In past market downturns, I’ve always maintained that an investor should stay the course, as long as she has a suitable asset allocation that she is comfortable with. Even though markets have been losing big chunks of their value seemingly every single day, the mantra remains the same: hold the course.

However, a number of investors are unfortunately finding out only now that their asset allocation was far too aggressive. What should these investors do?

The answer is easy for investors who find that they have an asset allocation that is inappropriate for their financial goals. For example, an investor who finds that the education savings of their child who is attending school pretty soon is mostly invested in stocks should take action now. She should reduce the risk of the portfolio right away by selling some stocks and parking the proceeds in savings accounts or cashable GICs. For all we know, it could get a lot uglier and it may be better to take the lumps now and preserve whatever capital is left.

It is harder to think of a suitable course of action for investors who have the ability to take risk but are only now finding out that their risk tolerance is a much lower than they had earlier estimated. There are no easy choices. They could sell some stocks now but they may be locking in their losses but selling may also mean that they don’t take an even more drastic action should stocks fall even more. Or they could resolve to reduce risk at the first available opportunity and plan to endure the current downturn. The obvious risk here is that things get a lot worse and they sell at an even worse time down the road when they feel they can’t take the heat anymore.

Personally, I’m opting to hold the course. My rebalancing spreadsheet indicates that the bond portion has increased to 2.5% of the portfolio. If current trends continue, it will soon be time to sell some bonds and buy some stocks. Until then, I’ll just be content to watch the horror show on Bay Street from the sidelines.

This article has 27 comments

  1. I think nervous investors have to suck it up and learn what investing in equities is all about.

    There is no perfect “sleep inducing” allocation that will get you through times like now without any worries at all. I’ve been investing in equities for 20 years and have been through a lot of ups and down. I’m fine with the drops, but I still don’t like them (ok, maybe a bit).

    If we end up with an extended bear market, I’ll have stress as well. That’s just the way it goes when you are investing in equities.

    One tip for investors is to compare the current market to further back than the recent peak. How far down is the TSX from a year ago? (It’s not).

    Another tip is to consider their entire portfolio. The headlines scream about equity index drops, but how many investors have 100% equities?

  2. In times of a sell off, I’m always curious about human tendencies getting involved in a passive indexed portfolio.

    Does one stick to their rebalancing schedule (quarterly, annually, new money only, etc…) or does one “time hte market” and buy on the dips to rebalance? Is that counter to the indexing philosophy?

    • @Mike: A little bit of perspective will definitely help. Investors all too often look at their current portfolio balance relative to a recent peak. Instead, they should be looking at their total rate of return on their original investments with the understanding that it will fluctuate dramatically in the short-term.

      @Jon: I rebalance in two ways. When adding new money or when allocation deviate a lot from their targets. Calendar rebalancing is fine if one has no interest in keeping track of the markets. As long as one rebalances occasionally (whichever way they pick) is fine IMO.

      I find it really curious that so many investors are shaken up as soon as markets start falling. I’m not sure what they expected: stocks go up at a gentle pace like interest payments on GICs?

  3. I see only two solutions,

    (i) move entirely out of equities and 100% into GICs or,
    (ii) modify your asset allocation based on short-term macro-economic trends

    What fun is it to watch your bond allocation increase 2.5% above target AND watch the markets tank yet do nothing about it?

    Do you keep cash in your portfolio CC?

  4. @Sampson: I think it is (ii) with most investors. They want to be in GICs when stocks are falling and they don’t want to miss out when stocks are going up.

    I keep some cash in our portfolios. Typically dividends & interest payments, new savings etc. that need to be deployed. I can ride through small blips in the market by just rebalancing with new money. A really big one would need rebalancing by selling bonds and buying stocks. Right now, we are not there yet.

  5. I’m a young-ish investor (early 30’s) and I’ve been through a fair bit already – Nortel crash, 9/11, tech crash, subprime collapse, etc. – and not once was I worried about my investments (all index, no bonds). I knew they were taking a beating, but knew I had a lot of time to recover. Also, I know that markets are highly emotional and way too reactive, and that once the hysterics subsided, things would come back.

    That said, I’m feeling far greater fear about what’s going on these days then ever before. Greece collapsing, Spain, Italy…and finally the US seems on shaky ground these days. Truth is that was inevitable given the spend, spend, spend mindset of the US, but given all these financial issues arising at the same time, I cannot help wonder if another major depression is underway. Afterall, the market is due for a MAJOR reset at some point – it’s just way too unsustainable.

    Look at what happened during the depression… even families that were doing well for themselves found themselves scrambling hard to find food for the table. My fear right now is that while I’m living comfortably and make a decent salary with a decent safety net, that if a depression comes, I’ll be yanking out any savings I have at such a negative ROI that I’ll essentially be dirt poor. That’s not a comfortable feeling.

