According to the Bank of Canada, the Canadian economy is expected to rebound slowly but steadily from the recent recession with estimated economic growth of 2.9% in 2010 and 3.5% in 2011. What does this mean for you as an investor?
The lesson from past recoveries is that, rather than reacting to changing conditions, your portfolio should be positioned to tolerate a range of economic and market situations. It should include investments from the 3 asset categories (cash, income and equity) in a proportion that is appropriate for your risk tolerance and investment time frame. This diversification will provide a built-in hedge against changing markets.
A study of 91 large pension plans over a 10-year period showed that the greater impact on portfolio success came from asset allocation (92%)—the strategic mix of cash, income and equity investments—compared to market timing (2%).1
As a leading economic indicator, the stock market tends to move ahead of the economy. The market will fall well in advance of an economic downturn and rebound before the economy does. For example, during last year’s economic slump, the S&P/TSX composite index rose 33% as investors snapped up stocks at bargain prices.
When stock markets are on the rise, investing in an index fund is one of the easiest ways to enjoy the markets’ gains in your own portfolio as the performance of an index fund will match the performance of the index it copies. An index fund invests in all (or a representative sample) of the investments of a stock exchange’s index. Because index funds are easier to manage, they have lower management fees. And, of course, saving money on fees is an important consideration regardless of market conditions.
While index funds are appealing in rising markets, in falling markets they will follow the index all the way down. That’s why equity investing is appropriate for those who have a long time frame to ride out any downturns. While there are no guarantees, past history shows that equity investments have the greatest potential for high returns over the long term (10 years or more). Diversifying your investment portfolio with funds that have different management styles, for instance, actively managed growth funds and more conservative value investment funds can also help minimize volatility, as managers of these types of funds may be able to maintain larger cash components in slumping markets.
Since economic conditions can also impact interest rates, a balanced portfolio should include fixed income and cash investments. This way, at least one component of your portfolio should perform well in any given market situation. Although stocks outperformed bonds in 2009, the reverse was true in 2008. Bond prices move in the opposite direction of interest rates and bonds generally perform best in periods of declining interest rates. Falling interest rates may occur when economies falter and governments attempt to encourage spending by lowering interest rates. In anticipation of slower economic growth in 2008, the Bank of Canada cut its overnight rate in December 2007 by a quarter of a percentage point. It was the first time the Bank had lowered its rate since mid-2004. By June 2009, Canadian interest rates had fallen to a near-record low of 0.25% (from 4.5% in mid-2007).
In terms of individual asset selection for your portfolio, consider including foreign investments in addition to domestic ones to increase the potential for growth, since other economies are poised to recover from the global recession.
For some investors, the instinct is to retreat to safety when financial markets fall. However, by staying the course, you’ll be well-positioned to gain when markets start advancing, as equity markets did in 2009. Even most investment experts can’t predict exactly when recovery will occur after a fall, so the best strategy is to remain invested and ensure your portfolio is structured to withstand, and benefit from, changing market conditions.
If you spent 2009 on the investment sidelines, contemplate using the strategy of dollar cost averaging (which involves making smaller, regular fund purchases) if you decide to get back into the markets. Studies show that with regular purchases, on average, you’ll buy more fund units at a lower cost, compared to investing the lump sum all at once.
To obtain assistance building a diversified investment portfolio, contact a financial planner at CDSPI Advisory Services Inc. at 1-877-293-9455, ext. 5023. (Restrictions may apply to advisory services in certain jurisdictions.)
- Source: Brinson, Singer, Beebower, Financial Analysts Journal.