Here’s the key to constructing a portfolio for what comes next

When it comes to describing today’s murky economic outlook, forecasters have to resort to “un-“ words.

Unprecedented. Uncertain. Unclear. Or even “unknowable” as Bank of Canada Governor Stephen Poloz put it in a speech Monday.

It is all rather, um, unsettling. All the “uns” point to the same conclusion: Nobody has a clue about what lies ahead. That won’t change until we get a better sense of how the novel coronavirus will proceed from here. So what can an investor do to keep his or her peace of mind?

Start by taking a long-term perspective. Aswath Damodaran, a business professor at New York University, demonstrates one way to do this in his blog, Musings on Markets. He begins by assuming that earnings for S&P 500 companies will slide 30 per cent this year. Why 30 per cent? Because the biggest plunge in earnings in recent decades took place during the financial crisis, when corporate profits tumbled 40 per cent. If you assume the current downturn will be less prolonged than the 2009 swoon, because of the massive government support already being deployed, a 30-per-cent slide in profits this year seems like a reasonable base case.

The next question is how soon profits will rebound. Prof. Damodaran assumes they will recover 75 per cent of this year’s lost ground over the next five years – a number that assumes some lingering damage from the pandemic but also credits the economy with the capacity to adjust and grow once the initial shock is past. Using these estimates, as well as adjustments for factors such as cash flow and risk tolerance, he concludes the fair value of the S&P 500 right now is around 2,750.

To be sure, this is a rough estimate. Prof. Damodaran shows how adjusting your assumptions can move the estimate up or down. The key point: Most plausible assumptions yield fair values for the S&P 500 somewhere between 2,500 and 3,000.

This helps put things in perspective. With the S&P 500 now at 2,955, investors haven’t lost their minds. They are still in touch with reality. However, they are clearly taking an optimistic view of what lies ahead. Some caution may be in order. This does not mean retreating to a cave. It does mean making sure your plans can sustain a period of lacklustre returns.

Personal finance authority Morgan Housel suggests the most important task at a time such as this is to build a portfolio that can survive the widest possible range of outcomes. The next few years could bring inflation or deflation, rapid recovery or slow rebound, a powerful vaccine or a new wave of infection. Your goal should be to construct a portfolio that can soldier through whatever comes. We can debate exactly what this portfolio should look like, but some fundamentals are clear. It should be diversified across many countries and industries. It should hold both stocks and bonds. It should be cheap to own.

Will this portfolio produce staggering returns? Probably not. But it is likely to produce steady results and sidestep disaster. In today’s environment, that is a more than decent outcome. Investors can begin their search by looking at the all-in-one balanced portfolios from Vanguard Canada or BlackRock Inc.’s iShares unit. Both do an excellent job of providing you with one-stop diversification at a low price. Check out the Vanguard Balanced ETF Portfolio (VBAL-TSX) or the iShares Core Balanced ETF Portfolio (XBAL-TSX) to see what is on tap. Even if you conclude these products aren’t right for you, they can provide a good baseline for comparison with other approaches in these unclear, unsettled and unknowable times.

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