How to Deal With Stock Market Volatility

by Mike Holman

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I’m a big fan of William Bernstein who wrote the book “Four Pillars of Investing”. One of the main points of the book is the idea that whatever your asset allocation is (ie 50% equities, 50% bonds) , you have to maintain the equities portion of your portfolio regardless of what happens to the market. This is easy enough to do when the market is flat or going up, but when it drops then it gets a lot harder.

His suggestions to accomplish this are as follows:

Study history: If you are familiar with the equity markets then you know that the long term trend is upward which means that regardless of what happens in the short term, over a long enough time period you will get through the ups and downs and achieve a decent positive return. Another part of history that is important to know about is market manias and the ensuing crashes. Knowing the history of these events from the tulip bulb mania of the 1600’s to the dot.com mania of the late 1990’s will allow you to know that the market always recovers and even if you do get caught up in a mania, if you stay invested in equities then you will do fine. Note that that by “equities” he’s talking about a widely diversified portfolio of equities.

One of his examples from the book “Four Pillars of Investing” uses the great crash of 1929 to demonstrate that if someone retired at the peak of the market in 1929 and had mostly equities in their portfolio (which lost 90% of their value), although they would have had a few lean years afterwards, if they had stayed invested in equities then they would have done just fine and wouldn’t have run out of money. If they panicked and switched into bonds or cash after the value of the portfolio went down, then they would have eventually run out of money.

Another psychological point Bernstein talks about is picking an asset allocation that you are comfortable with even in the bad times. He says you are best off having an equity allocation of 50% to 75% with the higher number being preferable in order to beat inflation. However if you can’t handle the volatility and switch out of equities after the markets crash and then wait until they are up again before switching back in, then you are losing money and you should lower your allocation of equities. You are better off with a lower allocation of equities that you can maintain during a market crash rather than a higher equity allocation that causes you to panic in bad times.

Some of my suggestions are:

Don’t focus on individual securities:

If you are going to monitor your investments then look at the total value of your portfolio including cash, fixed income, equities etc. Don’t just look at the individual funds. If you have a diversified portfolio then not everything will have the same loss so the total value is the relevant number to watch. Not all stock indexes dropped the same amount recently and if you have a portion of your portfolio in fixed income or money market funds then they should have held their value (unless of course you own National Bank money market funds).

Put market drops in the proper context:

Keep a record of your historical portfolio balance. You can either include contributions or not for this exercise. Investors who watch their investments closely in an up market tend to remember the highest recent value that the portfolio gets to and when it falls, they compare the new lower value to the recent high. If you keep track of your total portfolio value and write it down say every six months then you can get a more realistic picture of your investments. For example I know that my portfolio is down around 7% from it’s recent high but I also know that it’s still up about 0.5% from the beginning of the year. If I look at my records (I do a yearly performance analysis) then I can see that I’m still up about 15% (not including contributions) from Jan 1, 2006. Taken in that context, the 7% drop is not that big a deal.

Measure the volatility of your portfolio before it crashes:

You can’t have volatility on the upside without having it on the downside as well. There are many advanced mathematical tools to figure out the volatility of your portfolio but one simple rule is to measure how much your portfolio goes up in a good year and be prepared for it to drop that much in any given year. If that amount doesn’t appeal to you then choose a more conservative asset allocation.

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{ 13 comments… read them below or add one }

1 FourPillars

No problem.

Actually I did a tally last night and I have 77% equity and 23% cash, bond or whatever.

I’m in the process of moving my rrsp to Questrade so once that happens I’ll get back to my target of 75/25.

Mike

2 FourPillars

Another point about the context is that if you have a long term investment goal or assumption – ie 7% return on your portfolio long term then you can look at your history to see how it fits with goal. In my case, if my portfolio doesn’t change for the rest of the year then I’ll still be up about 15% for 2006-2007 which is roughly in line with my long term assumption of 7%.

Mike

3 moneygardener

I find it extremely difficult to measure returns when I am making significant contributions to my account each month…

4 telly

I’m with you MG. I don’t much worry about returns at this stage. Most importantly, I try to keep making regular contributions and keep our allocation while doing so. Our portfolio is still quite small with respect to our contributions.

One thing I’m curious about: I guess Mr. Cheap would be in a different situation, but for those of you with a mortgage (non-deductible), how do you feel about holding FI when you still have a mortgage? My husband and I do not hold any FI in our portfolio because of this. Our current contributions are set up such that about 40% of them go towards mortgage pre-payment (which, now that I’m typing this, I think is too high!).

What are your thoughts on this?

5 FourPillars

MG – that’s a good point. If your contributions are a significant percentage of your portfolio then the actual investment return is not very meaningful.

I’ve been contributing to my rrsp for a long time and I’m at a point where my annual contributions are about 6% of the portfolio value. I have a simplified method to estimate the investment return which I’ll post about (someday).

Mike

6 FourPillars

Telly – I think the returns are more important as you get closer to retirement rather than when you are just starting out with investing.

I personally don’t feel my house equity or mortgage are part of my investment portfolio so I do have FI in my portfolio.

I’ve heard the argument that you shouldn’t invest in real estate stocks if you own a house since you are over exposed in that category already – I don’t buy this argument at all.

Mike

7 telly

FP – I see your point. I don’t consider my home equity as part of my investment portfolio either but I’ve often heard of a mortgage being referred to as a “negative bond”. You avoid the interest on your mortgage as you pay it off, so with that in mind, the theory is that you shouldn’t keep any investments where expected after-tax return is lower than your mortgage rate. It’s really like putting money into GICs when you have debt.

Of course, this doesn’t really take emotion into consideration. I’m not sure many people out there, in a falling market, would say, “well, at least X% of my house is paid off”.

Just thinking out loud.

8 FourPillars

Telly – that’s the argument I’ve heard as well.

I don’t have any clever answer for you – I’ll try to think about this some more.

I don’t consider mortgage pre-payments as investments – more like savings. A debt is an obligation that you want to eliminate, an investment is a “thing” that will provide you with future income some day. To me, the fact that I owe money is a completely unrelated to the fact that someone might owe me money in my investment portfolio (ie fixed income).

One other point – I have fixed income in my rrsp only so it’s tax sheltered. For investments in taxable accounts I would have a hard time justifying any FI unless I needed the money sometime soon.

Mike

9 FourPillars

We actually have some GICs in our rrsp.

I haven’t researched it too much but it seems that the high interest savings accounts are generally not offered for rrsps. I’ll have to look into that again.

Mike

10 telly

Mr. Cheap: I do consider our mortgage pre-payments as FI.

Even at a rather low interest rate of 4.39%, there is no FI option out there that will pay better than 4.39% after tax. That’s our justification for no FI anyway. We also don’t keep an emergency savings fund either (have an untouched line of credit just in case).

I guess it depends entirely on your situation but it seems to work for us. The only bad thing about no FI is no quick money handy to buy a cheap stock at any given moment…we’d have to wait till pay day!

11 FourPillars

Telly – that’s what the line of credit is for!

Mike

12 telly

Good point Mike! I have to admit though, I didn’t expect that from you.

13 FourPillars

Haha…I wasn’t being totally serious.

When you set up your Questrade account, it will give u access to margin which is pretty convenient if you want to make a quick purchase.

Mike

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