Time to tune-up that portfolio
Managing risk important given market’s bull run
O ur family did our first mountain-bike weekend of the year and it was clearly not the time to be taking excessive risk. The snow in the west has just melted and the trails were slippery as a result, but it certainly helped that we managed our risk by tuning up our bikes before venturing out on the trails.
Investors, likewise, should be thinking about risk management, especially since this long-running bull market has left many of them feeling rather overconfident with unrealistic expectations, which can be a dangerous combination should conditions unexpectedly deteriorate.
For example, 80 per cent of investors believe they will do just as well in the markets, if not better, than last year, according to the recent 2015 Natixis Global Survey of Individual Investors. The same respondents also believe that the annual return they will need to achieve their goals has increased to 9.7 per cent on top of inflation — almost a full point higher than the 2014 survey.
Rather than looking at the equity risk premium or the return spread to interest rates, investors are once again basing their forward expectations on more recent returns, a strategy otherwise known as performance chasing.
This can be dangerous, especially when it means taking on new risks such as swapping out lowrate-paying bonds for equity-like instruments or heavily concentrating a portfolio in one particular sector or geographical location.
Like tuning up your bike for that first spring ride, mitigating some of the risks in your investment portfolio during a bull market — and before any possible correction — is good practice.
The two most effective ways are to rebalance your holdings and undertake a bit of low-cost hedging.
The first means reducing some of those overweight positions in stocks, sectors and/or countries that have outperformed and reallocating to other areas that offer better value opportunities.
For example, at the beginning of the year, we took some profit from our U.S. positions and reallocated to the underperforming and relatively undervalued Europe, Australia and Southeast Asia markets given the positive economic impact to come from central bank stimulus programs, low oil prices and currency depreciations.
More recently, we’ve noticed a strong pickup of fund flows into the energy sector as institutional investors reallocate to take advantage of the large sell-off. In total, such investors set an eight-year record by snapping up more than $12 billion in U.S. and Canadian energy financings last quarter, according to data from Credit Suisse Group AG and as cited by BNN.
For those who want to protect their gains, but don’t want to sell, buying put protection can be a very effective strategy.
A put option gives put buyers the right to sell their position before a specified date at a specified contract (strike) price. This enables the purchaser to continue to participate in any upside, while guaranteeing downside protection until the maturity date of the option.
For example, the current put option market on the S&P/TSX 60 index allows investors to protect nearly half of their impressive 11-per-cent 12-month gain for the next five months at a cost of only 1.5 to two per cent. The good news is that the portfolio will track all of the upside (less the premium paid) should the market continue to move higher.
Put prices will continue to fall as markets and complacency levels increase, making this strategy even more attractive for those wanting to hedge some of their gains.
In summary, being proactive and tuning up that portfolio can go a long way to ensuring a safe ride in the markets.
Being proactive can go a long way
to ensuring a safe ride