Lessons learned in the market

Once again our equity markets are trying to impart valuable lessons that they have tried to teach us before. In the past, many people just ignored them. Will it be different this time?

We are happy to report that most world equity markets moved up after the U.S. Fed announcement that rates would decrease. As a result, many investors shared a sigh of relief that the volatility would now be over. But instability is one constant we can count on in a continuously changing market.

We feel that these are the main lessons to take from the past:

1. Limit your exposure to investments that are exciting but risky

In recent years, some investors have become infatuated with fringe sectors such as emerging-market stocks, emerging-market debt, commodities, gold, oil, hedge funds, and junk bonds. Each investment has merit based on investor objective, and there is nothing wrong with a small stake in any of them. But we caution investors that all that glitters is not really gold and advise them to think long and hard before allocating more than five per cent of a portfolio to any one of these sectors. The upside might seem attractive, but a sudden change in the markets can quickly devastate a portfolio; it could then take years to recover your principal.

2. Ensure that your asset allocation mix fits your risk tolerance

Every investor should have exposure to:

• good Canadian equities with sound fundamentals
• high-quality bonds and fixed income investments, and
• developed foreign stock markets for diversity

These three core holdings should account for 70 or 80 per cent of your portfolio, and maybe more. How you divide your money among them will depend on your tolerance for risk and need for returns.

This brings us to another lesson that is driven home each time the market tumbles. There are, within reason, no bad investment mixes - just investors who can't live with them. In setting your target percentages, decide what mix you can live with when markets become volatile. Looking at just the upside may cause you to take potential risks that will keep you awake at night.

3. Don't be overconfident

Regardless of what we read in the newspaper, investing is an uncertain enterprise. Yet many investors are regularly able to shed all self-doubt and make outrageously bold investment bets. Some examples are:

• Buy more oil, since it's going to $100, and the war on terrorism is only going to cause higher demand for already limited oil supplies!
• Buy more Canadian resources, because China will increase their demand forever!
• Augment Indian and Chinese exposure because these countries are fiscally prudent and have the best accounting systems in the world!

In early 2000, investors bought technology stocks and ended up as Wall and Bay Street road kill. A few years later, the stock market appeared to be a loser's game. Then share prices came roaring back. By 2005, folks were adamant you couldn't go wrong with real estate in the United States, and even today we hear that real estate in Canada is a no-lose proposition.

Today, many condo flippers in the U.S. are suffering the consequences, and REITs have taken it on the chin. The markets are trying to tell us something here - and it isn't to chase performance.

The lesson to be learnt is that not only do we need to think about risk as well as reward, but also that we shouldn't be nearly so confident in our predictive powers based on past results.

Conclusion

When investments are hot, it seems as if there is no limit to the possible gains. Yet as trees do not grow to the sky, economic fundamentals always win out in the end. In the short run, the broad market's share-price gains may outpace the economy's growth rate. But unless investors are willing to pay higher and higher price/earnings multiples for stocks, it cannot last forever. Home prices can climb faster than household incomes, but this can't be sustained in the long run.

True long-term investors-represented by icons such as Warren Buffett, ignore short-term fluctuations, confident that what goes down will come back up.

Volatility can represent opportunity rather than risk, as this type of security tends to provide higher returns than more placid ones. We recommend this approach in dealing with volatility. In the long run, it can be your friend, not your enemy.

Learn these lessons well, because if you don't you'll be taught them over and over again.