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Ready for a stock market correction? Here are five things you can do to prepare

Traders work on the floor of the New York Stock Exchange (NYSE) in Manhattan on Thursday, June 28, 2018.

BRENDAN MCDERMID/Reuters

The well-built investment portfolio is always prepared for a stock-market correction. That’s the point of diversification and ongoing portfolio maintenance. You don’t have to make adjustments on the fly because you’re set for all market conditions. If you’re worried about a stock market correction and are unsure about how ready you are, check out these five suggestions:

1. Rebalance

Rebalancing means buying and selling parts of your portfolio to get back to the mix of stocks and bonds you set initially to meet your investing goals. Benchmark returns over the past 36 months for major stock and bond indexes highlight the need to rebalance.

While the FTSE TMX Canada Universe Bond Index averaged 1.6 per cent annually in the three years to May 31, the S&P/TSX Total Return Index (that’s share price changes plus dividends) made 5.4 per cent, while on the same total-return basis the S&P 500 made 12.4 per cent in Canadian dollars and the MSCI EAFE Index (Europe, Asia, Far East) made 5.7 per cent. With a $100,000 portfolio weighted 40 per cent in bonds and 20 per cent each in Canadian, U.S. and international stocks, you’d want to sell some of your U.S. holdings to top up your bonds.

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Investors have soured on bonds in the past year or so as a result of rising interest rates, which depress the price of bonds and bond funds. It’s easy to fall into the mindset where you let stocks take over your portfolio at the expense of bonds, but bonds add stability to a portfolio in a correction.

Pre-retirees – those retiring in the next few years – and people already in retirement must be extra diligent about rebalancing. A sharp market decline could severely damage the portfolio of someone with a portfolio dominated by stocks. At 30 or 40 years of age, you have decades to let your portfolio recover. At 65, you could find yourself having to dip into a portfolio that is 10 per cent, 20 per cent or even 30 per cent smaller than it was before stocks fell.

2. Tweak your bond holdings

If you’re worried about a correction, make sure your portfolio takes risks mainly in the stock side of your portfolio and not the portion in bonds. That means looking critically at your holdings in high yield and emerging market bonds. Expect both bond types to add to your losses in a plunging market.

Government bonds offer the best protection in a stock-market correction, but they’re also the most vulnerable in the sort of rising interest-rate environment we’ve seen in the past year. Corporate bonds hold up better when rates are rising, but are less of a help when stocks are falling. A blend of both types of bonds can be had in a broadly diversified bond exchange-traded fund, which is a solid core holding in a long-term portfolio.

An option for conservative investors is to use guaranteed investment certificates instead of bonds. GICs are illiquid in that you generally can’t sell until maturity without penalty. But they don’t fluctuate in price like bonds and are guaranteed to pay back your principal plus interest as long as you stay within deposit insurance limits.

Five-year GICs from online banks, trust companies and credit unions offer yields that topped out in the 3-per-cent to 3.5-per-cent range late this week, compared with around 2 per cent for a five-year Government of Canada bond. If you prefer not to lock money in for that long, it’s possible to get a quite decent return of 2 per cent to 2.5 per cent in one-year GICs.

3. Hold cash, but don’t get carried away

If you want to protect a portfolio against a plunging stock market, cash is your best friend. You’ll likely not make much more than 1.1 per cent annually on cash-type holdings, but you’re invulnerable to losses in both stocks and bonds.

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As with almost everything in investing, there’s wide variation in views on how much cash makes sense in a portfolio. Some say zero is the right amount in today’s low-rate world. A more cautious investor might consider what National Bank Financial has done in some model exchange-traded fund portfolios it recently created.

The income portfolio has a weighting of 7.5 per cent in cash, the conservative portfolio is at 6.5 per cent, the balanced and growth portfolios are both at 6 per cent and the maximum growth portfolio is at 5.5 per cent. A review of a few big balanced and equity mutual funds shows cash levels ranging from 3.5 per cent to 8 per cent.

Keeping more than 10 per cent of a portfolio in cash amounts to a market-timing exercise that can turn against you. One risk is that the market keeps going up and your resolve to stay in cash crumbles just ahead of a correction. Another is that you ride out the worst of the correction in cash, but then wait until the best of the subsequent recovery is over before getting back in.

4. Avoid trying the many new products Bay Street has to offer

It’s debatable whether anything has been added to the menu of useful investments since the exchange-traded fund was launched back in 1990 as something called Toronto 35 Index Participation units, or TIPs. But even if you’re intrigued by the many new products flowing into the marketplace these days, now is not the time to try them. Let other investors test-drive them through the next market crash.

There’s definitely a faddish aspect to a lot of the new ETFs coming to market. Many focus on sectors such as cannabis, cryptocurrency and artificial intelligence, which have generated good returns in some cases. But in a market downturn, sectors such as these will be scythed. It’s prudent to forgo any gains ahead in these sectors in order to insulate yourself from the risk of a correction.

Be cautious about new products designed specifically to protect investors in down markets. The term “alternative strategies” may be used to describe these products, which often delve into esoteric market niches in an attempt to generate returns that don’t move in sync with stocks and bonds. Fees tend to be high for these funds, and returns unpredictable.

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5. Treat Canadian and U.S. stocks differently

In a sharp correction for stocks, markets around the world will be punished. But given their outsize gains in the past 10 years, U.S. stocks would appear to be particularly vulnerable to a correction. The S&P/TSX Total Return Index averaged a very subdued 3.9 per cent annually over the 10 years to May 31, while the S&P 500 Total Return Index averaged 12.1 per cent when measured in Canadian dollars (9.1 per cent in U.S. dollars).

Here’s another perspective on how much more expensive U.S. stocks are: The price-to-earnings ratio for the S&P/TSX Composite Index was 15.7 in late June, compared with 23.6 for the S&P 500. Basically, you’re paying $15.70 for a dollar of TSX earnings and US$23.60 for a dollar of S&P 500 earnings.

Canadian investors have historically tended to overweight domestic stocks in their portfolio, but there was a strong push into U.S. stocks in recent years. That’s a good thing – Canada represents only about 3 per cent of the global stock market and is deficient in a pair of key economic sectors, technology and health care. U.S. companies also tend to have more of a global reach, which further enhances your diversification.

Now, it’s time to curb your enthusiasm about U.S. stocks. Consider adding new money to your Canadian holdings and paring your U.S. exposure back to levels specified in your original asset mix. A rough rule for diversifying the stock market holdings in your portfolio is one-third each in Canada, the United States and internationally (everywhere but North America).

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