For Canadians who rely less on government sources to fund their retirement, it’s important to ensure that the cumulative effects of market declines do not erode their retirement nest egg. In investment circles, this is referred to as portfolio “drawdown.”
It is essential to first understand the various characteristics of portfolio drawdown – depth, duration and frequency of market declines. Drawdown in the equity market – that is, a decline in the value of a portfolio from its high point – is nothing new and can be measured by three factors.
The first is depth, or how far an investment portfolio declines in any given period. Is the decline 2 per cent, 5 per cent or 20 per cent? For example, when the markets crashed in 2008, the Dow Jones Industrial Average (DJIA) experienced a 54-per-cent decline from peak to trough.
The second is duration, or how long the decline occurs and how long until it recovers. Is the decline one day, two months or three quarters? Using the same example above, the DJIA peaked on Oct. 9, 2007, at 14,164 points and dropped to 6,469 points by March 6, 2009, representing a duration of 17 months.
The third is frequency, or how often a portfolio declines in value. For example, there have been several major crashes in the United States along with many market corrections in between, including: the Panic of 1907, the Wall Street crash of 1929, Black Monday on Oct. 19, 1987, and the crash of 2008-09, to name a few.
The cumulative impact of these drawdown characteristics can certainly challenge portfolio returns and affect an investor’s long-term retirement plans. Fortunately, there are effective strategies to manage this risk.
Three ways to minimize the impact of market bumps
You can never eliminate volatility in the marketplace. However, you can minimize some of the bumps in the road by including a few basic protection strategies in your portfolio. Let’s review three basic strategies:
The first is to take a balanced approach to portfolio design and construction. In this instance, your portfolio is generally divided equally between fixed-income securities and equities based on your investment objectives, time horizon, risk tolerance and investment knowledge. It may include a diversified mix of assets across geographic markets and investments in business of different sizes.
For added diversification and to minimize the impact of volatility on returns, include an allocation to uncorrelated alternative investments, such as private debt, private equity, real estate, infrastructure and hedge funds. Keep in mind that as markets fluctuate and create imbalances, you should be disciplined enough to rebalance your portfolio back to its original asset allocation structure. This will inevitably force you to sell high and buy low.
The second approach is to align different asset classes to create income streams over time. For example, include a cash wedge strategy to generate income from short-term fixed-income investments. Combine it with a separate set of investment accounts or portfolios that continues to invest in a diversified mix of equities and fixed income so your investment will continue to grow over the medium to long term.
The easiest way to understand this approach is to think of your investments as three buckets, each with investments that have different time horizons or durations. Your “short-term bucket” holds investments that mature within one to two years (this is your cash wedge from which your draw income for immediate use; it can be a mix of 90-per-cent short-term bonds or money-market instruments and 10-per-cent equities). Next is your “medium-term bucket,” which holds investments for two to five years (this may be a mix of 50-per-cent fixed income and 50-per-cent equities). Finally, there’s a “long-term bucket,” invested for five to 10 years or more (it may be a mix of 20-per-cent fixed income and 80-per-cent equities).
Over time, shift your holdings from one bucket to the next to replenish your short-term cash wedge. These pro-active allocations create a waterfall effect, protecting income during periods of short-term market volatility or corrections while allowing you to participate in equity markets over the long term.
The third approach is to allocate a portion of your portfolio to equities that have defensive characteristics. This means investing in stocks whose businesses are not as sensitive to economic or market cycles and are, therefore, less volatile – for example, companies that have historically experienced stable earnings or steady dividend growth.
You can also adopt a systematic approach to reduce exposure to equities and move to cash or cash equivalents when signs of market stress are clear, and transition back into equities when the opportunity for equity market gains are clear to avoid losses.
No one has a crystal ball to predict the future, but you can maintain a disciplined and unemotional approach to investing. This is the difference between speculation versus a framework for protection. As billionaire investor Warren Buffett says, “to invest successfully, one doesn’t need a stratospheric IQ. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."
Adopting these strategies will help you minimize the impact of volatility on your retirement portfolio, provide protection against downside risk and allow you to focus on targeting your financial goals more effectively.