At this time last year the stock market was down almost 20%. Stock analysts wrote articles declaring a stock market crash. This was going to be 2008 all over again. Fast forward one year later and the story seems so different. The TSX is up almost 20%. The S&P 500 index has gone up over 29% in 2019. Add the dividends and the US benchmark is over 30% for a single year. That’s pretty crazy considering what all the analysts were saying at the end of 2018.
Many investors lost 20% and sold their entire stock portfolios, only to miss out on one of the largest gains in a single year over the past decade. This is why you cannot time the market. No matter what stock analysts or your mother-in-law says, never sell your stocks just because prices fall. It’s impossible to predict the stock market, so the best course of action for any long term investor is to hold the course.
The Stock Market Crash Is Coming
How many times have we read this sentence on a Google news feed or Yahoo Finance? Probably every day. With markets up over 20%, we all think the market is going to crash tomorrow. This might seem like rational thinking, but the stock market is anything but rational. Since 2008 when markets crashed 50%, this has followed on the S&P 500:
- 2009 +9.1%
- 2010 +8.9%
- 2011 +4.4%
- 2012 +13.5%
- 2013 +41.5%
- 2014 +24.0%
- 2015 +21.0%
- 2016 +8.6%
- 2017 +13.8%
- 2018 +4.0%
- 2019 +30.0%?
Every time the stock market rises, stock analysts think the next crash is coming. But the above shows that after spectacular rises, the market doesn’t always fall. In fact, there are even years where the stock market increases double digits again like 2014 and 2015.
Will 2020 be like 2014 or will it be like 2008? No one knows. My crystal ball doesn’t seem to be working lately and my psychic friend seems to be on vacation. There’s no way for me to predict the future. If we don’t know what will happen then what do we do? Surely there is something to protect our investments.
I repeat this all the time. Don’t get emotional and sell all your stocks. Be prudent and re-balance your investment portfolio. I’ve written many times before on how to re-balance your portfolio. This still remains the best way to maintain a health investment portfolio. Don’t sell all your stocks. Rather, pare down the gains and buy other assets that have lagged in growth. This is similar to buying low and selling high, but at no time do you ever exit an investment class.
Why does balancing work? Fundamentally, re-balancing an investment portfolio has the impact of doing the following:
- Dollar Cost Averaging
- Buying Low, Selling High
- Reducing Risk
- Eliminating Emotions
Dollar Cost Averaging
If you’re a fan of Vanguard ETFs like me, then you’ll know they are good, low cost index funds that help make up a balanced portfolio. Like normal stocks though, ETFs don’t always go up. In fact, over the last couple of years the TSX index has experienced some ups and downs.
- 2017 +8.46%
- 2018 -9.08%
- 2019 +20.0%?
If you’re using your TFSA properly to invest and did so with $5,500 in 2017 and 2018, by the end of 2018 the value of that $11,000 would be $10,424.25. That’s actually less than the $11,000 you would have invested with. At this point many investors would have sold their stocks. Who wants to lose money? Wasn’t investing supposed to make money?
Those that understand dollar cost averaging would understand that buying when prices are low means more shares can be purchased. This lowers the average cost of each share.
- 2017 50 shares @ $100
- 2018 46 shares @ $108.46
- 2019 63 shares @ $94.76
Buying shares at the start of 2018 would increase the average price of the shares to $104.05. By buying shares at the start of 2019, with the increased $6,000 limit, one would be able to buy 63 more shares at the lower price. This would average down the cost of each share to $100.37. Very close to the original $100 starting price in 2017.
By the end of 2019, the invested amount of $16,424.25 would now be $19,709.00. That’s the equivalent of $113.71 a share. That 13% gain over 3 years isn’t too shabby. How well did your GIC do?
Buy Low, Sell High
Re-balancing an investment portfolio has the impact of selling the winners and buying the losers automatically. This is what successful long term investors want to do. Don’t chase gains buying stocks that are high in price. Try to buy things when they are on sale. Don’t you already do that with everyday household items?
If you follow my preferred way of investing by using a Canadian Couch Potato portfolio, then 2019 would have been really good to you.
|Beginning of Year||Percentage Increase||End of Year|
|BMO Aggregate Bonds (ZAG)||40.00%||1.04%||36.31%|
|Vanguard All Canada ETF (VCN)||20.00%||18.40%||21.27%|
|iShares All World ex Canada ETF (XAW)||40.00%||18.05%||42.42%|
Stocks have done phenomenal this year. It comes to no surprise then that the initial weighting for a balanced 60-40 portfolio would be thrown far off. In the case for 2019, bonds lagged severely when compared to stocks. This makes a case to re-balance the portfolio to sell stocks that have gained almost 20% and buy bonds which have lagged.
By keeping with our original weightings of 40% bonds, 20% Canadian equities and 40% equities in international markets, we essentially sell our winners and buy the losers. This is what we want to do to maintain a healthy balanced investment portfolio.
We have all heard the term “Don’t put all your eggs in one basket”. A balanced investment portfolio does exactly that. Even though we could make more money investing in stocks only, we don’t want to do that. Holding only stocks in an investment portfolio puts us at risk of losing greater than 50% in a stock market crash. Normal investors can’t stomach that.
Since 2019 was such a great year for stocks, we might be tempted to put more money in stocks. Don’t. The point of having a balanced investment portfolio is to mitigate risk by owning assets in many investment classes. Re-balancing an investment portfolio eliminates the excess. The goal is to maintain a 60-40 ratio of stocks to bonds no matter what the market does. Good or bad.
In general bonds act as a stabilizer to the stock market. The negative correlation between the two helps us stomach the wild gyrations in the stock market. In the event of a stock market crash, bonds will prevent us from having to live through a 50% correction.
I’ve written much about bonds in the past and why everyone should have some in their portfolio.
The single biggest reason why normal people fail at investing is due to their emotional attachment to money. This is why re-balancing takes all the emotion away. We are basically doing standard arithmetic and following the guidelines we set when starting to invest.
If the goal of your investment portfolio is to maintain the 60-40 ratio of equities to bonds, then all you have to do is maintain that year after year. There’s nothing else to do. The goal in investing is to keep everything simple and have a long term horizon (greater than 10 years). That’s it. Let compound interest work for you.
Most people fail at investing because they get too emotional during a stock market crash. People tend to sell all their stocks after a crash, vowing never to return. That’s called selling low. That’s the kind of irrational behaviour that people do when they lose money.
The simplest approach is to re-balance. When stock markets fall, buy more stocks. When stock markets go up, buy more bonds. This very mechanical way of managing an investment portfolio is all that needs to be done. Taking a simple objective approach to investing is what a normal person needs to do to be successful.
2019 has been an exceptional year for investors. So good that we actually feel a bit fearful. That shouldn’t stop you from investing. In fact, the proper way to continue is to stay invested. We cannot predict what the stock markets will do. We cannot predict a stock market crash.
The most prudent thing to do is to re-balance your portfolio. Sell some of your equities if they’ve done really well. No one will ever tell you you’re wrong for taking a profit.
The key is to stay invested. Even if equities do fall we shouldn’t make irrational moves. Keep re-balancing the portfolio when the ratio between equities and bonds moves out of proportion. That is all the action we need to do. Most importantly, enjoy the holidays with friends and family. Stop worrying about your money. It will do just fine.