Is your portfolio ready for a sharp correction?


By Joel Schlesinger

View the original article. | View this article in PDF format.

Bull market, long may you run. It’s been going flat-out since 2009, and U.S. equities have surged to record heights, leading skeptical observers to wonder whether a crash is just around the corner.

Although no one can accurately predict a crash, investors need to take stock – pardon the pun – of what’s in their portfolios. A steep downturn could be devastating for retirees or those nearing retirement if they are ill-prepared.

“Know your risks,” says Uri Kraut, a Winnipeg-based investment advisor with CIBC Wood Gundy.

But that means more than simply understanding your portfolio’s mix of stocks, bonds, and cash. “You should be aware of the potential range of returns for each asset class, and recognize that market crashes and corrections can treat asset classes differently,” Mr. Kraut says.

Most downturns involve a steep, sudden decline in stock market prices, and diversifying is critical to softening the blow, says Robyn Graham, managing director of ETF Capital Management in Toronto.

“Many investors lack regional and asset-class diversification in their portfolios,” she says, adding that Canadian investors often focus on the Canadian marketplace first and the United States second.

Regularly rebalancing the portfolio is another way to manage risk. “An asset-mix review is also important to ensure an investor’s equity exposure hasn’t increased over time beyond their risk tolerance,” says Ms. Graham. “If an asset class, sector or security appears expensive [overvalued], consider taking some profits.”

The profits can then be reallocated to undervalued assets or those that are uncorrelated or generally move inversely to broader markets. These include real estate and infrastructure, which are increasingly popular with institutional and high-net-worth investors.

Phil Tippetts-Aylmer, investment advisor with Nicola Wealth Management in Vancouver, points to Nicola Wealth’s typical portfolio, which emulates pension fund investment strategies that lean more heavily on “alternative strategies such as private equity, private debt, and farmland.”

This “very broad diversity of asset classes … results in a much smaller exposure to public equity markets and the volatility that comes with them.”Perhaps a more important consideration for investors is not portfolio construction but

Perhaps a more important consideration for investors is not portfolio construction but mindset. “Investor behaviour is the biggest source of risk, and emotion-driven investing is the biggest threat to portfolio returns,” Ms. Graham says. “A red flag for any client is if they find themselves feeling increasingly uncomfortable with the fluctuations in value that are a normal part of market-based investing.”

To help counter the fear and loathing, investors should make patience a cornerstone of their portfolio strategy, Mr. Kraut says.

“Although having instant access to current and historical market data can be beneficial, in certain instances, this type of immediate access might not be the best thing,” he says. “You may see investments decline in real time, and this can cause panic.”

What’s more is that investors often fail to realize corrections and crashes have historically been followed by “very powerful rallies,” he adds.

With that in mind, profit-taking done now, when markets are highly valued, will result in cash that investors can then use to buy low, and then benefit from that post-correction upswing.

“I don’t want to suggest that we can perfectly time the market,” says Peter Kinkaide, president of Raintree Wealth Management, an Edmonton-based firm. “But there are times where you want to be overweight in cash when you believe markets and certain securities are overvalued.”More confident investors can also create short positions that increase in value during a correction, limiting overall losses to a well-diversified portfolio. Shorting, however, comes with a cost and can limit the upside of holdings when markets are doing well, he adds.

More confident investors can also create short positions that increase in value during a correction, limiting overall losses to a well-diversified portfolio. Shorting, however, comes with a cost and can limit the upside of holdings when markets are doing well, he adds.

“But it’s difficult to be ‘long only’ in the market, if you’re fully invested, to avoid downside risk,” Mr. Kinkaide says. “If you have some short exposure, then potentially you could even see gains in your portfolio during a down market.”

Two less flashy loss-prevention approaches are having a clear vision of why you are invested in what you own and rebalancing your holdings regularly.

And, above all, steal a page from Rudyard Kipling’s poem If – and try to keep your head when all about you are losing theirs.

“If you are prepared in this fashion, then corrections are not events to be feared,” says Mr. Tippetts-Aylmer. “They are to be embraced as opportunities.”