Patricia Lovett-Reid, Embracing the Retirement Roller-Coaster Ride
Surging equity markets over the last two years have helped many investors recover a significant portion of the losses suffered during the financial market downturn of 2008-09. High sovereign debt levels, simmering conflict in the Middle East and North Africa, as well as the catastrophe in Japan, have once again sent ripples of fear across global markets and uncertainty over how to position retirement plans.
Before running for the exits, I encourage you to consider some market realities: volatility is often short-term pain for long-term gain. Over the past 40 years, the S&P/TSX Composite Index has had seven peak-to-trough corrections of over 20 per cent. Yet, it has persevered and returned a compound annual growth rate of 8.98 per cent over the past 25 years (to the end of Quarter 1, 2011).
One of the greatest challenges in investing is building a portfolio that is aligned with your risk tolerance and time horizon. According to world-renowned neuroimager Dr. Ravi Menon of The University of Western Ontario, when considering investments, brain-imaging studies show a battle between two competing areas: the ventral medial prefrontal cortex, which processes the lure of a big gain, and the dorsal medial prefrontal cortex, which processes the fear of risk. This battle waging between two different parts of the brain is a war between greed and fear. Your emotions can easily get the best of you in these scenarios.
If the peaks and valleys of your investments take you on an emotional roller-coaster ride, you’re likely taking on too much risk. Working with an experienced financial advisor can help you better manage your emotions. Self-directed investors can also do this by setting strict trading rules for their portfolios.
To have peace of mind and still enjoy an optimal portfolio return, your strategic asset allocation should strike a balance between generating a reasonable income stream and protecting your downside risk with the potential for some capital appreciation.
A good starting point for many investors is to begin with a balanced portfolio of 50 per cent equities and 50 per cent fixed income. Based on your objectives, you can then tilt your portfolio towards growth or income by increasing allocation to either equities or fixed income, respectively.
I did a back-of-the-envelope calculation to demonstrate the power of diversification by using a balanced portfolio, equally divided between investment grade, Canadian fixed income and the S&P/TSX 60 index, over the last three-year period, ending March 31, 2011. This is a period that saw the markets peak in 2008, crash in 2009 and the subsequent run-up to today’s levels. The equities-only portfolio would have depreciated by just over 50 per cent from the peak in June 2008 to the trough in March 2009. In comparison, the balanced portfolio would have depreciated by approximately 22 per cent over the same period.
Even looking at the performance for the past three-year period, an equities-only portfolio would have earned a return of 3.93 per cent per annum, while the balanced portfolio would have earned 4.32 per cent.
While financial markets make other investors swing between fear and greed, having a more balanced portfolio and perspective helps to reduce emotional decisions, which could compromise returns and your retirement plan.
Guest Finance Editor, Patricia Lovett-Reid
Recognized as one of Canada’s leading financial authorities, Patricia Lovett-Reid got an early start in the banking sector. Today, she is senior vice president of TD Waterhouse Canada Inc., and host of BNN’s MoneyTalk. www.tdwaterhouse.ca