What investors should do when stock markets tank

Some Canadian investors are worried about their portfolio’s performance given recent market turmoil—turmoil that started earlier this month when China devalued the yuan and culminated this Monday morning when the S&P/TSX Composite temporarily dropped 700 points.

This sudden shock comes after almost seven years of equity bull markets—and it’s a reminder of how vulnerable our savings are particularly when swimming in the stock market without those trusted lifeboats known as diversification and balanced portfolios.

But now is not the time to panic. At least not according to any of the experts we spoke to. Instead, it’s a time to re-assess and, if you’re lucky enough to be sitting on some cash, re-invest.

Get some perspective

In the last 100 years, the stock market has dropped by 40% only two times: once in 1929 and once in 2008. “In general, we all suffer from 2008-syndrome,” says Ted Rechtschaffen, president of discretionary fund managers TriDelta Financial. “We fear the next great 40% decline and as a result we bail out too quickly.”

But year-to-date, the market has dropped less than 13% overall, which translates into more of a normal decline, says Rechtschaffen. Those with “intestinal fortitude” should stick it out and look for the good buys.

Macquarie analyst David Doyle agrees. “Despite recent volatility, we are in a classic mid-cycle correction. It’s a severe correction but that translates to a buying opportunity.”

And what a buying opportunity it is

Just because 90% of the S&P 500 Index fell in value over the last few days doesn’t mean that every single company on that index suddenly has a worse outlook than it did a week, or even a month, ago. “The dip is, in part, because investors are overly concerned with U.S. Fed rate hikes, with what’s going on in China, and a lack of confidence in the global economy,” says Doyle. “But things are actually better than what’s perceived in popular opinion.”

This is exactly why value-investor and MoneySense contributor, Norm Rothery, keeps a watch list. “There are no huge bargains at the moment,” but he’s literally watching, waiting and ready to buy.

If you see this as the start of a potential buying spree, consider keeping a watch list. Stick with companies and industries that interest you in the long term and start keeping an eye on them—remember: it’s better to buy them at post-sell-off low prices than at market-peak high prices. But to really get the good deals, you’ll need to go beyond individual stock prices. Look at the fundamentals, says Rothery, “Companies with solid balance sheets.” This means analyzing sales growth figures and price-earnings ratios, both of which help to measure how expensive a stock really is. Do this work now and, like Rothery, you’ll be ready to pounce on that good deal when it comes.

“Usually, if you buy in a market like this—where there’s been a drop—it proves to be a good thing over the next six months, and almost always a good thing after three years,” says Rechtschaffen.

What to avoid and where to buy

Could the same be said for commodity and resource stocks?

“If you’re a Canadian investor you’re already disproportionately exposed to the resource and banking sector,” says Doyle. As such, Doyle suggests doubling-down on U.S. equities (and to a smaller degree, on European equities).

“If you pursue foreign stocks, you’ll start to see more health-care and consumer discretionary options and this will help balance out that disproportionate exposure Canadian investors have to the financial and resource sector.”

Another benefit to investing in U.S. and European stocks is the opportunity to “sweeten the margins” as the Canadian dollar continues to decline. “Our domestic economy is going to stay weak for quite some time,” says Doyle. “So we think the Canadian dollar’s dip has further to go.”

Buying unhedged U.S. equities would not only enable gains from any prospective rebound in U.S. stocks but would provide added return from any currency boost should the Canadian dollar continue to slide against the greenback.

For those invested in balanced mutual funds or exchange-traded funds (ETFs) the message from our experts is clear: sit tight. “These sectors are a small component of your overall fund,” says Rothery. “Most people invested in a low-fee balanced fund hold about 20% of the TSX, and resources make up less than half of that,” explains Rothery. “So you’re potentially fretting about 5% to 10% of your portfolio. Everything else is doing OK.”

Still, if you find you have more than 10% of your portfolio in energy or banking stocks you may want to rebalance. Consider a tax-loss selling strategy. To maximize this strategy, you’ll need to sell stocks or mutual funds that are outside of tax-protected retirement accounts. Sell off your long-term losers and use the losses to offset gains and a portion of your ordinary income when it comes to tax time.

Evaluate yourself and your portfolio

While there were quite a number of news stories highlighting the recent market downturn, none of our experts were worried.

Rechtschaffen and his team at TriDelta took the recent market dip as an opportunity to communicate with their clients on the importance of a well-constructed portfolio that can weather these types of storms. “When the market is doing well, we become much more aggressive and then something like this happens,” says Rechtschaffen. “That’s when it’s important to assess your actual risk tolerance and see if your portfolio construction actually matches your risk tolerance.” If you can’t live with a 10% downturn then you have a bad investment plan for you.

For those self-directed investors with balanced portfolios, Rothery isn’t worried. “It’s not about how one portion of your portfolio is doing but how your overall portfolio is doing.” Fact is, he sees this type of downturn as an excellent testing ground. “If you have 20 to 30 stocks, you’re almost guaranteed several losers—and some could be big losers,” explains Rothery. “But you have to look at the overall results, not individual returns.”

Now, if you have a hard-time doing this then you might want to re-adjust how you invest. “By going with a broad-based ETF, or a low-fee balanced fund like Mawer, you only see the average results, not the individual returns,” says Rothery. “Then you can hide the market volatility from yourself while still benefitting from the upside of equity investments.”