This chapter was updated on Dec 3, 2016.
Chapter 3.1; Determine your own unique Risk Tolerance, and make it the driver of your asset allocation/mix, between riskier equites, and less risky income-generating investments such as GICS/Term Deposits
The fundamental question to ask oneself before considering any particular investment product or strategy is, “How Much of My Family’s Nest Egg should be invested in each of:
less risky assets such as Interest and Income earning investments like Guaranteed Investment Certificates/Term Deposits; and
Equities, (which have more risk of losses)?
The “problem” with taking no risks (of losses) with your investments, is that risk-free investments all pay low returns, which just barely keep up with inflation. Only the uber-wealthy can afford to earn a rate of return just above inflation, and still build a nest-egg to last untill old age.
The bottom-line is that most of us cannot simply invest only in ultra-safe investments such as Guaranteed Investment Certificates (GICs, sometimes also called “term-deposits”). How much, or little risk you can tolerate, and still achieve your retirement goals, is the subject of the next few sub-Chapters.
Sadly, I know of no way of as achieving above-average investment rates of return without taking on some risk that your investments could fall in value from time-to-time, and perhaps forever. Anyone who talks of “superior returns without risk” is either a liar or a fool. To achieve high single-digit, or double-digit returns, investors typically need to invest in real estate, or equities – either directly, – (by buying the stocks of companies listed on stock exchanges), — or indirectly, through mutual funds, or optimally Exchange-traded funds (ETFs), — (through which the investor indirectly invest in many stocks with a pool of several other investors).
Most Canadians do not have the temperament for investing in revenue real estate; and accordingly, the remainder of this manual ignores real estate, except for Appendix 1.7. This manual will accordingly differentiate primarily between income-seeking investing, and equity investing, as we go forward.
Equities have for the past 30 years performed better than income generating investments like bonds and GICs, but the ride is bumpy, and too gut-wrenching for many. Considered from a 10 -20 year perspective, equities tend to move in price-cycles between:
longer growth period swings (up or bull markets) in which most days and weeks are up;
and short and sharp unexpected busts (corrections, or bear markets).
Because there is, sadly, no “Stock-Market-Forecaster’s-Hall-of-Fame” – (or even a set of reliable tools for accurately forecasting large scale equity market drops) – most investors will only be able to sleep at night if they do not have all of their assets invested in equities or equity funds. Moreover, the historical superiority of equities may not repeat. Although most sensible investors believe that equities will generally rise in value for the foreseeable future, as they have for most of the last 30 years, we could be wrong about the future. (See Ch 5.1).
Accordingly, most investors should only invest a portion of their nest egg into equities and equity funds. The remainder of most Canadians’ nest eggs should be invested in “fixed income” (income-generating) products such as:
Bonds or Bond ETFs, but only after the Bank of Can prime interest rate rise to at least 3%,
Mortgage Pools (MICs),
and also “hybrid” investments that are part equity and part income such as high-yield bonds (but only after the Bank of Can prime interest rate rises to 3%+), Real Estate Investment Trusts, and perhaps preferred shares which pay an interest-like component (but only after interest-rates rise to 3%+).
Prudence requires that most of us should be diversified between different types of investments; — some with the risk of a drop, but larger possible gains (equities); — and some with low risk, and lower potential reward (GICs). Only young investors (40 or youger), or investors comfortable with a lot of risk should have an asset mix which is primarily invested in equities. This is true even for investors following the proven strategies set forth in the Equity Strategies Chapter 5. Most older investors will want to be more conservative, and invest significantly in Income-generating investment products, because a large stock market melt-down on the eve of, or just into retirement can be particularly devastating to your retirement. Here is an example – if we have a stock market catastrophe and most stock markets plunge by 30%, but you have only half of your assets in the stock market, – and half in income-generators, — your loss is a “manageable” 15%. It hurts, but it is probably not life changing like a 30% loss. A 30% loss on the eve of, or just into retirement is particularly devastating, because you will run out of time to recover from your losses. Such losses are rare but do happen, as they did in the fall of 2008, and Oct 1987. Moreover, the stock market may not react in the future the way it has over the last 35 years, and could turn bad for a long time. So, you, like me, should have some fixed income investments, so that not all of your nest-eggs are in one basket of equities that could drop and become completely scrambled. Younger investors can usually be more aggressive in their asset mix than older investors, because they will have more time to recover from any really bad equity meltdowns.
