I have about 10 years until I retire and I am becoming more concerned about preserving my capital. My portfolio is about 80 per cent in equities – mostly high-quality dividend payers. Should I sell some of my stocks and go to to cash/bonds or maybe hedge my portfolio with an exchange-traded fund that bets against the market?
First, I can say unequivocally that you should avoid inverse or "short" ETFs. These products are designed to deliver the opposite of the daily return of an underlying benchmark and are suitable only as short-term trading or hedging tools. They're not meant to be held as long-term investments and won't necessarily deliver the returns you expect.
To take a simple example, say you buy $1,000 of an inverse ETF and the index it is based on falls 10 per cent – to 9,000 from 10,000. After one day, your investment would be worth $1,100 – a gain of 10 per cent.
But if the index rises by 11.1 per cent the following day – which would bring it back to its starting level of 10,000 – your ETF investment would fall by 11.1 per cent to $977.78. So, even though the index breaks even, you would lose money. There will be times when an inverse ETF outperforms the index, but your actual return will depend not only on where the index is on any particular day but also on the sequence of daily returns that got it there.
Also remember that stocks, while volatile in the short run, tend to rise over the long run. The longer the holding period, the higher the probability that you will come out ahead. The S&P 500, for example, has produced positive returns in about 95 per cent of rolling monthly 10-year holding periods from 1926 to 2015, according to Morningstar data cited by Oppenheimer. For 15-year periods, the return was positive 99.8 per cent of the time. Do you really want to bet against a trend like that?
If inverse ETFs aren't the answer to preserving your capital, what is?
The simplest approach is to dial back your equity exposure to a level that makes you more comfortable. According to an old investing rule of thumb, the percentage of your portfolio devoted to fixed income should roughly match your age, So, if you're 55, you would have 55 per cent in bonds or guaranteed investment certificates and the remaining 45 per cent in stocks. At 65, your equity exposure would fall to 35 per cent, and so on, the idea being that the older you are, the less risk you can afford to take.
But this guideline is now widely thought to be too conservative, for a couple of reasons. First, people are living longer, so their money has to work harder. Second, fixed-income yields have plunged to historic lows, which is forcing people to seek higher returns available from dividend stocks and other investments.
What's the correct balance? I know people who have 100 per cent of their portfolio in equities. They've been investing for years and have the emotional discipline to weather bear markets without panicking. I also know people who are so terrified of losing money that they won't buy any stocks at all. Your ideal allocation is probably somewhere in the middle.
In his book, The Investor's Manifesto: Preparing for Prosperity, Armageddon and Everything in Between, William Bernstein recommends seeking what he calls an "equipoise point." This is an asset allocation that suits your risk tolerance and will help to keep your emotions in check regardless of what the market does.
"Here is how it works: During a bull market you will derive pleasure from your stock gains and will regret that you were not more heavily invested; your equipoise point is that allocation at which this pleasure and regret exactly counterbalance each other," he wrote.
"Similarly, during substantial market declines, the equipoise point is that allocation where the pain of loss in stocks exactly counterbalances the warm, fuzzy feeling provided by your bonds and the capacity they provide to buy more stocks at low prices."
That last point is important. For dividend investors, the silver lining of a bear market is that yields are higher after the market drops. But to take advantage of these higher yields you'll need to have some cash on hand (unless you want to borrow, which I advise against for all but the most experienced investors).
I'm not necessarily suggesting that you should sell a portion of your stocks now; you could always keep the stocks you have and channel any new money into cash or fixed-income securities to build up your war chest gradually.
One final tip: If you're easily rattled by falling markets, it may help to focus on the dividend income your stocks produce instead of watching the daily fluctuations in market prices. If you hold great stocks, your dividend income should rise steadily regardless of whether the market goes up, down or sideways. This can be very comforting, particularly during bouts of market volatility. (For more on the merits of dividend growth investing – and some specific examples – see my recent Strategy Lab column at tgam.ca/EPvL.)
John Heinzl