The trek to break even

Most likely, clients are as concerned about making gads of money as they are about recovering their losses. Advisors have to manage their clients’ expectations of when they will break even. A new survey suggests about one-third of Canadians expect to break even in less than three years, and more than one-third expect it will take longer.

Thirty-one percent of Canadians expect their retirement savings to recover the losses from the past year within the next three years, according to a new poll commissioned by Edward Jones. Roughly 40% of the more than 800 respondents in the survey believe it will take more than three years for their retirement savings to recover the losses of the past year.

The survey didn’t ask why Canadians expect recovery when they do, but for whatever reason, many of your clients may be working with these different timelines for recovery.

As an advisor, one thing you can work with is historical data, which suggest that full stock market recoveries are usually less than four years. This means, clients can probably expect to meet the return expectation of breaking even sooner rather than later, if they maintain a strong weighting in equities.

The S&P/TSX Composite Index has taken, on average, three and a half years to get back to its previous peak before the beginning of the bear market.

“I was expecting a few more people to remember that fact and expect their money to come back where it was sooner,” says Kate Warne, Canadian market strategist for Edward Jones. “Investors become more pessimistic about how soon things will come back after a period where there is a severe sell-off. Historically, the market actually tends to do better after a downturn. After a period of extreme underperformance, you tend to see a period of outperformance. One of the things we like to remind clients is, what you’ve seen in the recent past is not a good indicator for future returns. In fact, returns are likely to be a bit better than the recent past.”

Now, of course, peaks and valleys and when an investor enters the market have a huge impact on an investors own returns, but the last few years have been marked by returns substantially below that running average, Warne says.

“Since 1956, the TSX has provided an annual average return including dividends of about 9% per year. We would expect the next few years to be slightly higher-than-average-return years,” Warne says.

One firm adamant in its conviction that investors need to have a recovery strategy — which includes staying invested — is Franklin Templeton Investments. Since last fall, the firm has had a marketing campaign called Don’t Lose Twice, which explains how clients who divest drastically from equity markets will solidify losses of that asset class and will most likely miss out on the biggest part of the recovery — which happens shortly after the worst of the downturn.

Franklin Templeton has outlined that advisors need to use a downturn to position a portfolio for recovery.

“The average recovery since 1974 is only 24 months — that’s from bottom until recovery to the previous peak on the S&P/TSX Composite. This recovery could be quicker than the 36 months,” says Don Reed, president and CEO of Franklin Templeton Investments. “We’ve been telling investors to re-evaluate, rebuild and refocus. It’s really important that investors re-evaluate their investment objectives, they refocus by looking at those securities that should be removed from your portfolio whether they are mutual funds or stocks, and finally, they rebuild their portfolio based on your revised objective statement.”

Almost true to form, the near 40% recovery on the TSX points to this recovery mirroring bear markets of the past. That means, investors who have stayed invested in Canadian equity investors have already recovered a substantial portion of their losses assuming they stayed invested.

“Fewer investors approach the market in the early stages of a recovery,” Reed says. “If you miss the best 10 days of recovery, you typically miss about 90% of the recovery. You don’t know what the best 10 days are until it’s over. You can’t forecast when those days will be, so don’t try to time the market. The TSX is up roughly 40% off its bottom right now. If you try to time it and say there is going to be a check back to buy, you’ll probably miss it.”

The road to par

Historically, equities are the best way to capture most of a broad market recovery, but of course, they come with an elevated risk over other asset classes. Reed suggests that advisors gauge a client’s risk tolerance carefully before rebalancing a portfolio in this market. Small caps and riskier equities historically lead recoveries, but an advisor can drastically minimizea clients’ risk profile while still maintaining good growth potential by dollar cost averaging and investing in securities that have a diversified asset mix.

“You have to determine what the investor’s tolerance is for risk. A good approach for a risk averse investor would be to use a balance fund. By doing that, an investor would be able to participate in the upside as equities will show the biggest recovery,” Reeds says. “Dollar cost averaging is a good approach to use with these investors as well.”

If an advisor hasn’t already done so, capitalizing on tax-loss selling can also be a shortcut to get back some return. Tax-loss proceeds can be used to offset capital gains that were triggered in the past three years. They can be carried forward indefinitely. An advisor could use the proceeds from the sale to rebalance the client’s portfolio or wait 30 days to reinvest in the same securities.

This market has proven volatile, meaning that there is heightened risk over the short term. Reed, a long-time veteran equities manager, says the direction of this recovery is in line with historical expectations.

(06/16/09)