    • @EZ: I agree with you that things could possibly get quite bad if something isn’t done by many Governments about their debt situation. The problem is a lack of will to tackle it or postpone any tough measures that need to be taken. That’s where a crisis will help… nothing like a good crisis to focus the mind. Take the US. The debt situation isn’t all that bad. What’s required is a combination of belt tightening and increasing revenue by boosting taxes. There is quite a bit of room for the US to raise taxes. The question is one of will. Instead of concerted action we are getting political theatre. I have no doubt that the US especially has the capacity to right the ship – after all, that’s precisely what we did in Canada in the 1990s and it has improved out fiscal situation tremendously.

      @Phil: A big reason why employment is not coming back in the US is construction. But construction will eventually come back after working through the inventory. I see enormous reason for optimism myself. A huge chunk of the world is developing rapidly and that process will drive growth for many many years to come. It’s just that near-term we have some problems to work through.

  6. @EZ. It’s times like these that investors like to wax philosophically. In my humble opinion, you should think about what happens if there is a major recession or a depression.

    No matter how bad things get, we all have basic needs. We need a roof over our head, we need something to eat for dinner, some people literally “need” pharmaceuticals to keep them alive. So, those areas should be the MOST “staple” of the consumer staples.

    In modern society, we also need energy – not just for heat in the winter to survive but also for transportation to work, for those who are still working in a depression. We also need a monetary system to enable an economy, which requires support by a functioning banking system.

    As you progress up the “food chain”, the “needs” slowly turn to “wants” until you hit consumer discretionary items. In my opinion, if you are truly worried about a depression, you should consider this and invest accordingly to help you sleep at night. That said, I’m a stock picker, not an indexer, so I have a bit more freedom to pick and choose – but from indexers I know, I’ve heard that there’s an index for everything, so you should be able to construct a portfolio that suits your comfort level. And remember to breathe deeply! 🙂

  7. I liked your last line CC, I had a good chuckle 🙂 As always, good post.

  8. EZ, I have the same fears as you do. We’ve now had a decade where the total return of the S&P 500 is negative in US dollar terms (and was only slightly positive before the recent dip), strongly negative in CAD terms, and yet the Shiller P/E is still 20.4, quite high compared to the historical mean and median. This combo has never happened before. Combine that with demands for austerity and spending cuts, and I don’t have very much faith in future equity returns in the US. (Or Canada either.)

    Couple that with the traditional relationship between inflation expectations and bond prices having broken down in Canada as US investors have been increasingly turning to buy foreign bonds, and there really isn’t anywhere to invest that makes sense right now, except perhaps in nontraditional assets.

    I wish I had a spouse who had a government pension; might make me more relaxed. I think those of us who are indexers and have to fend for ourselves may well be more exposed to negative long-term outcomes than history suggests.

  9. I am sure that the US will raise taxes after the next election. They pretty much have to. By how much, remains to be seen.

    The US is filled with so many great companies, their stock market will do just fine, no repeat of Japan with their low rates.

    I would love to see a controlled default of some of the European countries, it wouldn’t be fun, but it would actually be a step in the right direction.

    Gret post, I would love to see more posts in the future discussing the markets like this.

  10. @Viscount: I have a slightly different take on valuations today. I agree that they are not great but I also think they are satisfactory. 2% dividend yield and 2% real earning growth will give us 4% real returns on the stock portion. The returns from the bond portion as you point out is a very low these days after adjusting for inflation. The question is what about future valuations? p/e ratios are right now in the ballpark of the long-term average, so the odds are good that we won’t lose some of the future returns to p/e compression.

    The problem we have is what’s the alternative? Some may say stock picking, some may say TAA and others may say trading. The problem is each of these alternatives have their own set of issues, foremost of which is the risk that an investor could do even worse than passive investing.

    That said, while we can make conservative estimate of expected returns, realized returns could be quite a bit different. So, we need a Plan B. We could save more, work a bit longer or pick up part-time work in retirement. We can only give ourselves very good odds of success; it is not guaranteed, of course.

    @Cal: The US would have to eventually act. I hope they do sooner. Perhaps this crisis will provide the impetus to act but next year being an election year complicates matters.

    It would have been a lot easier if European countries had their own currencies. A big drop in the value of the Drachma, Irish Pound etc. would have provided the necessary shock treatment.

  11. The discussion around the euro experiment I find interesting from a purely academic point of view. Pundits are calling for the breakup of the euro because the economies are so different, etc. But really, every federation of independent states have the same issue. In America, the differences between the economies of Nebraska and New York can’t be much greater than the difference between Germany and Greece. The difference between the economies of Alberta and Prince Edward Island can’t be more different, either. So, why aren’t the same pundits calling for the break-up of the USA into 50 different countries and currencies, or why don’t they call for the break-up of Canada into 13 different countries and currencies?

    • @Phil S: I’m definitely no expert on this but my understanding is that EU countries set their own fiscal policies and there is no concept of transfers like we do in Canada. That’s why EU is a strange beast. But that’s my understanding and I could be wrong on this one. 🙂

  12. @CC. Again, disclaimer first that this is an academic discussion – I’m not advocating one way or another for the breakup of Europe, Canada or the USA. But provincial governments set their own fiscal policies, maintain their own budgets, issue their own bonds, but rely upon the Bank of Canada to issue currency and set policy rates. The relationship between euro zone states and the European Central Bank is very similar.