I can’t tell you what percentage of your assets should be in higher risk/reward equities; nor can a financial planner or advisor. They can coach you, but you need to come to this conclusion yourself.
A good rule of theumb is that:
“the equities’ percentage of your total nest-egg should be 100 minus your age,
and conversely, that the income-generating percentage should be your age”.
I like and use that “age rule” for me, but it is just a rough “rule of thumb” for you to consider. The answer for you — (your “risk/reward tolerance/risk profile”) — is as individual as your shoe size. The important factors to consider are whether you can sleep at night with your investment mix, and whether you could recover from a worst case scenario with equities – i.e. a sudden 30% drop like many investors suffered in October 1987 and autumn 2008. Also, although the probability is low, stock markets could turn bad for a very long time. (Nobody has a good crystal ball).
Another main consideration is the extent to which you need your investments to grow in order to fund your retirement needs. For help with this, readers should consult Ch 1.1 and/or Appendix 1.1 (Retirementadvisor.ca), and give themselves an hour to work with various rates of return, and various levels of post retirement spending needs. If your projection is that 2-3% Guaranteed Investment Certificates (GICs) will be sufficient to fund a good retirement without running out of savings, you could devote only a small percentage of your nest egg to equities, — (perhaps zero) – and assume almost no risk of losses. If you need 6% returns, you need a good proportion of equities, with the risk that accompanies them.
The risk tolerance/asset mix appropriate for you will only be “finalized” after some trial and error, and should become more conservative as you advance in age. This is more about your comfort level, and ability to sleep, after and during significant equity market melt-downs, than it is about doing what others your age are doing.
Most folks over-estimate their tolerance for risk during bull (up) equity markets. Conversely, their pendulum tends to swing too-far-back in over-reaction during bear (down) periods. The best advice is to gauge your feelings during neutral and slightly negative equity phases, and if you can sleep well during those cycles, to go with that asset mix between equities and Income investments, while tending more towards Income Investments as you age.
Because Income-generating investments should be a feature of almost everyone’s nest-egg, the next full Chapter (4) deals extensively with them.
Chapter 4.1 Income-Generating Investments; General Principles
When thinking about income-generating (“Fixed-Income”) investments, you should think about holding your investments for several years. Whatever investments you pick, please do not be fooled into buying any:
Bond mutual funds,
Bond ETFs untill interest rates rise to at least 3%+, (and even 0nly buy corporate bond ETFs, or perhaps just stick with GICs )
Balanced Mutual Funds,
Equity-linked Notes, or Principal Protected Notes, all of which contain high, hidden, performance-killing fees. (See Ch 2.2 above).
Annuities with bells and whistles that offer “upside potential”, or “re-sets” (GWMBs). (That said, for unsophisticated investors, plain-old vanilla annuities can form all or a part of a fixed income portfolio, especially for persons over 70, but they tend to pay a poor rate of return to anyone who does not live to at least age 90, and you will leave nothing to your heirs). (See Appendix 6.4).
Chapter 4.2; GIC Investing, The Super Simple Income-Generating Investing System
If you are an investor who likes to keep things real simple, with no risk of losses, Income investing can be as simple as asking your discount broker to:
invest you in equal amounts of the “best available” (highest-interest-rate) 1 year, 2 year, 3 year, 4 year, and 5 year GICs (Guaranteed Investment Certificates, sometimes also called “term-deposits”):
then as these GICs mature, simply keep reinvesting in the best available 5 year GICs.
GICs are the least risky investment available, and are the easiest to buy and monitor. These investments are almost mistake proof. The main “downside” is that you are locked into this investment until the term expires — which for pre-retirees is not usually a concern.
