This Diversification Stuff Really Works
David Christianson, CFP, R.F.P., TEP
There is no escaping the fact that 2008 was a terrible year to be an investor. Even some guaranteed investments (like asset-backed commercial paper) cost some investors money.
Formerly safe investments like good quality corporate bonds and preferred shares had unprecedented declines, so even conservative portfolios were savaged. There were very few places to hide.
So imagine my surprise when the majority of my clients reacted positively to their year-end performance reports! The best was a letter from a client that said, “You guys rock!”
Haven’t had that comment before... Clients were greatly relieved when we showed them their actual overall returns.
A lot of it comes down to expectations and being realistic about the climate in which we were investing. If you expected a return of negative 40% to 50%, because that’s how much the major stock markets declined, you are pleasantly surprised when you are “only” down 17.7%, which was the average of our client returns.
More importantly, they all have enough guaranteed investments to carry them through two to five years of bear market.
It seems this diversification thing works. Our approach is to always have enough money in cash and guaranteed investments to cover at least two years’ expected withdrawals, and then have a segment of fixed income investments (bonds or GICs) with guaranteed maturity values to cover off years three to five.
In this way, we can comply with Dave’s Rule Number One of Investing – Never sell low. This means always avoiding getting into a position where you may have to sell a fluctuating investment to generate cash, because it may be a time when that investment is down, instead of up.
(The exception is selling to realize a capital loss for tax purposes, but then you will buy back a similar investment for the recovery.)
Do we set cash and fixed income aside even when “markets are good” and interest rates are low?
Yes, absolutely, because NO ONE ever knows what the markets are going to do tomorrow. We always have to be prepared for the worst, because there is no warning sign to say, “Markets will fall next year.” I would argue that there is more risk in “good” times, when the market has been rising for years without a break, than there is at a time like now.
So do these principles apply now, after an historic market decline, when we should all be piling into equities to make our money back?
Yes, the principle of always keeping enough of your portfolio in short term and guaranteed investments to satisfy your cash and income needs always applies, even if it means moving a small amount of your equities out of the market now.
I repeat, no one knows where the markets will go tomorrow or the rest of the year. Your planning requires that you limit the damage from a decline and maximize the participation in the recovery.
The headlines about the economy do not tell you where the markets are going and, even if they did, you still need to stay diversified.
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David Christianson is a fee-only financial planner and investment counsel with Wellington West Total Wealth Management Inc. His column, ‘Dollars & Sense’ appears Fridays in the Winnipeg Free Press.