I admit the above title may look a little strange, but I do believe you can actually win – even when markets are falling. You may well ask: How can this be? Most people don’t like losing money in their investment portfolios. It does not make them feel good and they often become fearful and anxious. But a bear market (a market in significant decline) is, in fact, a necessary evil on the path to achieving your financial goals, and a bear market actually presents excellent investment opportunities.

 

Here’s a question. Why do you invest in stocks or the stock market in the first place? Most people say stocks provide higher returns as opposed to safer investments such as cash or bonds. But this answer is only partly right. The complete answer is that the stock market has higher expected returns vs. cash or bonds. By investing in stocks you are adding additional risk to your portfolio, and therefore should expect to earn a higher rate of return from those investments. The key here is that this higher expected return is not guaranteed. Over the past 25 years (1983-2007), Canadian equities (stocks) have outperformed Canadian treasury bills by an average of 4.5% or 450 bps annually[1]. But this outperformance is not consistent year over year. In fact, during that same period there were nine years when it would have been better to have invested all of your money in Canadian treasury bills, which are basically risk-free, instead of Canadian equities due to their higher returns. Unfortunately, the patterns of returns of various asset classes are unpredictable, and moving large amounts of your portfolio from one asset class to another (known as market timing) in the expectation of higher profits is expensive, tax inefficient and risky. 

 

During this same 25-year period, Canadian equities have grown annually at an average rate of 10.93%. Like any average though, there will be results above and below this number. Given the volatility of stock market returns, when we consider data on the Canadian market’s historical returns we expect some annual future returns to be negative (approx 25%-30%). This is born out by the fact that the Canadian Stock Market contracted in seven of the past 25 years. This occurred most recently in 2001 and 2002 when the market posted back-to-back losses of -12.6% and -12.5%, respectively. Although it may initially sound illogical to suggest you should be happy that these negative return years occur, consider this: If the Canadian stock market became less volatile and you knew you would never lose your invested capital, and could initially still expect to earn an expected average annual return of 10%, would you allocate more of your portfolio to stocks vs. bonds or cash? I know I certainly would, and I suspect most of you would too.

 

What effect would this have on stock returns though? To begin with the demand for stocks would initially be enormous, and if the demand for stocks suddenly increased due to their increased level of safety, but the supply remained unchanged, then stock prices would be bid upwards. But if stock prices are bid up, then your future expected return would naturally fall. Why does this occur? Well, when you purchase a company’s stock, you are purchasing the discounted future earnings of that company. As an example, let’s imagine that the stock market is just one huge donut shop, which produces earnings per share (EPS) of $1, and this $1 is paid out to each shareholder as a dividend. This $1 dividend isn’t guaranteed though and could be higher, lower, and maybe even negative, so the stock trades at $10 and your annual expected return is 10% ($1 dividend/$10 stock price). Now let’s suppose that the donut shop’s expected earnings become more stable and you are guaranteed that the company’s expected annual EPS is still $1 and will never be negative. Because the company’s risk profile has decreased; people are now willing to pay $20 for one share in the donut company. This has the effect of lowering our expected return to 1/20 = 5%.

 

For many of you, stocks likely represent the riskiest asset class in your portfolio. Therefore, if the stock market’s overall risk declined and the expected return of the stock market thus fell, the expected return of your overall portfolio would also fall. If it fell so much that you could not expect to meet your future investment goals or fund your existing spending needs, this would be a big concern. To address this, you would have to seek out new investments and asset classes that had the higher expected returns you require to meet your goals. These new investments would invariably carry a higher level of risk (i.e. the possibility of losing money), or you would have to lower your investment goals or spending.

 

Previously, I’ve highlighted the fact that a large number of investors and advisors buy high and sell low, and down markets are one of the main contributors to this behaviour. Down markets transfer wealth from people who have no plan and/or a weak stomach to those who are clear in their investment goals and have a specific plan to achieve them. Buying into a down market doesn’t feel good, but if your plan calls for you to allocate 40% of your portfolio to stocks, then when the markets fall and this number declines you need to rebalance. This means you or your advisor needs the fortitude to buy into the market when it is low and increase your holdings back to 40%. Rebalancing your portfolio properly should ensure that over time you earn a higher rate of return with less risk instead of holding a portfolio that isn’t rebalanced or a market timer’s portfolio who panic-sells when markets decline. This process of rebalancing by buying when the markets are down and market sentiment is negative has been given a number of fancy names, including contrarian investing, bargain hunting, and opportunistic investing. I think it’s really just common sense investing, which unfortunately requires an iron will to implement. 

[1] Data and returns used were sourced from Ibbotson and Associates and are represented by: Canadian 30 Day Treasury Bills and the S&P/TSX Composite Index.