The long term expected rate of returns from GIC’s varies with prevailing interest rates, because the Bank or Credit Union with whom you invest pays you interest so as to to relend your money to their debtors and their mortgages. Typically, the longer the term, the better the rate. For the next decade rates will likely remain low at about 2-5%, but these rates will be higher than government bonds. In normal times, with rates of 3%+, GICs will pay slightly less than a good corporate bond portfolio. But with present super-low interest rates, no investor should buy bonds of any variety, untill the Bank of Canada prime rate rises to at least 3%+. (See below for how and why bonds lose value as rates rise). Interest rates might not rise for some time, but they cannot fall anymore, and the probability of rising rates is thereby too high to invest in bonds. Even after rates “normalize” from their crazy-low levels, for many many investors who like to keep things simple, (and mistake-free), investing in GICs only is perfectly acceptable, because GICs cannot lose value unless the issuer goes bankrupt, and your GICs from any one bank or trust co are guaranteed up to $100,000.00.
GIC rates vary widely, so you should ask your discount broker to quote you the best rates from various banks, trust cos and credit unions. Using your own bank or credit union will not get you the best rates. (Some “experts” say that you can probably get an extra tenth of a point in your returns by using a dedicated deposit broker such as GIC Wealth Management, especially if you have more than $50,000 to invest, but they forget that when your GICs mature, it takes a month or two to move your money to the credit union then paying the best rates, and this nullifies the “gains”). Accordingly, using your own discount broker’s good range of aggressive banks and trust companies is best.
But, remember to keep your GICs from any one financial institution below the $100,000.00 insured level. (That is, even though Credit Union “A” offers the best rate, you should also buy from Credit Union “B” if you would otherwise have more than $100,000 with “A”).
Untill the Bank of Canada prime interest rate rises to 3% or better, you can skip the remainder of the information in this Chapter on other Income-Generating investments, unless 2% GIC rates make you “reach for yield” into Mortgage Pools (Ch 4.5) and/or REITs and Dividend shares (Ch 4.6).
Income investing alternatives are best considered along a continuum of risk/reward, starting from least risky GICs. Next along the risk continuum are slightly more risky Government-issued Bonds (which almost always pay less than GICs, and should therefore be avoided), followed by slightly more risky corporate bonds. In normal interest-rate times of 3%+, high yield Bond ETFs, Preferred shares, and Mortgage Pools have about the same level of risk, compared to eachother, but are more risky than government and many corporate bonds. Again no bonds or pref-shares should even be considered until rates rise to 3%+.
Chapter 4.3 Income-generating investments (often called fixed income) – The risk and reward continuum; GICs, Government-issued Bonds, (including ETFs), Corporate Bond ETFs, Mortgage Pools, High-Yield Bonds, and Preferred Shares
There is no need to study anything about bonds in this chapter until the Bank of Canada prime rate rises to at least 3%+. Until then, and perhaps forever, investors should stay with GICs, perhaps MICs, and perhaps reach for yield into dividend paying equities for the Income-generating part of their nest-egg.
Again, there is no increased potential reward in the investment world, without an increased accompanying risk of a loss. The Income seeking investments listed in the Chapter Heading are best considered on a risk/reward continuum starting with the least risky and potentially rewarding category, and ending with the most risky and potentially rewarding, (but the last 3, or perhaps 4 categories have about the same level of risk depending upon the quality of payor).
GICs are the least risky investment available, and are the easiest to monitor and maintain, in the sense that you do not need to build a portfolio slowly. (See Ch 4.2 above). GICs provide the closest thing to mistake-free investing, and pay better than government bonds. After rates rise to 3%plus, corporate bonds might be expected to pay a titch higher than GICs on a long term basis, (historically 4-8%) but carry a bit more risk, and prices (and losses) vary inversely with interest rates – see below. MICs (Mortgage Pools) have paid considerably better, (4-12%) but carry more risk than GICs, though typically not as much as equities. Corporate Bonds (issued by corporations have differing levels of risk depending on the issuer, but carry about the same less risk as MICs. Preferred Shares and high-yield bond ETFs carry about the same risk and potential reward as MICs and corporate bonds. Preferred Shares (“Prefs”) are not technically pure income-generating investments, but most investors think of them as such, as does this manual.
