We are now over 8 years into the current bull market, the second longest bull market in history. This is a prudent time to take a second look at portfolios. Being a bit of a car buff, it’s quite easy to analogize the current markets to driving.
Have you ever ridden in a car with worn-out shock absorbers? I certainly have in a ’64 MGB (still owned). Every bump is jarring, every corner stomach-churning, and every red light an excuse to assume the brace position. Owning an undiversified portfolio can trigger similar reactions.
You can drive a car with a broken suspension system, but it will be an extremely uncomfortable ride and the vehicle will be much harder to control, particularly in difficult conditions. Throw in the risk of a breakdown or running off the road altogether, and there’s a real chance you may not reach your destination.
In the world of investing, a similarly bumpy and unpredictable ride can await those with concentrated and undiversified portfolios or those who constantly tinker with their allocation.
Of course, everyone feels in control when the surface is straight and smooth, but it’s harder to stay on the road during sudden turns and ups and downs in the market. For that reason, the prudent thing to do is to diversify, spreading your portfolio across different securities, sectors, and countries. That also means identifying the right mix of investments (e.g., stocks, bonds, real estate) that aligns with your risk tolerance.
Using this approach, your returns from year to year may not match the top performing portfolio, but neither are they likely to match the worst. More importantly, this is a ride you are likelier to stick with.
Here’s an example. Among developed markets, Denmark was number one in U.S. dollar terms in 2015 with a return of more than 23%. But a big bet on that country the following year would have backfired, as Denmark slid to bottom of the table with a loss of nearly 16% in 2016.1
It’s true that the U.S. stock market (by far the world’s largest) has been a strong performer in recent years. But a decade before, in 2004 and 2006, it was the second worst-performing developed market in the world.1
Predicting which part of a market will do best over a given period is tough. Historically, the majority of portfolio managers underperform their benchmarks. U.S. small cap stocks were among the top performers in 2016 with a return of more than 21%. A year before, their results looked relatively disappointing with a loss of more than 4%. International small cap stocks had their turn in 2015, topping the performance tables with a return of just below 6%. Although the year before, they were the second worst with a loss of 5%.2
Alternative Investments that employ strategies which are not correlated to the stock market may be another way to weather the volatility for some investors. While one may immediately think of equity hedge funds when they hear the term Alternative Investments, the area of fixed income alternatives can be a very attractive niche. Potential returns may be higher than traditional bonds and may even approach that of equity-like returns, in some cases, but without similar volatility. Some examples include:
- Mortgage financing to borrowers that are under-serviced or ignored by large financial institutions;
- Project financing to niche market segments that require specialized knowledge to underwrite;
- Private corporate debt that includes options for future equity participation;
- Short-term inventory and working capital financing to various industries;
- Purchasing life insurance policies from individuals who no longer want or need them.
Prudent investing is important, and so are appropriate expectations. We remember that stock we purchased with an OSAP loan that made 40% in a few months, while we don’t want to think about the Blackberry’s, Nortel’s, Valiant’s, etc. that went down over 90%. It is also nice to see the TSX increased 21% in 2016. If you were 100% invested in equities (stocks) in 2016 you would have done very well, albeit in 2008-2009 would have been down 43%, while Canadian bonds increased 3.8%. The stock market returns are not a benchmark. They are the performance of equity markets over a given time period. The right benchmark is the return that allows us to meet our goals, balancing risk and reward, to ensure that what we wish to happen, will happen.
If you’ve ever taken a long road trip, you’ll know that conditions along the way can change quickly and unpredictably, which is why you need a vehicle that’s ready for the worst roads as well as the best. While diversification can never completely eliminate the impact of bumps along your particular investment road, it does help reduce the potential outsized impact that any individual investment can have on your journey.
As we are currently in the second longest bull market in history, consider upcoming potential downside risk. Consider shifting to be more conservative, diversifying globally, and alternative investment strategies that are not correlated to the markets, which have more predictable returns. That, in turn, helps you stay in your chosen lane and on the road to your investment destination.
1. In US dollars. MSCI developed markets country indices (net dividends). MSCI data © MSCI 2017, all rights reserved.
2. In US dollars. US Small Cap is the Russell 2000 Index. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. International Small Cap is the MSCI World ex USA Small Cap Index (gross dividends). MSCI data copyright MSCI 2017, all rights reserved.
Note: This article is not intended for personal advice. Please consult your portfolio managers before making any investment decisions.