Investing: The Amusement Park Portfolio

Written by Camilla Cornell

Hang onto your hats, investors—you’re in for a long and bumpy ride. That’s the not so new news from industry watchers, who warn that market volatility isn’t likely to end any time soon.

“I’m seeing glimmers of light at the end of the tunnel,” says Patricia Lovett-Reid, senior vice-president of wealth-management firm TD Waterhouse Canada Inc. “But it’s not a beacon yet.”

So, what can you do to ensure that your portfolio survives, and maybe even thrives, in this bear market? Read on for the Five Rules of Recessionary Investing:

1. REDUCE VOLATILITY. The key to reducing volatility is to revisit your portfolio’s asset allocation. You want a diversified mix of assets, such as stocks, bonds and cash, that perform differently at any given time. When some asset classes rise, others will fall, so your portfolio’s overall volatility should be reduced. Your asset allocation should reflect a number of factors, including your risk tolerance, time horizon and personal circumstances (e.g., net worth and family situation). To get an idea of how portfolios can be structured to reduce risk, Lovett-Reid suggests you look at the “smart money”—namely, defined-benefit pension funds. Because these funds need to grow by a prescribed annual rate to meet their obligations to planholders, pension-fund managers structure their portfolios to reduce risk while delivering solid returns. According to Pyramis Global Advisors’ 2008 Canadian Defined Benefit Survey, at the end of 2007 the average Canadian DB plan had allocated 54% to equities, 33% to bonds, 2% to cash and 11% to alternative investments. (Although you can bet they’re holding more cash now.)

2. PARK YOUR EMOTIONS AT THE DOOR. When the financial markets make their stomach-churning swings, the average investor’s inclination is to do something—anything. But that often produces stomach-churning results. That’s why it’s crucial to stick to a predetermined investment strategy through turbulent times, advises Adrian Mastracci, a portfolio manager with KCM Wealth Management in Vancouver. He recommends investing at regular intervals throughout the year (monthly or quarterly) and rebalancing your portfolio only on fixed dates (perhaps twice a year) to avoid trading every time a spectacular headline leads the financial pages.

If you’re going to sell between pre-established intervals, define your “risk parameters—the point at which you can’t take the losses anymore” and your response strategy, says Mastracci. For instance, you might sell half your holdings in a stock or fund once it drops by 25% from the price you paid for it, then sell the balance if it drops by another 25%. “That gives you two shots at dealing with losing positions,” explains Mastracci. Whatever your parameters, stop-loss orders—which tell a broker or mutual-fund adviser to sell a stock or fund once it dips to a certain price—help take the emotion out of the process and prevent you from cherry-picking. The good news: those losses can offset your capital gains, reducing your tax bill.

3. BUY AGAINST THE CYCLE. Some stocks increase in value during a recession and taper off during times of economic growth. Examples include outplacement agencies or private-prison stocks such as Corrections Corp. of America, says Lovett-Reid, “because the number of people incarcerated increases during times of economic turmoil.” Other good bets include companies such as SNC-Lavalin, Caterpillar and General Electric, which stand to benefit from increased government spending on public infrastructure.

4. AVOID THE CYCLE. An even better bet than countercyclical stocks might be shares in non-cyclical companies. They produce such necessities as telecommunications services, health-care products and consumer staples (see chart above), for which demand remains relatively constant. Recession-proof blue-chip companies tend to do particularly well during a downturn. To wit: the share price of McDonald’s grew by 11% in 2008, while Wal-Mart climbed by an impressive 22%.

5. BUY GOLD, BUT NOT GOLD STOCKS. Gold can act as a life preserver in stormy seas, protecting you against the dollar’s decline in purchasing power. But Lovett-Reid prefers bullion over shares in the companies that produce it, as they can suffer from financial problems, operational issues or political unrest at mines. Consider that in the 15-year period ended November 30, 2008, the price of gold appreciated by 119%, while the S&P 500 gold index dropped by 21%. Purchase gold through a gold exchange-traded fund, with the shares backed by the metal itself, held in storage. Alternatively, you could buy gold coins, certificates or bullion, but you’ll pay additional commissions, safekeeping charges and bank fees.

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