October, 2008
The Second Opinion: Turbulent Markets

FIVE ACTIONS CANADIAN INVESTORS SHOULD TAKE IN RESPONSE TO THE U.S. FINANCIAL CRISIS

Press Release Sept 18, 2008

Warren MacKenzie, President of Second Opinion Investor Services Inc (“Second Opinion”) warns investors that this is no time for inaction. “Many investors are acting like a deer in the headlights,” states MacKenzie, “afraid to sell because their investments might bounce back, but afraid to buy in case the market drops further.”

In response to what Alan Greenspan calls ‘the worst economic crisis of the century’, Second Opinion today released “Five Positive Actions to Take during Negative Market Conditions’.

Mr. MacKenzie advises; “Rather than ignore the pain and uncertainty in a bear market investors need to use the opportunity to position their portfolio for the future.”

Five positive steps investors can take include:

  1. Review current holdings and determine how losses have changed the percentage in each asset class
  2. Re-evaluate sector exposure and your financial plan in view of a less certain future
  3. Rebalance the portfolio to reflect the desired long term asset mix (buy low and sell high)
  4. Harvest tax losses to recover capital gains tax previously paid
  5. Look across the valley and remember that bear markets eventually end and the best opportunities will be found by those who have the courage to invest.

“Investors should be aware that almost all financial advisors are now saying the same thing; “Do nothing, don’t sell when the market is down. Hold on because everything will be all right in the long term.” MacKenzie disagrees – because as a minimum this down turn is an excellent opportunity to rebalance the portfolio.

MacKenzie continues. “Investors have a problem getting good information. Even in normal times when investors ask their advisor if they’re in a good portfolio the advisor will always say “yes it’s an excellent portfolio”, but if they ask another advisor the same question the answer will almost certainly be that it’s a poorly designed portfolio and should be moved to the new advisor where it will be managed properly.

MacKenzie explains; “Because we do not sell investments Second Opinion is one of the few places where investors can get independent, unbiased advice on the investment process - advice that is free from conflict of interest”.

About Second Opinion Investor Services Incorporated

Second Opinion is a national financial services corporation that provides unbiased, expert, independent advice on the investing process. Second Opinion does not sell investments and can therefore offer advice that is free from any conflict of interest. Second Opinion’s advisors work solely for their clients, and unlike transaction oriented advisors, they are compensated for advice, not trades.

For more information contact:
Media Contact: Warren MacKenzie
416 640 0550
wmackenzie@secondopinions.ca

More details of the five positive steps:

1. Review your current holdings - Most investors don’t know what to do because they have not analyzed what they own today. Now is the time to review current holdings, the current asset mix, and see the impact the downturn has had on sector concentration. Investors need to accept some risk but also need to understand which risks they are taking – and are they taking more risk than necessary? Are the fees and commissions they pay justified by the value they receive?

2. Reevaluate your investment and financial plan – Looking to the future, should your investment plan change? Should you change your asset mix, investment strategy, how your funds are managed, or your advisors? If markets take a long time to recover will it impact your long term financial security? In market weakness investors close to retirement should update their financial plan and consider delaying their retirement date by a few years. Those just retired should reconsider their expense budget.

3. Rebalance – Rebalance your portfolio to reflect your long term asset mix. The current weakness in stocks means that your portfolio might contain less equity and more fixed income and cash than your long term asset mix requires. Rebalancing is a buy low sell high strategy that in the long run should mean improved performance for your overall portfolio.

4. Tax Loss Harvesting - Most investor in taxable accounts will have unrealized capital losses. When triggered, these losses can create tax credits that can be applied against capital gains earned in the last three years. Triggering these losses can turn a loss into an asset. For those who want to remain invested they can use the proceeds to buy an asset that is very similar. As an example, if you owned one large financial services company you could sell what you own and buy another company in the same sector.

5. Look across the valley - Bear markets eventually end and some of the best buying opportunities are found near the end of bear markets – for those with the money and those looking for them.

Recognize that you can make money in a bear market

by Warren MacKenzie

Why this is important: Investors who think that everyone loses in a bear market may lose more capital than necessary because they become more accepting of losses.

Some investors believe that when the market goes down, everyone loses money. In fact, when skilled investment managers believe that the market is going to go lower, they can position themselves to make as much money (if they are right and the market does go lower) as they can make when they position themselves for a rising market and the market obliges by going higher.