Chapter 4.4 Bonds (and Bond ETFs); Government; Corporate; and High-Yield
Invesors can skip this Chapter untill the Bank of Canada prime interest rate rises to at least 3%.
Thereafter, in “normal times” — (of interest rates between 5 and 10 percent) — if you want to optimize your income investments, (with medium risk of losses/mistakes) you will probably want some corporate Bond investments. Government-issued Bonds typically pay less than GICs, on a long-term basis, but with price fluctuations, and the risk of losses if interest rates rise, and price increases if interest rates fall. I do not recommend government bonds, because GICs pay better, without the risk of losses due to probable interest rate increases. In “normal” interest-rate times (3%+) I do recommend corporate bonds along with GICs. I also recommend a few select MICs to compliment GICs, even in these low-rate times.
Again. regarding corporate bonds, in these abnormal times with interest rates at once-in-a-generation-lows, I would wait until interest rates rise to at least 3% before buying any corporate bonds or Bond ETFs – (see below for the inverse relationship between interest rates and bond performance). Therefore most investors can skip the discussion of bonds until interest rates “normalize” and stick with GICs and perhaps MICs to compliment their equities. They might also “reach for yield” into REITs and dividend payors as set out in Ch 4.6, but with the increased risk of losses.
Most government issued and top quality corporate Bonds are sold in denominations of $5,000 or $10,000. (Canada Savings Bonds are sold in low denominations, but pay a poor rate of return and should be avoided). Bond prices fluctuate up and down, inversely with/opposite to, interest rates; (see below).
Therefore, to prudently invest in Bonds directly, an investor will buy several bonds with staggered maturity dates:
– i.e. some mature in one year,
some in two years,
some in five, ten, etc.
This is called a bond “ladder”.
Buying corporate bonds – (promises to re-pay by corporations) — carries some risk of default, (which is minimized by buying an ETF fund of the bonds of many different corporations). Like government bonds they fluctuate opposite to interest rate changes. High Yield bonds pay high interest, and depending upon the financial strength of the payor, carry more risk. Some high-yielders are so risky that experts call them “junk-bonds”.
Bonds can be bought through all discount brokerages. Prices of longer-term corporate and Government Bonds, (maturing in 5-10 or more years), fluctuate significantly, and inversely with/opposite to interest rates; (as interest rates go up, Bond prices go down, and vice versa). Short term Bond prices fluctuate less with interest rates than Long term bonds. A rough rule of thumb is that short-term bonds can fall in value by 3% for every 1% rise in interest rates; long term bonds can fall in value by 8% for every 1% rise in prevailing interest rates. (A more precise rule of thumb is to analyze the duration of “years to maturity” of your bonds (or your bond funds); and to take the duration in years, and multiply that by the rise in interest rates; for eg. a bond with a duration of 10 years will fall 10% for every 1% spike in prevailing rates. A 5 yr duration = 5% loss, for every 1% rate spike, etc). Gains result from falling interest rates in the same ratio.
This is why I would not buy any new bonds or ETFs until interest rates rise to at least 3%, from their present lowest-in-a-generation level.
Moreover, the price fluctuations in bonds means that most middle-class investors will not have a sufficient portfolio to buy a properly diversified ladder or basket of individual bonds directly. Therefore, after interest rates “normalize“, they could buy a corporate bond ETF – (Exchange Traded Funds are a cousin to Mutual Funds) – but they should do so s-l-o-w-l-y, over a time period of 5 years – (see below). Bond ETFs are much better than Bond Mutual Funds. Nobody but advisor/sellers recommend that you buy Bond Mutual Funds, because they carry a hidden Management Expense (MER) of up to 2% per year, which kills the returns. Bond ETFs are better, and have much lower MERs. ETFs are a cousin to mutual funds, in which the fund manager does not try to buy “good” bonds, but merely mimics one of the various Indices (a basket of bonds), and therefore the hidden MER is lessened. You can buy ETFs through your discount brokerage account. However, the relative ease of buying Bond ETFs does not mean that you should rush out and take a big position in Bond ETFs (or even a bond ladder) all at once, even after interest rates rise to 3%+. You need to always remember that Bonds and Bond ETFs fluctuate in value as interest rates fluctuate, — (especially long-term bonds; see above) — and therefore if you invest in a corp bond ETF you must do so:
in roughly equal incremental installments over period of 5 years,
leaving the balance of your money earmarked for bonds in GICs, or in a money market fund or high interest savings account until you slowly build up your corporate bond ETF portfolio. Building slowly is important, because when rates rise, bond prices fall, — (see above for how much). That said, after you have yourcorporate bond ETF ladder in place, you should be able to leave it alone for a very, very long time.
