Riding the Investment Roller Coaster

If you are a stock market investor, lately the ride has felt distinctly like a roller coaster - gut-wrenching daily swings up and down, things going topsy turvy as major financial market players with long histories go bankrupt or get acquired in distress sales. It would be no surprise if you feel like the "I can't look" mother and terrified daughter on the real coaster in the photo.

In the last year, markets worldwide have suffered significant losses, as the chart below from Google shows (the blue line is the Toronto TSX Index, the red line is the US NASDAQ, the orange line the US S&P 500 Index and the green line the Exchange Traded Fund from iShares that tracks the EFA Index representing Europe, the Far East and Australasia).


What, therefore, should an investor do to make the ride less stressful, since unlike a roller coaster, which is just a trivial amusement, serious savings for retirement, a house or education are typically at stake?

Short-term Tactics

• Protect against drops (hedge) with options - e.g. buy put options (see Put on Investopedia); like all insurance, there is a premium so this can get expensive
• Protect against drops in stocks you own using various types of Stop Orders (see BMOIL's FAQ on Stops)
• Do the "buy low" part of the old dictum Buy Low, Sell High - the survivors of the current financial debacle might well get stronger; the challenge is figuring out whether an individual company is a winner or a loser. Diligent homework and perhaps a bit of luck is required.
  

Long Term Strategies

• Acknowledge the difference between short term swings and longer term market upward movement and stay in the game. The Google chart below shows the same market indicators since 2002, a mere six years ago - they are still significantly positive. Cast your mind forward six years, or better 10 or 25 years, and ask yourself whether the markets will be up. Nothing in life is guaranteed and markets could stay down a long time (Japan since 1990 being an example) and if you are convinced that is the case, pull your money and stay out. The worst thing to do is to try pulling out temporarily until better days arrive - many studies have shown that investors who try to time markets this way end up losing money compared to simple buy-and-hold (e.g. How to Handle a Market Gone Mad by Jason Zweig). The roller coaster always returns intact despite the scary ride. Trying to jump out of the coaster in motion is not advisable!
  

• Adopt a portfolio suited to your psychology - if your ride creates real fear, maybe you should be on a tamer coaster, i.e. with less volatile investments. Maybe the girl should not have sat in front. Note in the photo how the lady in the second row seems to be calm and smiling to her child and the kids in the back are whooping it up! Partly, I believe this is a matter of getting used to it - having gone through the tech slide in 2001/02 this downturn is much less stressful for me.
• Diversify your portfolio - as noted before in this blog in posts about portfolio design, having a number of stocks will dampen the swings and minimize the impact of disasters like the Lehman bankruptcy. Mixing in fixed income will further reduce variability and downward movements.

Ultimately, the stock market is not like a roller coaster - it does not return you to where you started out, it tends to end up higher.

Investments to Protect against Inflation

Inflation has been mercifully tame for years but the recent spikes in gas and food prices has raised the menace of this scourge, which eats away at savings and investments by reducing purchasing power.

What are some ways for an investor to gain protection from inflation in a portfolio?

Real Return Bonds: this is the surest and safest inflation-fighter. Such bonds (in Canada) are issued mostly by the government of Canada with a few offerings by provinces. They are thus ultra-safe. The critical component of inflation-protection is ensured by the continual adjustment of both the interest payment and the principal for Consumer Price Index inflation. RRBs do not pay a high return - the real yield is hovering around 1.6 to 1.7% currently. They are best held in an RRSP or other registered account since the interest is taxable. To buy them you would need to phone the bond desk of your brokerage, as they are likely not available online. Minimum purchases are usually $5000. Get more info from CanadianFinancialDIY, ByloSelhi and current yields at CanadianFixedIncome.ca.

Equities: in the short term, inflation will harm the stock market, driving down prices but in the long term (i.e. ten+ years) companies can and do increase their prices to restore their profits and stock prices recover accordingly. This is an overall effect and individual companies can suffer lasting harm so the protection is more at a portfolio level. To benefit from this protection you need to have a broadly diversified portfolio, more or less the entire stock market. I believe the best way to achieve this is through market index mutual funds such as these listed on ByloSelhi, or similar ETFs, some of which are traded in Canada on the TSX, such as iShares Canada's and others on US exchanges. Seeking Alpha has a comprehensive list of worldwide ETFs.

Commodities: The agricultural products, industrial and precious metals, livestock and oil / energy goods that make up commodities tend to rise in price along with inflation. Indeed, the current inflation surge comes directly from energy and food price increases. Gaining protection from commodities fortunately does not require storing a big pile of wheat in the garage since there are funds focused on commodities. To invest, there are US-traded ETFs such as:

• iPath DJ-AIG Commodity Index Total Return (DJP)
• iPath GSCI Total Return Index (GSP)
• Powershares Commodity Index Tracking Fund (DBC)

The Canadian stock market itself, apart from the financial sector, is about two-thirds composed of resource companies and most of the main commodities are represented within those companies. A company's profits do not exactly match resource price swings but there is nevertheless a fair degree of inflation protection from commodities in the TSX. To give more weight, consider these ETFs:

• iShares Canada - Energy (XEG), Materials (XMD) and Gold (XGD)
• Claymore Canada - Global Mining (CMW), Oil Sands (CLO) and Global Agriculture (COW ... nice to see a sense of humour with the symbol!)

There are other investments sometimes touted as inflation hedges - tangible assets like fine art, wine, land and real estate. Apart from real estate, such assets can be hard to buy/sell (illiquid) and difficult to diversify. Real estate often doesn't rise with inflation, now being a prime example, so it is not nearly as good protection as the main options above, which should do an effective job relieving you of the worry of inflation. It's annoying enough to drive up to a gas pump these days. Having a little gas in your portfolio can salve the pain.

As usual, these are my thoughts and opinions, not investment advice to you. Make your own choices.