The steep dive in stock prices in February and March has taught a hard lesson on how quickly your portfolio can lose a lot of ground.
Now that stock prices have rebounded close to where they were before the crash, it’s a good time to make sure your portfolio and finances are resilient. Although no one can reliably predict what’s going to happen to markets in the next year or two, the potential threat of a second COVID-19 wave creates lots of financial uncertainty.
“Given what happened in March and that sharp market crash, clients are focused on protection. They want resiliency in whatever way it can be delivered to them,” says Neville Joanes, chief investment officer with WealthBar, a robo-adviser type of investment firm.
In what follows, we describe key things you can do to make sure your portfolio and your finances are resilient no matter what happens to stock prices in the short term. We have included insights and practices cited by Joanes and a chief investment officer at another robo-adviser firm, Justwealth’s James Gauthier.
Start with a resilient attitude
While there are a number of concrete things you can do to make your finances resilient, it’s important to realize that you also need a resilient attitude to go with it.
It’s human nature to feel anxious when your stocks get pummelled, which makes it tempting to sell. Unfortunately that means selling low — doing the wrong thing at the wrong time. So you have to resist that urge and stay invested in stocks for the long term.
Realize stock market downturns happen periodically and unpredictably. “If the markets seem crazy, you have to stick with your plan, stay focused on the objective you have, and the time horizon you have,” says Gauthier.
Find the right balance
A resilient portfolio needs the right balance between stocks and fixed income like bonds and GICs. That balance should be based on your financial objectives, your risk tolerance, your time horizon and other personal circumstances. An asset allocation of 60 per cent equity and 40 per cent fixed income is a classic split for investing long-term, but individual situations vary. Retirees often suit a little less equity (50 to 60 per cent equity is a reasonable range for most retirees, in my view). On the other hand, younger investors can often benefit from more than 60 per cent equity.
The equity in your portfolio is the main driver of long-term returns and growth, but suffers during market meltdowns. Relatively safe forms of fixed income like investment-grade bonds and government-insured GICs don’t generate much interest these days. However, they generally hold their value during stock downturns and therefore provide stability when you need it most. So equities and fixed income are complementary and you generally need both when investing long-term.
That balance helps you do smart things when stock markets swoon. The fixed-income component reduces the impact on your portfolio when stocks are beaten up, thereby making it easier to “stay the course” and benefit from the eventual market recovery. It also sets you up to benefit from rebalancing back to your long-run asset allocation. In that case, you sell the asset that has held its value — fixed income — to buy stocks cheaply, so you’re selling relatively high and buying low.
Diversify your equity
You should spread out risks from different stocks so you’re not overly dependent on the returns of a particular company, industry or geographic area. That helps you avoid a common pitfall of loading up on a hot stock, sector or area just before it turns cold and drops sharply. The tech boom and bust of the late 1990s and early 2000s is a famous instance, but that pattern repeats in smaller-scale examples. “Most recently we had the cannabis sector which had this huge run-up and effectively fizzled out,” points out Joanes.
There is no one right formula for diversifying, but one simple approach is to use broad-based ETFs to invest one-third in Canadian stocks, one-third in U.S. stocks, and one-third in international stocks. Investment firms such as Justwealth and WealthBar typically apply similar principles in a more sophisticated fashion with a number of sub-asset classes. For example, the U.S. stock exposure might be disaggregated into large-capitalization, midcap and small-cap stocks.
Invest conservatively for short-term goals
If you’re saving up for a definite short-term goal, you should avoid stocks and instead invest in something that you know will retain its value. Good options for short-term money include an investment savings account (a WealthBar option) or a very conservative fund dominated by fixed income (which Justwealth offers). Unfortunately, you also have to put up with very low interest rates on short-term money these days.
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What’s the dividing line between short term and long term? In my view, money that you’re pretty certain to need in the next year or so should be invested short term. Money that you’re pretty sure you won’t need for at least five years can be invested long term, in line with your long-term asset allocation. For time horizons between one and five years, look for an in-between asset mix that provides the desired tradeoff between short-term protection while providing some exposure to higher expected returns from equities. Figuring out the right balance can be tricky because it can depend on evaluating different factors such as the concreteness and relative priority of your goal. Investment firms like Justwealth and WealthBar offer processes to help you figure out what works best for your situation.
Have a source of emergency cash
Many experts advise that most people should have an easily accessed “emergency fund” that covers three to six months’ worth of spending, while recognizing that retirees often benefit from more. In my view, that is good advice, but there are a couple nuances to consider.
For one thing, money set aside for short-term goals might do double duty as emergency cash. If, for example, you’ve set aside money in an investment savings account for the down payment on a home, but you lose your job because of the COVID-19 crisis, then if necessary you can dip into the down-payment money to support yourself until you get another job.
Also, your emergency money doesn’t all have to reside in a separate account. You might also tap into the short-term fixed-income part of your portfolio to supplement your separate emergency fund. (But be cognizant of the tax impact if you’re potentially withdrawing those funds from an RRSP or RRIF.)
Protect retirement withdrawals
Retirees generally need to draw money from their portfolio to live on. But in generating that cash flow, they need to avoid having to sell stocks at distressed prices. If you encounter a steep and prolonged stock downturn early in retirement, selling stocks to cover living costs can diminish your portfolio so much that you don’t benefit much when stocks eventually recover. (The experts refer to that as “sequence of returns” risk.)
There are three main strategies for protecting retiree finances from having to sell stocks at the wrong time. First, there is a general approach to structuring your portfolio known as the “bucket” strategy. Under that approach, you notionally divide your portfolio into at least two “buckets.” You create a short-term bucket composed of cash and reliable forms of short-term fixed income, which is separate from your long-term bucket holding your equities and other relatively risky assets. The idea is to make sure you have enough assets in your short-term bucket to supply your withdrawal needs for an extended period if and when stock markets are depressed. That leaves your long-term bucket untouched during a market sell-off, thus allowing it to recover undisturbed.
The second approach is income investing, where you rely on reliable forms of dividends and interest to generate most of the money you need to live on. On the equity side of your portfolio, you generally invest in blue-chip, dividend-paying stocks such as large Canadian banks, insurance companies, telecoms, and utilities. You’re looking for stocks that pay ample dividends, but you also want to make sure they’re reasonably reliable and won’t get cut during recessions (although even blue-chip stocks come with some risk of that happening). On the fixed income side, you stick mostly to relatively safe investment-grade bonds and government-insured GICs. If most of your cash-flow needs are covered reliably, then that helps you avoid getting cornered into selling equities at the wrong time to cover living needs.
A third approach is using part of your portfolio to purchase annuities, which provide guaranteed cash flow for life. However, annuity payout rates are closely linked to interest rates, so payout rates are very low right now. Still, they can make sense in the right situation.
Like many investment firms, Justwealth and WealthBar offer retirees the option of portfolios focused on generating cash flow. They also offer some bucket-strategy features, although not in a fully elaborated form with formally defined buckets. For example, WealthBar offers retirees the ability to redirect withdrawals so that they are taken from the fixed-income part of their portfolio if stock prices become depressed.
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