The stock market bends, but does not break. Now, what about your confidence as an investor?
Crises like Tuesday's terrorist attacks have happened before in the past century and stocks have always shown resilience. But, oh those temporary shocks. They can test even the most resolute investor's ability to think long term and forget about the moment.
For this reason, it's worth taking a close look at defensive investing. Build some defence into your portfolio and you'll be in good shape to withstand whatever the world -- never mind the markets -- has to offer.
First, though, consider how the markets have historically recovered from catastrophe.
Take the 1991 Persian Gulf war and the 1941 attack on Pearl Harbour, both of which sent the stock market reeling. Research from Merrill Lynch Canada shows the Dow Jones industrial average plunged 5.7 per cent in the week after the Gulf War began and 5.0 per cent after Pearl Harbour.
Twelve months after the start of the Persian Gulf war the Dow was up 4.1 per cent, while the index's loss was trimmed to 1.4 per cent 12 months after the Pearl Harbour attack.
Recoveries aren't always so predictable. After the Cuban Missile Crisis in October, 1962, the market fell 0.7 per cent over a week but then surged to a 30.9-per-cent gain after 12 months. After the 1987 market crash, the Dow rose 3.2 per cent in the following week, but was down 3.9 per cent in the 12-month period.
Jolts like these fade over the long term, but the volatility they cause can be unsettling, or even panic-inducing, if you're not prepared.
The most basic step in portfolio disaster readiness is diversification. It sounds trite, but it's as true anything in investing. Studies have shown that the mix of investments accounts for about 80 per cent of your returns, while the actual securities you choose accounts for the rest.
A financial adviser can help you decide how much to put in stocks, bonds and cash, or you can use innumerable books and Web sites. A crude rule of thumb for diversification: Take your age and subtract it from 100, then use that number as a guide for what percentage of your portfolio should be in stocks.
Adjust your diversification plan to account for changes in your life cycle and objectives, not market conditions.
Now, let's look at some specific ways of building security into your portfolio:
Money market funds
No risk, with current yields around 3.3 per cent. Money market funds are best thought of as a parking place for money you want to deploy quickly at a future date to buy stocks or mutual funds. Long term, the low-risk, low-return nature of these funds don't make them very attractive.
Guaranteed investment certificates
As safe as safe gets, but the returns are piddling and your money may be locked in until maturity. One-year GICs currently pay somewhere around 3 per cent on average, and locking up your money for five years gets you about 4.4 per cent annually at many banks. If you do go with GICs, split your money into one- through five-year maturities so that you have fresh money available each year to take advantage if rates move higher.
Canadian and U.S. government bonds are ultra-safe if you hold them to maturity and collect your interest payments. Bond prices fluctuate a fair amount, which means you may lose money if you sold before maturity. You can also buy a bond mutual fund, but management expenses will cut into your returns.
Bond funds may be your best bet if you want to reduce your holdings in equity mutual funds that you bought with a deferred sales charge, which means you have to pay a redemption fee for withdrawals made within seven or so years of purchase. If you switch into a bond fund offered by the same fund family, no fees should apply.
A nice compromise between holding bonds and bond funds are the exchange-traded funds that are designed to provide the returns of the five- and 10-year Government of Canada bonds. The symbols of these funds on the Toronto Stock Exchange are XGV and XGX. Very low management expenses and twice-annual cash interest payments are key features of these ETFs.
Think of them as a conservative stock that pays out monthly income. Over the course of a year, many trusts yield 10 per cent or more. The downside is that trusts can fall in price, and that can cut their monthly distributions. Trusts are basically businesses in sectors such as oil and gas production, real estate and electrical power generating.
Earnings from the business are passed on to unitholders in the form of regular distributions that get better tax treatment than regular income.
Many of these increasingly popular investment funds use short-selling to capitalize on falling stock prices.
Problem: Most hedge funds require high minimum investments that range from $150,000 in Ontario to $25,000 in some cases in British Columbia.
Solution: A few mutual funds have used the short-selling strategy, notably the @rgentum Canadian Long/Short Equity Portfolio, the @rgentum U.S. Market Neutral Portfolio, Transamerica Canada Life's Global Market Neutral Fund. There's also the Newcastle Market-Neutral Trust, a closed-end fund of hedge funds that trades on the Toronto Stock Exchange under the symbol NMN.UN.
While hedge funds are often marketed as risk reducers, some use complex investing strategies that may not work out as expected. That's why it's best to keep hedge fund exposure to something like 5 to 10 per cent of a portfolio.
Food, consumer goods, utility and tobacco stocks are often said to be defensive in that their fortunes are tied up in products that people will buy, regardless of what's going on in the world. You could broaden this definition to include the stocks of stable blue-chip companies that pay a decent-sized dividend. The big Canadian banks would be a good place to start looking for such stocks.
In an advisory this week, money manager MacDougall MacDougall & MacTier suggested such stocks as Toronto-Dominion Bank, Loblaw Cos. Ltd., TransCanada PipeLines Ltd. and Westcoast Energy Inc.
Gold prices have moved up in the aftermath of the terrorist attack on Tuesday, and that's typical. In times of uncertainty, investors have long turned to gold.
Then, when the uncertainty is over, they turn away. Leave gold to its fanatical fans and look elsewhere for safety.