Crash Course — How Safe Is Your Portfolio?

The markets were exceptionally kind to investors in 2024. Nvidia (154%), Palantir, (344%) MicroStrategy (500%+), and Bitcoin (all-time high of USD $73,000+) are just a few examples. Recency bias leads us to believe the good times will roll into 2025 and beyond. On the surface, things look rosy. The interest rate regime is dovish with regular quarter-to-half-point drops. A more business-friendly stance and a looser regulatory environment from the U.S. government are likely to give small-to-midsize companies the boost they’ve been waiting for, and possibly pull up the other 493 companies in the S&P 500 that missed the capital bonanza. What could go wrong in these halcyon days?

Look under the hood and the picture is cloudy and contradictory. Stocks are up, which speaks to investor optimism, and expectations of strong corporate earnings and a robust economic cycle. Despite inflation at, or near, the U.S. Fed’s target, gold is up, which signals rising inflation expectations. While short-term interest rates are dropping, the U.S. 10-year bond yield has risen. They can’t all be right. Which asset market is making the right call?

Over in Canada, the economy is in a slump with steady declines in Gross Domestic Product (GDP). Our currency is in freefall. If we were the 51st state, we’d be worse off than Alabama, the fourth poorest in America, according to a report by The Economist. Chew on that piece of tobacco.

Now, let’s look at consumers. They are stretched: auto-delinquency rates and personal bankruptcies are the highest they’ve been since 2010. Student credit card debt, mortgages, and car loans are all at record highs, too. No wonder that retail sales are on a downtrend. Meanwhile, equity investors are not being paid to take on the additional risk. The S&P 500 risk premium (earnings yield of stocks subtracting the 10-year Treasuring rate) is flat or negative.

Major economies are like big ships: they sail along—until they meet an iceberg. (If a politician is lucky, the giant iceberg is the next guy’s problem.) Pay less attention to what politicians are doing and more to your portfolio. The prudent investor builds one to handle a variety of potential outcomes. Before the winds pick up and the seas get choppy, swab the deck, check the anchor, and set the sails for safer harbours.

Spread Your Bets: Diversify

At the end of 2024, the mostly mega-cap technology companies dubbed the “Magnificent 7” represented nearly one-third of the value of the S&P 500. (During the past 35 years, the average weight of the Top Ten stocks has been around 20%.) The irony is, originally, one of the most attractive features of passive Exchange-Traded Funds (ETFs) was instant and massive diversification. This is no longer true. The average investor has a more concentrated portfolio based on a few large-cap stocks than ever. The implication is they are assuming more risk. Behemoth funds like Blackrock (CAD 12.7 trillion AUM) and Vanguard (CAD 9.5 trillion AUM) that run these ETFs are not in the business of price discovery. Their algorithms simply buy more of what is going up, feeding the bubble/mania in large-cap tech stocks that siphon capital away from the rest of the market.

One of the best ways to increase portfolio diversification is through regular rebalancing. When a sub-set of equities is on a tear, letting our winners run is a great temptation. Selling big winners takes a strong stomach. In addition to possibly missing out on future gains, rebalancing involves costs such as commissions and taxes which are a drag on total returns. The rationale behind rebalancing is that asset prices mean-revert. By selling some of what’s gone up to buy more of what’s gone down, we avoid the risk the typical investor makes of timing the market: buying high and selling low. Studies show that rebalancing on its own is less advantageous than advertised. The benefit of rebalancing is in the diversification it can provide among sectors, geographies, and even investment styles.

Row Your Boat, Across The Moat

Warren Buffett looks for businesses with large moats. These are companies with strong recurring revenues, pricing power, and other defensive characteristics. He is comfortable holding large amounts of cash which provides optionality to swoop in during periods of extreme market volatility. Is your portfolio well-defended? Could it withstand a crash like 1929 which was caused by excessive leverage and speculation? Back then, the average price/earnings ratio was 32.6 (today it’s over 33). The market dropped 89% and took 25 years to recover. Many investors had no cash cushion against the sudden drawdown and long recovery process and were left destitute. In 2007, the Global Financial Crisis led to a drop of nearly 57%. These events do happen.

Building a defensive moat around your portfolio involves reducing excessive risk. Have you determined what annualized return you need to reach your financial goals? A good financial plan will help you decide if you need to chase performance, or still meet your financial goals with lower real returns. Some investors habitually reach for higher returns and take on unnecessary risks.

Raise the quality of your investments. In a downturn, there is a “flight to quality”. Avoid the speculative micro-cap biotech companies and meme stonks (sic), or keep a tight cap on what percentage of your portfolio you invest in them. (No more than 2-5%.) If they go up, great. If you lose your shirt, don’t add to your “mad money” pot.

Contrary to popular opinion, cash is not “dead money”. It is ballast in a storm, and it gives you the possibility of buying assets at very attractive prices. Today’s interest rates do provide a small real return. Always keep dry powder for these unpredictable opportunities. Returns are often best in times of capital scarcity where your dollars go further. How much cash to hold is a personal decision, and depends on many factors such as employment security, age, and short- and medium-term financial obligations, including debt servicing. The closer to retirement age, the more cash or short-term paper we should own to avoid sequence-of-returns risk by selling into a falling market.

Resist Narratives:

“It’s A New Era” Blah, Blah

Humans like stories, especially when they confirm our own biases. Ye olde chestnut, “This time is different” is making the rounds again. Machine learning is disrupting how we work and live. Will AI spur an economic boom with strong earnings growth across multiple sectors?

In the late 90s, the internet boom lit a fire under any company that had a dot-com in its name. For example, Pets.com, one of the poster children for the mania, had a billion-dollar valuation and no revenue. Was the internet innovative? Sure. Did price and value eventually matter to investors? Yup. During the Dot-Com Bubble in 2000, the market dropped nearly 50% and it took 7 years to recover.

My crystal ball is broken, how about yours? Stay safe out there.

Rita Silvan, CIM is a finance journalist specializing in women and investing. She is the former editor-in-chief of ELLE Canada and Golden Girl Finance. Rita produces content for leading financial institutions and wealth advisors and has appeared on BNN Bloomberg, CBC Newsworld, and other media outlets. She can be reached at rita@ellesworth.ca.