Increasing Investment Returns in Volatile Markets

2019 was a fantastic year for stock market investors. 2020 started off tentatively before markets fell sharply due to the COVID-19 pandemic. These recent swings in stock prices provide a case study for how to increase investment returns—or avoid losses—amidst the volatility.

We will consider the investment strategies of three notional investors: Buy-and-Hold Barry, Spontaneous Sam, and Rebalancing Rita.

Buy-and-Hold Barry

Barry owns a portfolio of stocks he purchased many years ago and has held through thick and thin. The stocks are primarily Canadian banks, pipelines, telecoms, and utilities—traditional domestic income plays. The dividend yield averages about five per cent per year. Barry feels confident in his stock selection and that he can hold these companies forever.

His stock allocation was 60 per cent at the start of 2019. The other 40 per cent of his portfolio was made up of cash, money market funds, Guaranteed Investment Certificates (GICs), and bond funds.

Barry’s investments performed well in 2019. His stock portfolio returned 21 per cent, in line with the FTSE Canadian High Dividend Yield Index. His fixed income investments returned about three per cent, due mainly to his bond funds that returned almost seven per cent as interest rate declines pushed up the net asset value of the funds.

On January 1, 2020, his asset allocation had increased from 60 per cent in stocks to 64 per cent. Rather than rebalancing and selling stocks to get back to a 60 per cent equity target, Barry enjoyed a good start to 2020 before stocks fell due to the Coronavirus.

Barry is a buy-and-hold investor, so does not buy or sell, simply living off his dividend income. He is confident that even in a down market, his dividends are likely to continue, and believes dividend investing is the best way to make money in the markets.

Little does Barry know he may have missed a couple of opportunities. By not rebalancing, his returns may be lower than our other notional investors. Also, by focusing on a narrow selection of high dividend Canadian stocks, he missed out on the benefit of geographical and sector diversification. The better diversified S&P 500 returned almost 14 per cent annualized for the five years ending 31 December 2019, compared to about six per cent for his Canadian high dividend strategy. U.S. stocks have outperformed Canadian stocks over the long run as well, by about 2.7 per cent annualized over 30 years. The lower tax rate on Canadian dividends only reduces the gap slightly.

Spontaneous Sam

Sam received an inheritance in late 2019 after his mother passed away. He does not have much experience investing because he works for the government and is covered by a defined benefit pension plan.

At a New Year’s Eve party, someone mentioned to Sam how great stock markets performed in 2019—a 23 per cent return for the TSX, 25 per cent for the S&P 500 in Canadian dollars, and double digit returns for most international stock markets as well.

Sam immediately opened a discount brokerage account and put half his money into an Exchange-Traded Fund (ETF) tracking the TSX and the other half into an ETF tracking the S&P 500. Markets moved modestly higher in January and February, and Sam was happy he took the plunge into the markets rather than leaving the inheritance earning one per cent interest in a savings account.

As the COVID-19 pandemic hit, stocks began to freefall, and the news, people on Facebook, and Sam’s brother-in-law were all talking about how stocks were in the fastest bear market in history. Sam decided to sell to avoid losing more money and put his inheritance back into a savings account, where he wished he had left the money in the first place.

Sam’s investments were down 29 per cent in value less than three months after taking his initial plunge into stock markets. Sam regretted investing, but felt if he did not sell, his investments could be down another 29 per cent a few months later and would be worthless before the end of the year at that rate.

Sam made a couple mistakes with his investment strategy. A 100 per cent equity allocation was inappropriate in the first place. More importantly, he bought high and sold low, making a temporary loss a permanent one. Investing the proceeds of his stock sales into a savings account may have seemed like the right approach when the sky was falling and stocks were in the red, but stock returns after 30 per cent declines are historically quite strong in the subsequent year, and more so over the medium term.

For perspective, the ten worst peak to trough declines in the nearly 100-year history of the S&P 500 have ranged from 32 per cent to 86 per cent losses. The 86 per cent loss was over almost three years during the Great Depression. The next worst loss was 57 per cent during the 2008-2009 Financial Crisis. The average loss for these ten worst U.S. market declines was 47 per cent.

The average subsequent one-year return from the bottom during those ten instances was 54 per cent. The lowest one-year return was eight per cent.

The average three-year return was 93 per cent cumulatively, and the worst was 38 per cent.

Over five years—a 142 per cent average cumulative return, with 42 per cent being the worst five-year cumulative recovery.

The point is a stock market decline increases the future expected return for stocks, despite investors like Spontaneous Sam worrying that another large loss may follow an initial market drop. Statistically speaking, this fear is unfounded over a long enough time horizon, which grows shorter the more stocks fall.

