There has never been a market correction that has not recovered. Of course, this time could be different — but something tells me it isn’t. Market corrections are part of the natural cycle of the stock market. Those who have level heads and view pull back as opportunity, will profit from those who do not stay the course.
In the past, I have explained how the stock market upward movement is like riding up on an escalator. When the markets have these sharp declines downward, it feels more like riding a vertical downward elevator. Eventually, though, it does reach the bottom floor and rises up again. The stock market will, in the future, end up higher than the highest point it reached before the previous correction.
Action depends on situation
The natural tendency during these times is to feel like you have to do something. Nothing pains me more than to see someone liquidate quality holdings after a market decline. When an investment is sold after a correction, you make the situation permanent. Sometimes, I think the ease with which stocks can be sold results in people making poor short-term emotional decisions.
Managing expectations and emotions
When we meet with new clients we purposely do not promise any specific future return. We don’t even provide an estimate of what they might make.
We are happy to provide our historic returns. The nice part about reviewing historic returns is that they can look at multiple years and calculate averages. New clients that transfer in an existing portfolio already have some experience with their previous performance. We typically ask how long they have been investing to obtain an understanding of the market cycles they have experienced.
Occasionally, we get a new client who has limited investment experience. They may have sold a business, received an inheritance, or sold a house. Prior to investing for these clients, it is important to discuss volatility and how to react to it. Getting the funds initially invested is done over time. We may invest 25 to 50 per cent of the funds within three to six months. The percentage could be greater depending on market conditions.
Those who manage the emotional component of a potential correction are able to stay the course with their portfolio. Below are a few tips that help both experienced and new clients deal with market volatility.
Creating wedge
All of our clients have an Investment Policy Statement (IPS) that outlines their cash flow needs for the next two years.
As an example, a client may have a monthly systematic withdrawal plan (we call this a SWIP) to pull $5,000 per month ($60,000 annually) from their investments to fund their day-to-day expenses. This same client has communicated that they may need $50,000 for a new vehicle in the next 12 months. When this is communicated to us then we would have at least $110,000 in a combination of Bank of Nova Scotia High Interest Savings Account and iShares Canadian Short Term Bond Index. This money is earmarked for the required cash flow.
We do this with every client to ensure that when markets decline, we are selling cash equivalents and short-term fixed income. We are never forced to sell equities at the wrong point in the market cycle. This approach is essential for those individuals living off their investments.
Avoiding speculation
Within our IPS we outline the investment objectives of each account. The investment objectives are income, growth, and speculation.
Our model portfolios have zero allocated to speculation. Market corrections are a cleansing exercise for those who chose to speculate. When markets are volatile, speculative names typically have a sharper decline. Some of these speculative names may not recover.
Before purchasing any company for our model portfolio we always look at the stability of its earnings, and the quality of its balance sheet. Ensuring a company can weather economic cycles is a key component to being a constituent within The Greenard Index model portfolios.
Most of the companies we have invested in have been around for over 100 years and have survived dozens of corrections in the past. Just knowing you have solid holdings is reassuring during periods of volatility.
Rebalancing both ways
Let us say an investor has $1,000,000 in 2019 in a moderate growth portfolio with 20 per cent (or $200,000) allocated in fixed income and 80 per cent (or $800,000) allocated in equities.
During the year the equity markets have a great year and the portfolio increases to $1,150,000. Periodically we would have rebalanced by selling a portion of equities and always maintaining the fixed income at 20 percent. In this case we had sold $30,000 of equities in 2019 and increased fixed income by $30,000.
If, for example, the equity markets decline then we will do the exact opposite for our clients. We would sell some of the fixed income, which would then be overweight, and buy equities at the lower level. As discussed further in this article, our IPS will also permit a range to temporarily underweight or overweight either cash, fixed income, or equities.
Cash to invest
Sharp market declines have been some of the best opportunities for long term investors to put cash on the sidelines to work. As Warren Buffett has said, “be greedy when others are fearful.” The volatility can be a bit paralyzing and many will be told to hold off believing the markets will continue to decline.
The financial crisis was a good example of a correction that appeared to have multiple good entry points, but then markets kept declining, starting at the peak in August 2008, and eventually hitting the lows in February 2009.
Often, the answer when there are unknowns is to go between doing nothing and investing it all. If you have an extra $100,000 in total, you may want to start with $35,000. If the markets decline further, then invest another $35,000. If the decline goes down even further then invest the final $30,000. Provided you are a long-term investor purchasing quality holdings, I’m confident that in the future, you’ll be content with this approach.
No cash to invest
Within an IPS there is an acceptable range at which fixed income can deviate from the optimal range. Clients who have a moderate growth portfolio have an optimal fixed income set at 20 per cent. The IPS enables the moderate growth portfolio to have as low as zero per cent in fixed income or as high as 40 per cent. Clients who have a balance growth portfolio have an optimal fixed income component set at 40 per cent. The IPS enables the balanced growth portfolio to reduce fixed income to as low as 20 per cent and as high as 60 per cent.
These ranges are meant to assist clients who wish to temporarily increase equities when opportunities are available. The greater the decline in the equity markets, the more consideration should be put on underweighting fixed income temporarily. One of the benefits of working with a Portfolio Manager is the ability to talk through these options during periods of volatility.
Pandemics and epidemics
With most market corrections, they are normally triggered by some event. The spread of the coronavirus (COVID-19), and its impact on the economy, has been the trigger for the 2020 correction to date.
There have been previous pandemics/epidemics that were also concerns. This has included severe acute respiratory syndrome (SARS), H1N1, middle-east respiratory syndrome (MERs), swine flu, influenza, Ebola, Zika, and so on. We believe we will get through this trigger event as well.
Every few years I publish an article that provides the historical greatest fears that have transpired in each calendar year over history. COVID-19 will certainly be on the list of concerns and fear for 2020.
Statistics to consider
Pullbacks are normal, even in periods of outstanding market returns.
An interesting statistic is that markets experienced intra-year losses averaging 14 per cent over the past 40 calendar years but still delivered positive annual returns 30 times over the same period.
Another interesting statistic relates to trying to time the markets. The 15-year annualized return for the TSX was 7.2 per cent. If you missed the ten best trading days within that period, it would have lowered the performance to only 2.8 per cent. Some of the best trading days are those days that follow a market correction.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138.
