WEALTH Matters — FALL 2008

Managing portfolio volatility

The past 12 months have been the most difficult investment climate we’ve seen since the technology ‘bubble’ burst in 2001-2002.  In our past few newsletters, we’ve reviewed the steps involved in building an efficient portfolio. But even with close attention paid to selecting an appropriate asset allocation, and selecting excellent managers for each asset class, most diversified portfolios have delivered a loss over the past year.  Let’s have a closer look at how often and how large negative performance usually is, and how we can manage it.

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Bce stock buyout

The dividend tax credit

Managing portfolio volatility

Variable annuities

The graph below shows that ‘Bear Markets’, or periods of prolonged stock market decline, are regular occurrences.  Bond markets can decline as well, but this is less frequent and the declines are usually much smaller than in stock markets. The key to note here is that bear markets occur on average once every 3 or 4 years, but in almost every case, the decline is followed by a much longer and larger period of increase, or ‘Bull Market’.

From the chart it is easy to tell when a bear market begins, or when it ends.  But as these events unfold, it is almost impossible to tell until some time afterward. By the time we know we’re in a bear market, we’ve already lost some value, and the recovery may be about to start – or may already be underway. So it is almost impossible to ‘time the  market’ by selling off an equity position and attempting to ‘buy it back’ later at a lower price.  It is better to stay invested and let the eventual recovery restore your value.

The longer you hold volatile assets, the more the ups and downs cancel each other out, and the return gets closer to the long-term average. In the chart below, we show the ‘volatility’ of three different asset allocations (n 100% bonds, n 50% stock, and n 90% stock) for several holding periods across the past 35 years.

A lower proportion of equities (stocks) will reduce volatility, but will also reduce the long term return potential needed to keep pace with inflation. The 90% Bond portfolio above has a historical average return over 5%, but after tax it would hardly keep up with inflation, which averaged 3.1% over the same period.  Holding some portion of your overall portfolio in equities has been necessary over time in order to allow your portfolio to grow faster than inflation, even after income tax on investment earnings.

What’s Right for You?

When we first started working with you, we probably had an in-depth discussion about risk and return, and the asset allocation that can maximize your long term return but limit your overall volatility to a level that you are comfortable with. If your allocation is far off its target, we will call and advise that you rebalance back to your target.  Otherwise we would advise our clients to stick to their target asset allocation through bear markets such as the one we’re currently in.  It is very unlikely that you can sell the equity portion of your portfolio and then buy it back before missing a good portion of the recovery, so it’s better to ride out the storm.  We would be glad to review your situation with you to reconfirm the ideal asset allocation for your unique circumstances.

Also in this issue of Wealth matters:

Bce stock buyout

The dividend tax credit

Variable annuities

For the 1 year period shown, the coloured dots show the average return of all 1 year periods in the past 35 years, while the black vertical bars show the higest and lowest of all 1 year returns. This short period has a very wide range of high to low outcomes.  As the holding period lengthens, the range of returns is much narrower, because each 10 year period, for example, will include several bull markets and several bear markets which cancel each other out.  Note that no 10-year period in the past 35 years shows a negative return, even for a 90% stock portfolio.  And for the 20-year holding periods, the lowest observed return for the 90% stock portfolio is no lower than the lowest return for the 100% bonds portfolio.  The main conclusion is that risk diminishes over time.  In the long run, volatile assets have no more risk of loss than stable assets.

Our final illustration is the Asset Allocation Risk and Reward chart below.  It shows a number of different stock/bond allocations, and compares the long term average, and the range of one-year returns over an 80-year period.  As expected, the 90% stocks portfolio has a much higher average return than the 90% bonds portfolio, but its highest one-year gain and loss, and average gain and loss, are also much larger.

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