Lessons Learned from the Downturn
Kate Warne, Ph.D., CFA
Canadian Market Strategist
It’s been almost a year since global stock markets began to rebound. After a financial crisis, many investors want to know how to improve their approach. Here are six lessons we think could help you in achieving your long-term financial goals:
- Look Forward, Not Back
Your mix of assets (asset allocation) determines the risk of your portfolio and also is the key to your long-term expected returns. After stock market downturns, a normal reaction is to reduce risk by putting less money in stocks and equity mutual funds. However, that’s almost always the wrong move, because the recent past is rarely a good guide to the future. During the past 10 years, the S&P/TSX Composite’s annual rate of return was 5.6%. Although past performance does not guarantee future results, our expectation is that returns will be in a range of 7.5% to 9% during the next 10 years, based on the price-to-earnings ratio and our long-term expectations for earnings growth. Foreign equity returns look slightly higher at 7.5% to 9.5% annually, in our view.
In contrast, returns on less risky investments such as short-term fixed income are very low today. While they are likely to increase whenever the Bank of Canada (BOC) raises short-term interest rates, most investors need to stay in investments that are riskier but also have higher expected returns. If you have too much invested short term, consider adding equities and bonds to help improve your long-term return prospects. - Invest with Discipline
One of the overlooked lessons from the downturn was the importance of meeting regularly with your Edward Jones advisor to review and rebalance your portfolio. A disciplined investment process helped identify opportunities and kept your portfolio near your target mix of investments, which helped reduce overall risks and enhanced returns.
However, it’s quite difficult to stick to your strategy of keeping an appropriate allocation and rebalancing when needed if your investments are spread in many places. In addition, you may discover you don’t know how your portfolio fits together. If you aren’t sure about the role each investment plays in your portfolio, ask your Edward Jones advisor for a complete portfolio review and consider consolidating your accounts. Make sure you understand what you own and why you own it. - Stay Diversified
While diversification doesn’t prevent losses, it remains one of the best strategies for long-term investors. In a well-diversified portfolio, each stock and bond constitutes just a small fraction of the total value – our recommendation is no more than 5%. You can accomplish this by owning mutual funds and segregated funds or by owning a wide variety of individual investments directly.
In general, diversification reduces your portfolio’s volatility because stocks and bonds don’t move together, but during last year’s declines, almost all prices fell simultaneously. It was a comfort that some dropped less than others, but the more important benefit of diversification was the smaller impact from those that declined the most. - Borrow with Caution
Too much borrowing was at the centre of the global financial crisis. In good times, debt enhances returns and finances higher spending. However, as we’ve seen, too much debt can overwhelm individuals and companies. While consumers in most other countries reduced their borrowing in 2009, many Canadians increased their debt (shown here), despite tight credit conditions.
Review your financial flexibility. When short-term interest rates rise, perhaps as expected later this year, many mortgage rates are also likely to increase because they are based on short-term rates. Make sure you’re prepared. - Protect What's Important
Many investment strategies focus primarily on the potential growth of your wealth, but make sure you’ve addressed the risks as well. Our approach includes owning investments such as bonds that potentially perform less well but can help reduce the risk level of your portfolio. We think it’s important to take a broader view and evaluate other risks that can disrupt your life. Consider adding insurance to help ensure your loved ones can afford their current lifestyle even if a critical life event happens to you or your spouse. - Follow Time-tested Principles
As a result of last year’s financial crisis, some have concluded that long-term investing doesn’t work. We’d say the opposite: Although no one wants to repeat the experience, those who owned quality investments, stayed invested and rebalanced if needed eventually benefited from the sharp rebound.
If you think these lessons can help you make needed changes, contact your Edward Jones advisor to see how they might improve your situation.
Diversification does not guarantee a profit or protect against loss.
S&P/TSX Composite is an unmanaged index that is not available for direct investment.
