Hey there [FIRST NAME GOES HERE].
Much like we do every year, we felt it would be good to go over some notable events and potential lessons learned of 2022. In fact, we had so much to say about 2022 that we needed to split our year in review into two parts. This will be part 1, with part 2 to follow Friday.
Despite one of the most aggressive bear markets we’ve witnessed since the Financial Crisis, we continued to have hundreds of members pour into Premium in 2022, and we are going to close the year out with over 1.3 million Canadians visiting our website.
Investing is still alive and well, and it is clear on our end that there are still plenty of people looking to take advantage of this bear market instead of running away.
Is 2022 a year to forget? For the first time since we launched Stocktrades Premium, we entered a prolonged bear market. There was a small bear market in the latter half of 2018 when we initially launched, but nothing compares to the length of the current bear market, which began in earnest around March of this past year.
While it can be difficult to stomach such a bear market, let’s not dub 2022 a year to forget but rather a year of learning.
What did we learn? Quite a few things; let’s highlight two of the major ones.
Risk Tolerance
It may seem like we talk ad nauseam about investing within one’s own risk tolerance. There is a reason for that – everyone is different. Like everyone handles stress differently, each of us has varying levels of risk tolerance.
If you’ve had a financial advisor, you’ve likely answered a series of questions that identify your risk level, or you may have completed your own risk tolerance test online. These tests and questions are completed so that whoever is investing your money knows what strategies to use when doing so.
We’ve always said there is no better way to gauge one’s risk tolerance than through experience. You can answer as many questions or fill out as many forms as you’d like, but in our opinion, you only truly get to know your level of tolerance when the bear comes roaring, and you have real money on the line. And roar it did. If you started investing after the COVID crash of 2020, this is realistically your first taste of any sort of adversity and volatility in the markets.
Unfortunately, some investors get scared and run for the hills. In fact, we’ve had several members that have left the platform because the stock market isn’t for them, or they’ve sold everything and will come back when things stabilize. To each their own, of course, and we won’t hold it against them.
But unfortunately, unless they are doing so because they need the capital, they’ve let fear and emotions take hold. As we know, emotions are the single biggest reason why retail investors underperform.
Fear leads to short-term thinking and knee-jerk reactions in a bear market and causes “fear of missing out” (FOMO) in a bull market. This creates the buy high, sell low cycle that many investors fall victim to.
For everyone else still here (and we’re proud to say that the vast majority of you are), use this opportunity to truly understand your risk tolerance. If your portfolio is down 30% on the year and you are losing sleep, you likely overinvested in growth stocks or small caps.
Learn from this, and adjust your portfolio accordingly so that you are better equipped to handle the next bear market, whenever that may be.
It was easy to overlook the short term risks of the stock market during the pandemic and “chase returns” as they call it. This worked out fine for those who were able to lock in those returns and rebalance. However, this requires a high degree of luck on the timing end.
The more likely scenario is many investors got caught owning some stocks that are going through some significant drawdowns. Which, leads us to our next point.
Allocations
We get many questions about how much a single stock should make up your portfolio or how many stocks one should have. There is no perfect answer here.
However, the recent bear market and huge impacts on the Technology and REIT sectors, along with growth and small-cap stocks, has likely led many of you to come to your own conclusions. Good or bad, you might be looking back and saying to yourself, “ouch – I shouldn’t have over-invested in XYZ.”
While there is no hard and fast rule, there are some generalities that we’ve shared with you over the years. Lets go over them.
Portfolio size
Research has shown that the benefits of diversification top out at around 25 stocks. Anything more than that, and there is minimal effect on reducing the unsystematic risk associated with diversification.
There are two types of risks – unsystematic and systematic. Systematic refers to broad, macro-economic events that cannot be controlled. You can’t diversify to lower systematic risk because it impacts the entire market.
Investors have been absolutely blasted with systematic risk in 2022.
Inflation, rising interest rates, war, and natural disasters are some of the top examples of systematic risk. We’ve witnessed every one of them this year, in large quantities.
This is exactly why unless you were very heavy in energy stocks, your portfolio has likely taken a hit in 2022. These types of risks tend to impact the market as a whole.
Some will say that this was avoidable, as rising interest rates were inevitable and you could have prevented some losses.
However, we would counter with the fact that the Bank of Canada and the Federal Reserve stated numerous times they did not expect any sort of material increase in interest rates until 2023, at minimum. This misled a lot of investors in both the stock market and real estate.
Unsystematic risk on the other hand is narrower in scope and only affects individual companies, industries, or sectors. When you diversify your portfolio, you do so to reduce unsystematic risk.
Some examples of unsystematic risk would be regulatory changes, shifts or missteps by company management, a change in company structure due to rising interest rates, or a prolonged period of poor results.
One of the more notable events related to unsystematic risk in 2022 here in Canada was Algonquin Power and Utilities. Some company missteps and impacts due to rising rates caused its share price to fall significantly, much more than you’d expect out of a regulated utility.
But unlike systematic risk which we cannot avoid, we can reduce our risk of this impacting our portfolio by diversifying and owning more stocks overall.
With that in mind, a well-balanced portfolio between 20-30 stocks is a good target for reducing unsystematic risk. This is not to say you can’t have more, but for the sole purpose of reducing risk, the benefits are minor beyond that.
Individual stock allocation
Over the years, both Mat and I have shared our own strategies with members. When it comes to the core holdings of our portfolios (think our Foundational Stocks), we tend to stick to 4-5% allocations.
