With equity markets pushing all-time highs and interest rates sitting near all-time lows, is now the time to throw out the balanced portfolio approach? As tempting as it might be to shake things up, the answer is likely “no.”
What is a balanced portfolio?
Traditional axioms point to a 60/40 balanced portfolio, meaning a 60-per-cent weight in equities and a 40-per-cent weight in fixed income. The equity portion allows the investor to participate in the compounding growth of companies over the long term, whereas the fixed-income portion has typically reduced portfolio volatility while providing a reasonable return.
Naturally, the 60/40 asset allocation varies depending on individual constraints such as time horizon, liquidity needs and risk tolerance. A retiree may rightfully have a fixed-income weight that is much higher than 40 per cent, whereas a young person with a long investment horizon may be primarily invested in equities.
Should I eliminate equities or fixed income based on market valuations?
What is an investor to do when it appears that future growth is already priced into equities and fixed income is offering, to put it kindly, less than reasonable returns? Human nature tempts us to take profits now and stay protected in cash until the next market downturn.
There are two issues with this approach. First, if you sell stocks and bonds to avoid a decline, the likelihood you’ll be brave enough later to buy into crashing markets is low and the likelihood you’ll reinvest at the bottom is zero. The second problem with moving to cash is that expensive assets tend to become more expensive before they become cheaper. Although subsequent corrections are inevitable, timing them is next to impossible, and being uninvested over an extended period can be just as detrimental to your investment objectives as a market correction.
The S&P 500 Index in the United States has risen from 1,469 at the start of the century to 4,308 on Sept. 30, 2021. This represents a price return of 193 per cent. Including dividends, the index is up 340 per cent over the same period, or 7 per cent annualized.
During this period, there were three bear markets. The market had dropped -49 per cent from its previous peak by October 2002, -57 per cent from its previous peak by March 2009 and -34 per cent from its previous peak by March 2020.
Being able to foresee and avoid corrections and bear markets would be a very profitable trade – obviously. Unfortunately, this ability remains elusive. Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
If we can’t avoid corrections, how do we deal with them? Below we present 2 strategies.
Strategy 1: Shift Into defensive equities
The valuation of the overall stock market shows the price-to-earnings ratio is sitting at about 25.8x, well above its 21-year average of 19.5x. Market commentators may argue that these elevated levels are justified, given how low interest rates are, but valuations 32 per cent above the long-term average in any event do not provide a significant margin of safety.
The good news is that a third of the companies within the index still trade below this average, and several sectors, including financials, utilities and consumer staples, offer below-average valuations. If you are worried about an equity market sell-off but don’t want to be uninvested while waiting, shifting into defensive equities and defensive sectors is an option to take you through the next correction.
Strategy 2: Ignore short-term market movements
All good investors know that the longer your time horizon the higher your probability of success. If you look at one-day price returns of the S&P 500, 53 per cent of the time the market has “up” days and 47 per cent of the time it has “down” days. These odds don’t look to be much better than a single hand of blackjack.
But extend that time period to one year, and your odds of a positive return shoot up to 70 per cent, whereas sitting at a blackjack table for a year will likely leave you busted. Extend the time period even further and you continue to improve the “up” probability:
- 1 day – 53% chance of an “up” day, 47% chance of a “down” day
- 1 year – 70% up, 30% down
- 10-year period – 90% up, 10% down
- 25-year period – 100% up, 0% down
Under this strategy, you may rightfully say, “Who cares what the market does day-by-day or year-by-year, I’m going to be invested for multiple decades.” A disciplined approach that sees you routinely and consistently contribute to your portfolio over a long period, regardless of what’s happening in the markets, has proven to be a successful strategy.
Another reason not to fully sell out of equities is that the bond markets look expensive. Hopping to the Canadian markets, the yield on a 10-year Government of Canada (GoC) bond ended the quarter near an all-time low at 1.5 per cent.
As a reminder, bond prices drop when bond yields increase. The longer the term of the bond (10-year versus 1-year), the higher the duration or sensitivity to movements in yield. The duration of the 10-year GoC bond is 9 years, meaning if bond yields increase by one percentage point (from 1.5 per cent to 2.5 per cent), the bond will drop approximately 9 per cent in price. And if the yield moves back to long-term averages, say above 4 per cent, well, things look much worse.
To avoid potential disaster that comes with a rise in bond yields, it is prudent for investors to shorten duration. This can be achieved by buying bonds with a shorter term to maturity, bonds that have floating interest rates (rates that reset every 3 months) and corporate bonds that provide additional yield, or a credit spread, on top of government bonds.
Flight to cash
So what’s so bad about cash? I can’t lose, right? Wrong!
As mentioned above, human nature leaves us risk-averse and tempted to stay protected in cash. Although cash may protect you from paper losses, opportunity costs and inflation costs must be factored in.
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Opportunity costs hurt the young investor. If a young investor with a 40-year time horizon stays uninvested for 10 of these years (attempting to time corrections), he or she could retire with 20 per cent less money.
Inflation costs affect everyone, especially those on a fixed income. The average retirement period in Canada is close to 20 years. If inflation averages 2 per cent over a 20-year period, which is the Bank of Canada’s target, the value of a dollar at the end of the period will be one-third less than it is today. If the Bank of Canada is less successful at keeping inflation under control and inflation averages 3 per cent or 4 per cent over a 20-year period, then a dollar today will be worth half as much in 20 years.
Whether you are invested or uninvested, it is impossible to avoid risk. Accepting that future prices cannot be predicted, your individual circumstances, and not market valuations, should be the drivers of your asset allocation.
Jason Davis is a Portfolio Manager at Canso Investment Counsel, a credit and corporate bond specialist based in Richmond Hill, Ont. Jason is a CFA charterholder.