Controlling your investment risk
Article By: Gordon Pape
The stock market dive that ushered in March should be treated as a wake-up call. It's time to take a fresh look at your portfolio and see how you can reduce risk.
March came in like a lion as far as the stock markets were concerned. In five trading sessions from Feb. 27 to March 5, the S&P/TSX Composite Index lost almost 700 points or more than 5 per cent of its value. The sharp drop frightened many people and raised concerns about the possibility of a new bear market. If you were among them, it may be time to revisit your portfolio. It probably contains too much risk for your temperament.
Actually, a 5 per cent drop is rather modest by historical standards. But it should serve as a wake-up call to all investors. Stock prices don't go to the moon. Sooner or later, the markets will retreat and consolidate before starting to move higher again.
The current bull market began in late October 2002 so we've enjoyed over four years of steady profits. People tend to become complacent in that kind of situation. While that's understandable, it is also dangerous. Bull markets don't last forever. No one can predict exactly when the next downturn will come but the smart investor is prepared for any eventuality.
How do you do that? By paying close attention to your asset allocation. Most investors are more concerned with trying to pick individual securities than they are with ensuring that their asset mix is right for their goals and temperament. That's putting the cart before the horse. Asset allocation should be the first step. Once you know how you want to structure your portfolio, you can concentrate on selecting the best securities. But put first things first.
I know that to many people this sounds very basic. I make no apologies for that – it is. But asset allocation is the cornerstone of smart investing. Repeated studies have shown that having the right mix is more important to your total return than the individual securities you choose. Yet even seasoned investors lose track of their portfolio balance from time to time, especially when markets are volatile.
When markets are performing well there is a natural tendency to direct more of your money towards equities. Steady profits produce a sort of investor euphoria, a state which leads to impaired judgement. That lasts until the moment the market turns around. Then people rush to make changes – perhaps too late, depending on the speed and severity of the slide.
Remember 2000? At the start of the year, investors were giddy. The high-tech boom was making instant millionaires out of thousands of people, the Dow was setting new records, and many pundits were telling us that we were experiencing a new paradigm which would see stocks continue to rise for the next decade. By Easter, the markets were in full retreat and we all know what came next.
So don't procrastinate any longer. If you've been telling yourself for some time that you really need to sit down and review your portfolio, then do it now. Perhaps the next bear market is many months away. But maybe it is only days away. Be prepared!
The best way to do that is through proper diversification. For most people, that will mean reducing stock market exposure and increasing bond exposure. Using a computer program developed by Ativa Interactive of Hamilton, Ontario, I looked at the impact of different asset mixes on a portfolio during the period from August 2000 to September 2002, when the bear market was in full control. A portfolio that was 80 per cent in equities and 20 per cent in bonds would have lost 30.7 per cent during that period. A portfolio with a 50-50 weighting would have been down 11.7 per cent. With a 60-40 weighting in favour of bonds, the loss was trimmed to 5.6 per cent. At a 30-70 stocks to bonds ratio, the portfolio actually turned a small profit over that period. That's the power of asset allocation at work!
I do not mean to sound like a Cassandra. I am not suggesting that you convert all your assets to gold and cash and head for the hills. What I am advising is a healthy dose of prudence, reality, and common sense so that when the next big dip comes (which it will) you can rest more comfortably.
© March 2007 Gordon Pape Enterprises Ltd.