It is easy to conclude from this that the vast majority of our portfolios are made up of core, blue-chip holdings. I (Dan) hold 15 of the 21 Foundational Stocks, most with allocations in the 4-5% range. If they drift from this over the course of the year, I tend to rebalance on an annual basis.
We take a very different approach to high-growth or small-cap stocks. While both of us have different risk tolerances, neither of us take large positions in these stocks. No high-growth or small-cap stock will typically make up more than 0-2% of our portfolios.
There are rare instances where I (Dan) have allocated larger amounts to small-cap companies I have higher conviction in, like Equitable Bank (EQB) or Park Lawn Corporation (PLC). But for the most part, I tend to stick to this rule.
One angle that Mat and I differ on is that Mat tends to take profits much earlier to keep allocations in check. In contrast, I will let them run on for longer, typically rebalancing on an annual basis.
Being overexposed to a small-cap or high-growth stock is likely a lesson many investors learned over this past year. The crash has been swift, prolonged, and, quite frankly, brutal. If you held double-digit allocations in some of these stocks, you are likely underperforming the markets.
Does that mean one should never invest in growth or small cap stocks? Absolutely not. In fact, they outperformed defensive, dividend, and value stocks for almost a decade. It is simply their time to give some back in this risk-off environment.
It is not time to make rash decisions. If the companies in this bucket are still performing well operationally and the thesis is in tact, there is no need to sell (unless, of course, one needs the cash).
Patience will be key here as they can move to the upside quickly, and one can miss out by sitting on the sidelines. If you are holding some of these positions that are down quite significantly but are doing just fine operationally, sometimes the best course of action is no action.
Small caps and growth stocks are not the only companies we need to keep an eye on allocation wise
There are some strong companies out there that have taken a beating over the past year. One perfect example of this is Algonquin Power (AQN). Who would have guessed that one of the best dividend growth stocks in the country, a historically stable utility, would be among the worst-performing stocks on the index?
If you scanned the various investment services across Canada, you’d find that AQN was featured within most of them. Why? It had been one of the best dividend growth stocks in the country with a strong history of execution.
So what went wrong? It all started with the impacts of the Texas storm back in 2021, from which the company never fully recovered in terms of stock price. Then it announced the Kentucky Power acquisition, which was not an issue. In fact, it was supposed to be accretive to earnings.
Unfortunately, the company did not anticipate the quick rise in rates or the multiple delays in closing. Looking back, one could criticize management for taking on billions in floating debt and not fully anticipating the risks associated with such a strategy.
However, let’s not fool ourselves – at the beginning of 2021, few if any of us could have predicted what has transpired. In fact, as mentioned earlier the Bank of Canada and Federal Reserve led many to believe that rates were not moving upwards anytime soon. Fast forward to the end of 2022, and we have witnessed the fastest increase in policy rates in history.
The lesson is that one must still be mindful of single allocations for all stocks. No company is immune to poor decision-making or one-time adverse events that may impact operations for years to come.
Maintaining your portfolio in terms of allocations is quite possibly the easiest, most routine investment task, but is one that is largely ignored.
Having a good foundation
Finally, we want to highlight the importance of having a solid foundation. We have noticed that until this year, our Foundational Stocks have largely gone unnoticed.
Relatively little feedback, interaction, or questions on these stocks. Most all the hype has been around growth stocks. And we get it – as mentioned, growth stocks have outperformed materially over the past decade.
However, all it takes is a good bear market to remind us why the bulk of our (Mat and I’s) portfolio are in the Foundational Stocks. While they may not be “sexy,” our Foundational Stocks have crushed the market over the course of this prolonged downturn.
In fact, they’ve been one of the best performing baskets of stocks in North America every year we’ve released them.
Unfortunately, a lot of investors focused too much on growth and needed to focus more on their core holdings. As I mentioned earlier, getting caught chasing returns a bit. If this is the case, then they are likely underperforming.
It’s OK – don’t give up
If you fell victim to underperformance this year – don’t beat yourself up about it. Many of the greatest investors of all time have bad years.
From Buffet to Lynch and everyone in between, no one is immune to periods of underperformance. Prem Watsa, often referred to as Canada’s Warren Buffett, went through years of underperformance – his Fairfax Financial (FFH.TO) struggled as a result.
Pundits were calling him finished but guess what happened? He rebounded and did so in a big way. In fact, FFH is up 35% this year, and while it is still trailing the TSX over a five-year period, it has nearly erased all of its underperformance in a single year.
So what separates a good investor vs a bad one? It is learning from one’s own experiences – both the good and the bad.
If we give up when times are tough, then we aren’t likely to be better prepared the next time the markets take a turn. We’ll be stuck in the vicious cycle of jumping into the stock markets in a bull market and selling out in a bear market. You know, the buy high and sell low strategy. This isn’t a means to build wealth.
As stock prices fall, they ultimately become more attractive
Although it is painful over the short-term, falling stock prices ultimately means solid companies are becoming cheaper to own, and cheaper to average into if we already hold positions.
If we are in the accumulation phase of our investing careers, we should ultimately be welcoming a prolonged bear market.
What to expect in Part 2
As mentioned, we planned for our year in review to be a single e-mail. However, there was simply too much to talk about and we had to break it up.
In Part 2, we’ll summarize the overall performance of the Foundational Stocks on both the Canadian and US end, along with an in-depth review of some of the best/worst performers on the Bull Lists.
