John Kenneth Galbraith once said: “The only function of economic forecasting is to make astrology look respectable.” Based on this, we can safely assume that he didn’t try to ‘time the market’ with his portfolio. After the TSX’s three strong years of growth, a discussion about when the next decline is coming has been increasing.
Given the current volatility of the markets, here are a few questions investors should ask themselves:
- When will the next recession and stock market decline happen?
- What will be the impact on my investments?
- How will this change my retirement plan?
The first question is easy – Mr. Galbraith essentially answered it. Although a negative year will eventually arrive, it is not possible to accurately predict the timing.
The second one is a bit more nuanced since a broad decline in the stock market will affect investor portfolios in varying ways, depending on a few factors. The TSX is made up of a diverse group of industries including financial services, energy, materials and others. Not all sectors fall equally. Therefore, one consideration is based on how cyclical your portfolio’s holdings are.
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Concentration in a few growth-based industries like technology or cyclical industries like energy could mean significant volatility. Another factor to consider is the market capitalization of your holdings. Large-cap stocks that pay dividends generally decline less than the market average during a recession and recover quicker. Accordingly, a portfolio well positioned for a recession should have less exposure to cyclical industries, and more weighting towards large cap, dividend-paying companies.
Arguably, question three matters the most. It really asks what will happen to your goals? The answer to this will depend on whether you are an active trader, or a long-term investor.
If you are an active trader, or one who only intends to hold any asset for a short period of time, then a recession and stock market decline will have a significant impact on your portfolio. There really is no way to prepare for it, other than trying to time the market. The difficulty with this approach is not only predicting the fall, but also the eventual recovery, so you can reinvest.
If you are a long-term investor who is saving for retirement, or currently funding your retirement, then there are several things you can do to weather the financial storm without having to cash out your portfolio. The key to this situation is having a detailed financial plan, which would include your retirement date and expected cash needs. As a rough estimate, the Canadian stock market has about three negative years every decade. Although not all are major declines, this shows investment income will be volatile so a well-prepared plan should already have built in regular market declines.
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The next aspect to consider has to do with which stage of life you are in. If you are saving for retirement, then you have a longer time horizon to recover from market declines. Your plan will also most likely have you making regular contributions, meaning you will have the benefit of purchasing equities at a lower price.
But what if you are currently retired and withdrawing from your investments? During a market downturn, you should draw from the stable part of your portfolio (bonds), while leaving the volatile part (stocks) untouched until it recovers. This approach prevents you from selling stocks at the worst possible time. In the interim, it is important to have enough bonds to cover your projected cash flow. The exact amount will depend on your specific situation, but a rough guideline would be to have at least three to five years of projected withdrawals in bonds, since most market downturns recover within that timeline.
Here’s an example: After the 2008 global financial crisis the market took approximately three years to recover. A 65-year-old retired investor withdrawing $30,000 per year from their investments could target holding $150,000 of bonds. This would allow them to wait for a market recovery for as long as five years, while withdrawing from the bond allocation of the portfolio.
For a long-term investor with properly prepared plans, a market decline may have an emotional impact, but not a financial one on your retirement goals. What this means is that you can get ahead of the next fall. Sit down with an advisor and ask what the impact of a future downturn would be on your goals and run a few scenarios. If it has already been incorporated into your projections, then you don’t need to worry. If it hasn’t, then it is not too late to prepare now.
Anwar Husain is an award-winning finance professor at the University of Toronto and a senior investment advisor and wealth advisor with Richardson Wealth. He is also a published author in several peer-reviewed academic journals in the areas of finance and economics.