Desperately seeking safety

Kelly Rodgers, MoneySense February 2001

As people become more and more nervous about the outlook for the stock market, many of us have begun to change our priorities. We used to focus on how to make money. Now, damage control is the name of the game and we're working hard to hold on to what we've got.

This growing caution is entirely understandable. Many researchers in the field of behavioral finance have concluded that we feel the pain of losses much more keenly than we feel the joy of gains. You would need cast-iron nerves to have sailed through the dramatic ups and downs of the last six months without feeling a bit seasick.

If you're one of the many investors desperately seeking a safe port in this storm, where do you look? Let's start by examining what not to do.

The most extreme solution is to simply pull out of the market altogether and wait things out with a big stash of cash locked safely away in a money-market mutual fund or a bank account. After all, when markets are falling, cash is king.

This all-cash option is certainly a safe haven, but I don't recommend it. It amounts to extreme market timing, and you will lose out on the eventual recovery of the stock market if you don't reinvest in time. Think of all the people who were waiting for a correction when the Dow Jones industrial average was sitting around 4,000 points. Some of them are still waiting 6,500 points later.

A slightly better option is indexlinked guaranteed investment certificates. These GICs, offered by the chartered banks, have returns that are pegged to a stock market index such as the TSE 300. Your capital is guaranteed, so you don't have to worry about losing money. However, you also don't get the benefits of a soaring market. The bank that issues the GIC may take as much as 20% to 30% of the upside return. What's more, these specialized GICs can be difficult to find when markets are volatile, since the banks don't want to lose money any more than you do.

Another option is a guaranteed mutual fund, offered by companies such as Trimark. An insurance company guarantees your principal over a set period of time, so if your fund has lost money after a specified number of years, you will be reimbursed for that loss. This is not a great idea, in my opinion. The cost of the guarantee is high in terms of the management expense ratios that are charged, typically 3% to 4%. Even worse, the guarantees against loss are far off in the future - a minimum of five years and more commonly 10 years. History indicates that the stock market is unlikely to lose money over such a long period. If you're searching for a hedge against short-term volatility, the guarantees offered by these funds aren't worth much and you're paying through the nose for them.

So what's my ideal method for dealing with volatility? Simple: balanced mutual funds. These funds hold stocks, bonds and cash. When stock markets are falling, the bond component generally performs well. This gives the funds a much less volatile performance. For example, in November, when the S&P 500 lost 7%, the TSE 300 fell 8.4% and Nasdaq plummeted a heartbreaking 22.2%, the average balanced fund suffered only a 2.3% loss.

The typical balanced fund holds 50% to 60% of its assets in stocks. If you want even less exposure to stocks, you can choose a balanced fund that holds only 30% to 50% of its assets in equities. You can find funds of this type listed in the Canadian high-income balanced fund category in your newspaper or on Web sites such as www.globefund.com. The average loss for this group in November was a mere 0.2%.

Keep in mind that neither type of balanced funds will shoot the lights out when the market rebounds. And be wary of the many balanced funds that charge high fees. These fees cut into your returns and dissipate most of the advantages of choosing a balanced fund in the first place. When you go shopping, look for balanced funds that charge a management expense ratio of 1.5% or less.

Two of my favorite balanced funds are the Mawer Canadian Balanced RSP Fund (offered by Mawer Investment Management) and the PH&N Balanced Fund (offered by Phillips, Hager & North Investment Management). Both are well-managed funds with MERs that are under 1%. I could sleep well at night with either of these funds, no matter what the markets do.