The key is to understand the difference between being “long” the market and being “short” the market. Being long a stock is simply another way of saying you own a stock. Being short a stock means that you borrowed a stock and then sold it and now you have the obligation to return the stock when you are asked to do so.

As an example of a short sale, imagine that when Nortel was trading at $100 per share you believed it was due to go lower and you called up your financial advisor and told him to make a short sale of 100 shares of Nortel. Your financial advisor arranged this sale by having his firm lend you 100 shares of Nortel which you then sold at the market price of $100 per share. The proceeds from this sale were $10,000 and this money was deposited to your account. At some point you know you will have to purchase 100 shares of Nortel on the open market so that you can return the 100 shares to the brokerage firm. If you repurchased the shares when they were trading at $10 per share, then you would have made a profit, before trading costs, of $9,000.

There are significant risks to selling short because after you borrow the shares and sell them, the shares may go up in value rather than down in value as you expect. In the above example, if the price of Nortel shares went up to $150 after you sold them at $100, then when you have to buy on the open market to replace the shares you would suffer a loss of $5,000, plus your trading costs.

While selling short is a risky proposition for the average investor, in the hands of an experienced money manager, it is an effective tool to reduce losses in a bear market. With short selling, your potential for loss is almost unlimited, whereas with a “long” position, you cannot lose more than 100% of your investment.

One of the most significant differences between hedge funds and mutual funds is that hedge funds are permitted to sell short while mutual funds are not. Since mutual fund managers are not permitted to use this risk-reducing tool, some industry experts describe mutual fund managers as working with one hand tied behind their back.

True diversification means holding different asset classes selected so that the gains on one type of security can be expected to offset the losses on other asset classes. In a bear market there is no better way to minimize the loss to the portfolio as a whole than to have asset classes that have some short exposure to the market. The profit of these short positions may go a long way toward offsetting the losses on the long positions.

Bottom line: Selling short is a very risky strategy for investors to undertake on their own. However, owning a professionally managed investment that has some short exposure can reduce losses in bear market.

What you can do now: Ask your financial advisor about investment products, such as hedge funds, that have some short exposure to the market.

Rebalancing: A How To Guide

Rebalancing is the process of buying and selling investments in order to bring your current asset allocation in line with your target asset allocation and to lock in profits by “buying low and selling high”.

Since the goal of rebalancing is to restore the target asset allocation and lock in profits, it is important to note that the target asset allocation is the most important investment decision. It is responsible for 80-90% of all portfolio return variation.

There are two ways to rebalance. The first one is periodic. An example would be to rebalance the portfolio once every year. The second process is based on asset weights. For example, you may decide to rebalance your portfolio when a certain asset class deviates from its target weight by 5%. Let’s say that your target weight for stocks is 50% and currently your portfolio is 56% stocks; it would be time to rebalance your portfolio.

To understand how rebalancing works, let’s take a simplified view by assuming that there are only two asset classes; stocks and bonds. Let’s also assume that your portfolio has a value of $100,000 and has a target asset allocation of 50% stocks and 50% bonds. The make-up of the portfolio is:

Asset Class Market Value Weight
Stocks $50,000 50%
Bonds $50,000 50%

Let’s assume that, over the past year, stocks have fallen 20%, meanwhile, bonds have risen 5%. The portfolio’s holdings and weighting scheme follows:

Asset Class Market Value Weight
Stocks $40,000 43%
Bonds $52,500 57%

Notice that the two asset classes have deviated from their target weight by more than 5%. This is the signal that rebalancing is necessary. In order to rebalance this portfolio, the following transactions should be made:

Asset Class What it is: What it should be (based on a 50/50 target asset mix): Transaction
Stocks $40,000 $46,250 Buy $6,250 of stocks
Bonds $52,500 $46,250 Sell $6,250 of bonds

Therefore, in order to restore the asset mix you should buy $6,250 worth of stocks and sell $6,250 worth of bonds. Which specific stocks to buy and which specific bonds to sell is not as important as restoring the target mix. Nevertheless, some consideration should be given to maintaining a balanced geographic and sector allocation.

This example displays the simple reason why rebalancing is such prudent advice: by rebalancing, you are effectively always buying the underperforming asset and selling the outperforming asset. In other words, you are always buying low and selling high.

Second Opinion has always been an advocate of periodic rebalancing, and we have always suggested that rebalancing should occur at least annually. We still strongly believe this; however the reason for rebalancing now is that, given the market volatility, your portfolio is probably off of its target weighting by large enough amounts to warrant rebalancing immediately rather that at your next annual review.