Avoid The Next Catastrophe

Stock markets around the world were in turmoil from summer 2008 to spring 2009. Stocks have been a disaster for investors across virtually all categories. Worst of the breed have been financial services equity mutual funds, down 53.8 per cent for the 12 months ended February 28, 2009. Next in line of the flopped — real estate equity funds that fell 49.0 per cent and emerging markets equity funds that were down 48.2 per cent in the same period. Hedge funds lost 19.2 per cent. So much for idea of neutralizing the effect of market trends with a blend of long and short positions. There was no category that provided safety in the stock market. Short selling, a risky business at best, would only have neutralized the worst effects of the market’s collapse. Making profits has been nearly impossible for all but the bravest investors who were willing to be entirely short — at the risk of unlimited losses if stocks rose substantially.

FAILING STRATEGIES

For the past few years, investment gurus have been preaching the virtues of spreading money out geographically on the theory that what happens in the U. S. or Canada has little effect on China or Brazil. That turned out to be utter nonsense. China’s economic situation is worse than Canada’s. The leading Chinese index, the Hang Seng, was down 47.3 per cent for the 12 months ended February 28. Worse happened in Europe. For example, Italy’s Milan General Price Index dropped 51.6 per cent in the period. Globalization made markets go up together and has brought them down together. “No country has escaped from carnage,” says Dan Stronach, head of Stronach Financial Group in Toronto.

Then there was the idea that you should invest in diverse industries. That flopped too, for science and technology funds lost 27.8 per cent of their value in the 12 months ended February 28. You could argue that there is a big difference between that drop and the nearly double drop of financial services, but both industries lost big.

A BETTER WAY TO DIVERSIFY

Other asset categories — bonds, cash, life insurance and some kinds of property — did much better than stocks. For example, Canadian fixed income mutual funds, most of them loaded with bonds, broke even in the 12 months ended February 28 with an average gain of 0.6 per cent. But one category — global government bonds — actually rose 25.5 per cent in the period. Even short term bonds maturing in five years or less gained 3.3 per cent with very little risk.

Returns to cash were not bad. Canadian money market funds gained 1.7 per cent. Add in an average fee of 1.0 per cent and you get a 2.7 per cent gross return on treasury bills and bankers acceptances that are blended in these funds. That is, in fact, the gain that dull old Canada Savings Bonds paid.

There is nothing remarkable in these numbers. The old concept of diversification was to put money into the three categories of liquid assets: stocks, bonds and cash. An investor with a 33.3 per cent weighting in each category and using nothing but the S&P/TSX Total Return Index for stocks would have ended the year down 14.6 per cent on stocks, flat on bonds and up about one per cent on cash. That’s a net 13.6 per cent loss, something that the stock market can eliminate in a week or two of bullish trading, Stronach adds.

KEEP IT SIMPLE

What is essential in avoiding the next meltdown is to think simply, Stronach says. Diversify into stocks, bonds and cash. “Cash is valuable when nothing else works and it should be given more respect,” Stronach says. “It is like house insurance in that, while the premium is a cost and not a return, it covers the much larger potential cost of losing your home to a fire.”

The point of diversifying into stocks, bonds and cash is that their returns tend to be mutually if not perfectly independent of one another. In a boom, for example, stock prices rise along with interest rates. Rising rates also push up the interest one gets on bank accounts and treasury bills, but they push down returns on bonds which tend to fall in price until their existing interest payments produce the same yield (interest divided by bond price) as bonds with new, higher interest rates. When there is a bust, bond prices rise while returns on stocks and cash fall. And when, as in the late 1970s, high inflation wrecks both stocks and bonds, cash continues to do well.

The principle is to ensure that one rising investment category offsets another that may be falling. Loss minimization always requires spreading money as widely as possible. That includes unlined assets. Returns on life insurance, an unlined asset, are determined substantially by mortality expectations. As well, one can buy commodities — but note that farmers are already commodity producers and should add to their exposure outside of their own crops and crop futures.

The final category of assets, the “everything else” residual of gems, antique Barbie dolls and other goods traded on e-Bay, shows wide spreads between buy and sell prices. These assets tend to be illiquid, and do not have the depth to support major movements of money. At best the market for such exotica shows the wisdom of diversification. Moreover, it shows that one should never misunderstand what a real financial asset it: a store of value, readily traded, and easily priced.

The old adage that you should never put all of your eggs in one basket remains the guiding light of diversification. The trick is to make sure that what goes into it is a genuine financial asset that is easily bought or sold, readily priced, and different from the other assets in the basket.

Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life After Work, was published in December by Penguin Canada.

About the author

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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