    It wasn’t too long ago that Canada had similar disparities – the economy was red hot in Alberta and needed higher interest rates to keep inflation down while at the same time Ontario’s manufacturers were suffering and needed a lower interest rate to stimulate investment. The “have not” provinces are perpetually up to their eyeballs in debt, just like the PIIGS in europe. The “have” provinces drive the country forward like Germany.

    My thesis is that the problems being experienced by the euro zone aren’t much different than any and all large federations. Do they really need to smash it all up and start from ground zero again, or do they just work through their problems like we or the Americans have had to do under similar situations?

    As much as sovereigntists in Quebec would beg to differ with my next statement, a fiscally united market of 30 million people that is Canada is much stronger than a busted up bunch of ridiculously small little countries. One could draw a parallel with the Euro zone – that together they form a population and economy that has the potential to rival America. Apart, they are a bunch of little countries, most of whose markets are too small many multinational corporations to be interested in doing business. If you have as much bureaucratic red tape to do business in Germany as it would take to do business in Luxembourg or San Marino, which market would you rather pursue as a businessman? But united, they are (collectively) an impressive unified market.

    Again, I realize that this is purely an academic argument. As a student of history, I realize that there is thousands of years of history in Europe including much bloodshed, resentment, hatred and prejudice and it is rather amazing to me that they have come this far with their experiment through setting aside their differences. It would be disappointing if it were to calamitously collapse at this point.

  13. @Phil:
    There are real structural differences between the EU and other large federated entities. The core differences, as CC pointed out, is that the EU is both not a transfer union and has no central fiscal policy. The architects of the Maastrict treaty were in adamant that the EU was not to become a transfer union; and there is a clause in the treaty that prohibits transfers that was added at the behest of Germany and others. The treaty would have to be re-ratified if this was changed.

    Canada and the US have both of these elements that the EU lacks. The US does not have explicit transfer payments like we do, but the federal government’s unified taxing and spending power accomplishes much of the same thing. (The military alone functions as a giant welfare and equalization scheme.)

  14. I certainly sympathize with the investor who has a poor asset allocation, and it’s times like these that really begin to put your portfolio to the test. I think your example with RESPs really highlights how serious market swings can affect a family’s real-life objectives.

    From a personal standpoint, I’m staying the course and looking for bargains along the way. I’d be lying to suggest that I know where the next bottom will be.

    NIce post.

  15. @Viscount. My point is that you don’t necessarily have to destroy the Euro to fix this problem. They may be able to “tweak” the system to make it work better.

    The talking heads who comment on this speak in extreme “black and white” terms. If it doesn’t work, destroy it completely and start from scratch.

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  19. Everything is so interrelated now that it is hard to pinpoint an impact in Europe let alone anywhere else in the world. The common thread that runs through everything is currency, the lifeblood and that would mean the US$. Start there and then reason your way through the possibilities. Below is a quick and dirty mind-map off the top of my head.

    Rising US$ when (crisis Europe, currency controls, another credit crisis, QE stops, US makes tangible budget reductions, terrorist attack, trade barriers rise, Fed jacks up rates) = Gold falls = Oil falls = US exports fall = US profits fall = US stocks fall = US stocks more expensive) = inflation falls = GDP falls.

    Therefore strategy = Short US stocks = short Oil = take US$ hedges off = average down high quality stocks in a sell-off.

    Taking the other side:

    Falling US$ when (US govt impotence, China revalues yuan, Fed starts the printing presses again, zero interest rate policy for x years) = Gold rises = Commodities rise = US stocks on sale (especially one’s with global exposure) = US exports rise = US profits rise = inflation rises.

    Therefore strategy = buy US stocks with global prescence (i.e blue chip, low debt, high cash), hedge US$ positions, buy oil/gold,

    Surrounding either of these paths are investor sentiments (VIX, retail investor fund flows, inside selling), which drive your entry/exit points. Last week was perfect example of how if disciplined and armed with a mind-map (not necessarily like my blurb above), one could exploit the fear that was oozing out of the market.

    Cheers,

    @sageinvestors

  20. @ Phil S: Gwynn Morgan wrote an article in the Globe today about the euro zone. He reckons that the union is doomed to failure because there is a lack of a strong central governing body (individual nations retain nearly autonomous control over fiscal policy within their own borders). He compares the situation to a 17 member family opening up a joint bank account – the free spending siblings will drag the others to financial ruin. Gwyn is a bit right wing (my opinion, from having his articles over the years), so must sometimes taken with a grain of salt to moderate to the
    middle ground, but the argument rings true to me.

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  23. The ECB may have to lower rates this Thursday, this should help bonds and my cause the $ CDN to fall due to fear of weak commodity prices?

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