see coming. I don't want to sell everything, because my remaining stocks are paying decent dividends. I'm holding all of my Canadian stocks for now, because I believe the Canadian market still has room to grow. And essentially, I'm a "buy and hold forever" type of investor. But that leaves me concerned about some possible market disaster over the next year or so. My question is: What methods do you recommend for hedging a portfolio?
Before I answer your question, may I ask you a favour? Could you let me know who will win the Stanley Cup this year and, if it's not too much trouble, what the winning Lotto 6/49 numbers will be? Forgive me for being facetious, but what struck me about your e-mail is the remarkable precision of your market outlook. Not only do you see the U.S. market heading for a fall, but you seem to know which U.S. stocks are most vulnerable (the "overbought" ones you sold, presumably) and that Canadian stocks will continue to rise.
If I sound skeptical, it's because the market has a way of humbling people who try to forecast where it is heading in the short term. (Remember Royal Bank of Scotland's call in January, 2016, to "sell everything"? The S&P 500 is up 22 per cent since then.) The truth is that nobody knows what the market will do tomorrow, next week or next year. The only thing we can say with any degree of confidence is that the stock market tends to rise over the long run, with lots of bumps – occasionally nasty ones – along the way.
I believe the secret to building wealth is to learn to live with these inevitable setbacks, not to try to avoid them. Let's say you're convinced a market drop is coming. How will you know when it's time to sell? What will you sell, and how much? What if you sell too early, or too late? And if you do sell, how will you know when it's safe to get back in? I have never known anyone who can do these things reliably. Market timing is frowned up for a good reason: It rarely works.
With respect to hedging, my first recommendation is to stay away from inverse exchange-traded funds that let you bet against the market. These products are for short-term trading purposes only and won't necessarily deliver the return you expect. Some investors hedge their portfolios with index put options that rise in price if the market falls. But I don't recommend this strategy, either, for two reasons: First, options pricing is complex and the market is dominated by professionals who have far more knowledge and experience than the average retail investor; and second, studies have shown that retail investors who use options have lower returns, on average, than those who do not use options. "You can very clearly say in the aggregate, this doesn't help individual investor portfolios," Daniel Dorn, a finance professor at Drexel University, told The New York Times.
A better approach – and the one I use – is to stop worrying about what "the market" will do, and instead focus on the individual stocks in your portfolio. Remember, stocks aren't just pieces of paper to be flipped; they represent part ownership of a business. So, look at the list of companies you own and ask yourself: Is the business profitable and growing? Does it have a solid competitive advantage or "economic moat"? Will it still be thriving 10 or 20 years from now? Does the company pay a dividend, and do you expect that dividend to grow? If the answers to all of these questions is yes, then selling the stock or hedging against a temporary drop in its market value – which may or may not happen – would seem unnecessary. On the other hand, if you have concerns about the outlook for the business, then selling might be prudent.
I would agree that Donald Trump's first month as U.S. President has been, er, interesting, but I don't see it materially affecting the earnings of Procter & Gamble, Johnson & Johnson, Enbridge, Telus or the other stocks I own personally and in my Strategy Lab model dividend portfolio. So, as a buy-and-hold investor, my plan is to simply hang on and collect my growing dividends. Focusing on your dividend income is a great antidote to the stress of watching the market.
If you're still worried that about a potential "market disaster," perhaps this would be a good time to revisit your asset allocation to make sure it fits your risk tolerance, age and other factors. You don't have to necessarily sell stocks to reduce your equity weighting; you can accomplish the same thing gradually by plowing your dividends – or any new cash you have – into bonds, guaranteed investment certificates or, for maximum flexibility, a high-interest savings account. That way, if the big one does come, you'll have some cash to go bargain hunting.