Build a portfolio for troubled times

I’ve had recent conversations with two friends that ended up sounding exactly the same. Both were bemoaning the fact that they have taken terrible losses over the past year. Both were trying to figure out exactly what had happened and why, and were debating whether to stick with their current positions or completely overhaul their portfolios.

There’s no easy answer to that dilemma. There are too many variables: age, risk tolerance, quality of the securities, asset mix, tax situation (for non-registered accounts), and more.

However, if you’re down more than 15 per cent year over year and you’re feeling uncomfortable about what has happened and the prospects for the coming months, you owe it to yourself to devote some time to a complete portfolio review.

Here are the four basic steps for a review:

1) Start with basics
Start with the basics – your asset mix. What percentage of your money is invested in the stock market, either directly or through equity and balanced mutual funds? If you don’t know the number within five percentage points either way, you don’t have any handle on your portfolio structure.

Under the current marketonditions, a prudent investor should have no more than 50 per cent equity exposure. Older people (those over 60) should have even less.

2) Assess equity investments
Next, carefully assess the nature of your equity investments. Many stock selections have done quite well despite the poor stock market environment. The great majority of those were what are known as “value” stocks. These are companies that are trading at reasonable to cheap prices relative to their earnings and have strong balance sheets and a sound core business.

Value investing is a proven technique, but it doesn’t always yield the best results. During the market boom of the late ’90s, for example, growth stocks led the charge. These companies were deemed to have the greatest potential for rapidly expanding revenues and earnings in what were expected to be the technology-driven years of the early 21st century.

Value stocks trailed in the dust and so did most of the mutual funds that used that style of investing.

Value cycle continues
But we all know what has happened in the past 18 months. Many growth stocks have come crashing down as the realization sank in that expectations for them were wildly overblown. The green eyeshade value issues emerged as the heroes that have saved the markets from total collapse.

It is likely that the value cycle will continue for some time to come. Therefore, your equity emphasis should be on that side of the equation. That is not to say you should ignore growth stocks or mutual funds entirely.

They will come back at some point and you want to be there when they do. But your weighting should definitely be to the value side, by at least 60-40. If it isn’t, then some restructuring is in order. If your portfolio is non-registered, be sure to consider the tax consequences of any sales, however.

3) Review fixed assets
Now take a look at your fixed-income assets – your bonds, preferred shares, GICs and the like. A well-balanced portfolio should hold somewhere between 25 to 45 per cent in these types of securities.

The problem is deciding what to buy. With interest rates so low, there isn’t much out there that’s very attractive. Five-year GICs are paying 4.5 to five per cent. Canada bonds are yielding between five and 5.8 per cent over five to 30-year maturity ranges.

You can do a bit better with provincial and corporate bonds. Preferreds aren’t much better, although they offer the advantage of the dividend tax credit if held outside a registered plan.

Don’t lock in
My recommendation is that you trade off return for safety. Go for short-term bonds (maturities out to five years) or for some top-quality preferreds if you’re investing in a taxable account.

Don’t lock in for the long term at current rates. Even though interest rates are likely to drift lower in the coming weeks, making a big bet on long term bonds at this stage in the cycle doesn’t look like a smart move.

4) Hold cash reserves
Finally, to cash. Your cash reserves should be anywhere from 10 to 20 per cent of your assets. I recommend that half that money be held in U.S. dollars as protection against a further decline in the value of the loonie. I make that suggestion in full knowledge of the fact that the U.S. dollar is overvalued and has been in decline against currencies like the euro in recent weeks.

However, it is more difficult for Canadians to hold euros (or Swiss francs or Sterling), especially in registered plans. Moreover, most of us are more likely to have a practical need for U.S. dollars in the future. If you plan to retire to France, then by all means substitute euros. Most Canadians choose Florida or Arizona, however.

Limit loss exposure
No one likes to lose money. And if you lose a lot, you may endanger your health worrying about it. Your portfolio should be constructed in such a way as to offer you reasonable profit opportunities without exposing you to heavy losses. If it isn’t set up that way now, make it so.

From the September 4, 2001 issue of the Internet Wealth Builder.