Rebalancing Rita

Warren Buffett once said that investors should be fearful when others are greedy and greedy when others are fearful. Rebalancing Rita is an unemotional investor who takes this advice to heart and likes to buy low and sell high. Buying low and selling high infers timing the market. Market timing is notoriously difficult to do but using simple principles, any investor can time markets and potentially increase investment returns.

After a strong 2019 pushed global stock markets up 23 per cent in Canadian dollar terms, Rita’s asset allocation needed rebalancing. Like Buy-and-Hold Barry, her 60/40 equity/fixed income portfolio was 64 per cent in stocks and 36 per cent in fixed income at year-end. She sold stocks in early 2020—in retrospect, at the peak—and reduced her stock allocation back down to 60 per cent.

As stocks fell amidst the Coronavirus pandemic, she did the opposite of what others were doing by buying stocks instead of selling.

If she did not rebalance during the first quarter of 2020, her stock portfolio would be down over 20 per cent by April 1, 2020, and her 60/40 asset allocation would have fallen to 53 per cent in equity. This would trigger her to buy stocks that had fallen, knowing that they were on sale, to increase her equity allocation back to 60 per cent.

Rebalancing Rita timed the market, but not based on a tip from her neighbour, a gut feeling, or her crystal ball. She simply stuck to her target asset allocation and used discipline to help her time the markets intelligently.

It can be hard to sell stocks as they are rising, especially when everyone is talking about how rich they are getting at a New Year’s Eve party. It takes nerves of steel to buy stocks when everyone on TV and on social media is talking about the trillions of dollars of losses the stock market has incurred.

When—not if—stocks rise after Rita rebalances by buying stocks while they are on sale, her returns may exceed those of Buy-and-Hold Barry. The more volatile stocks are, the more the benefit of rebalancing. Rita may underperform Barry if stocks move consistently higher for an extended period, or consistently lower as well. But given most investors are depositing and withdrawing from a portfolio rather than leaving the holdings stationary, maintaining a consistent asset allocation can be that much more beneficial for those saving or decumulating.

This is because when contributing, an investor would buy more stocks when stocks are low, and when withdrawing, an investor would withdraw more from fixed income if stocks have fallen.

Implementation

There are pros and cons to investing with a robo-advisor. One benefit is they rebalance regularly by selling as stocks rise and buying as stocks fall like Rebalancing Rita. They generally have thresholds a portfolio can diverge from the target before buying or selling is triggered.

A benefit of all-in-one ETFs like those offered by iShares, BMO, Vanguard, and Horizons is they rebalance daily as stocks rise and fall.

A do-it-yourself investor or a professional portfolio manager may think they can consistently buy and sell in anticipation of stock market increases and decreases. In the short run, they may get lucky a few times. But over the long run, it can be difficult to consistently time stock markets meaning a buy-and-hold or rebalancing strategy may be more successful than jumping in and out of the stock market.

Looking back to the start of the bull market in 2009, there were plenty of events that seemed like they could derail stocks.

There was the debt ceiling crisis of 2011, when negotiations to increase the U.S. government debt limit came down to the wire and the U.S. had its credit rating downgraded by Standard & Poor’s for the first time in history. The European sovereign debt crisis emerged the same year and Greek interest rates skyrocketed to almost 30 per cent.

Between 2012 and 2015, Middle East Respiratory Syndrome (MERS) began to spread and peaked in 2015, impacting Saudi Arabia and South Korea primarily. Deaths were also recorded in several European countries and the U.S.

In 2015, the Chinese stock market crashed, and oil prices plunged, raising concerns of a global recession.

In 2016, the U.K. voted to exit the European Union, and the resulting Brexit debacle provided significant global uncertainty. That same year, Donald Trump surprised the world by winning the U.S. presidential election, and several political controversies have ensued south of the border in the subsequent years.

Between 2017 and 2018, North Korea’s Kim Jong-un engaged in multiple nuclear missile tests, threatening several countries and raising the risk of nuclear war with the U.S., Australia, and South Korea.

In 2018, a trade war between the U.S. and China led to tariffs and retaliation between the two countries that risked impacting the global economy.

The S&P 500 rose more than 500 per cent from 667 points in March 2009 to 3,394 points in February 2020. There were several “sell” signs during that 11-year period that could have triggered an investor to get out of the markets and would have reduced returns as a result. Rebalancing may be an investor’s best defense against selling low and buying high if they maintain a consistent asset allocation during good times and bad.

Rebalancing Rita is likely to outperform in a volatile market. Buy-and-Hold Barry’s approach can work well in a prolonged bull or bear market, but his is a strategy that is difficult to implement in real life when most investors are adding and withdrawing from their investments over time. Spontaneous Sam has the most to lose as an investor, so anyone with money in the markets must expect to lose money temporarily from time to time, as part of the risk associated with earning long run stock market returns.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.