Investing is a risky game where nothing is guaranteed, but there are ways to mitigate some of this uncertainty.
Much like a mortgage or vehicle maintenance, your portfolio can benefit from undergoing a “stress test” to assess and quantify what the impact an event would be. The end result is to see a potential return that would reflect how a portfolio could perform under that scenario, such as a recession.
A quick an easy online assistant to help is the Portfolio Visualizer. It offers analysis tools for backtesting, tactical asset allocation and optimization, as well as investment analysis tools for exploring factor regressions, correlations and efficient frontiers. It also has Monte Carlo simulations, which are a broad class of computational algorithms that rely on repeated random sampling to obtain numerical results. The underlying concept is to use randomness to solve problems that might be deterministic in principle, because when it comes to the stock market … anything can happen.
(Example image via Portfolio Visualizer.)
For investors who want to do a bit more manual digging and perform some personal due diligence, there are some added steps.
The first thing to understand is where we are at in this current economic climate. Many economists believe the market cycle is nearing the end of a bull run. In this October 2019 interview with CNBC, BMO Capital Markets’ Chief Investment Strategist Brian Belski told Mike Santoli that this is the second-half of a 25 year secular bull run.
“We really believe that 2019 is this generation’s 1995.”
While everyone has their own varying option on what is going to happen in the near future, much like the “next big natural disaster”, you have to assume that the market cycle will repeat and turn into a recession at some point. Not every stock will weather the storm equally and this is a major consideration to prepare for.
Margin of safety:
A margin loan can be a useful buffer to serve as an alert when things go awry, but requires dedication to actively monitor and manage investments. When borrowing money from a brokerage firm to purchase an investment, margin loans use a trader’s shares or managed funds as security. These loans can help increase returns while also magnify losses. An entire portfolio should not be invested into a margin account.
Investors should also have enough income to reduce their margin or purchase stock outside of it. A good rule of thumb would be around 60/40 to 70/30 split between a TFSA and a margin portfolio.
How much risk a trader takes on always depends on their financial situation. Saving a few hundred dollars a month may not be enough to invest a substantial amount into the margin account or make meaningful stock purchases.
Be prepared when history repeats:
With the 2007 - 2009 financial picture in the rear-view mirror, it has become easier to track exactly how much damage any company that survived that crisis endured.
An example chosen entirely at random - Canadian Tire Corporation Ltd. (TSX: CTC). You can look this ticker up here on Stockhouse (or the ticker of just about any company) and check its performance, which has been selected from January 2007 to December 2009 for reference below:
(Canadian Tire stock performance 2007 - 2009.)
You can see here how much prices dropped over that time and then also look over a broader period to assess its overall volatility. Things have certainly bounced back for this particular retailer, though it is impossible to determine exactly what a new recession would do for good ol’ CTC shares. It still offers an indication of how it would handle an event like the 2008 financial crisis, were it to happen again.
(Canadian Tire stock performance 2011 - Present.)
Damage will occur:
Rest assured, everyone’s shares will take a hit, but regardless, some important factors to keep in mind are:
- How much are you earning on your investments every month / year?
- How long will it take to repay that margin loan?
- How much are your monthly interest payments?
- Do your dividends cover that interest?
- How much do you save every month?
Just how stable do you feel your portfolio is and do you conduct stress tests on it? Have you considered margin loans and do they work for you? Let us know in the comments below.