Over the long term (and after rates rise to 3%+) your corp bond portfolio should pay an average rate of return of something like 4 – 8%, but it will fluctuate over the short term. You also need to know that you pay commissions on ETFs of about 5 cents per share, when you buy and sell (unless you have $100,000 or more in a discount brokerage, and qualify for $5 – $9.99 trading commissions; See Ch 2.1 for a list of good discount brokers). But if you hold your ETFs for a long period of time, (as you should), your commission costs will be more than off-set by the MERs saved, in comparison to Bond Mutual Funds.
In normal interest rate times, my StraightTalkInvesting.ca Newsletter contains clear recommendations for when and which corporate and high yield corporate bond ETFs to buy and sell.
Again, if you are intimidated by the nuances of corporate bond investing, and the possibility of losses and mistakes, GICs are a good alternative which should pay better than government bonds over time. Also, remember again to avoid bond ETFS altogether until interest rates rise to at least 3%.
Chapter 4. 5 Mortgage Pools (MICs) .
This chapter is only of interest to investors prepared for some risk of loss. Again, income-generating investments are best presented in a risk/reward hierarchy or continuum. MICs can lose money; GICs from any one issuer under $100,000.00 cannot. Income investing (and even equity investing) can be considered as similar to eating from a salad bar at a restaurant. Choosing a few, or several different types of investments, — (even some with higher risk/higher potential reward), – can be healthy, because diversification is a good goal in investing, providing protection against any dropped eggs not scrambling one’s whole set of nest-eggs.
At about the same point on the risk/reward continuum as corporate bonds, are investors in well-chosen mortgage pools (MICs). If you are comfortable with this risk level, one or two few long-established and diversified MICs should form at least part of the income-generating part of your nest-egg. Well chosen MICs can be expected to pay 4 – 8% per year, (which can fall initially with increases in interest rates) and are typically less risky than most equity portfolios. In a MIC, your money is pooled with thousands of other investors and lent to shopping center and apartment builders. MICs do not typically losebig money when interest rates rise because they pass on rate increases to their borrowers.
MICs are not recommended by banks or financial advisors because they pay them no commissions; but most investors should own one or more good MICs.
My family and I are significant MIC investors, because the expected yield in the good ones is much better than most bond portfolios and GICS. My opinion is also that reputable “first” MICs (but not “second” MICs) carry less risk than many or most corporate bond portfolios. But success depends upon picking established MICs which carry all or predominantly first mortgages, and which are well diversified among many borrowers and in many regions. You need to know that MICs also come in different priority classes, and that this is critical to your risk. “First mortgage Pools” have less risk than “Second” and “Blended” Pools. I typically only invest in, and recommend pools of first mortgages (“Firsts”), because in a worst-case/foreclosure scenario, most or all of my first mortgage money is likely to be recovered, in complete priority to Second mortgage holders, who get a higher rate of interest for the huge risk involved. Sometimes the names of a particular MIC corporation’s various pools have confusing names, and you need to satisfy yourself that you are getting a true pool of first mortgages, and the lower risk that comes with it. Further still, not all MIC issuers are created equal. The best First Mortgage MICs have historically paid rates of return of about 8-12%. Lately, with low interest rates they have paid 3 – 8%. Seconds and Blends have paid better, but are very risky. First MICs from reputable Companies with many mortgages in their pools are reasonably safe, but higher-risk MICs are also available from start-ups, and less reputable companies offering higher rates which are risky.
When considering a MIC, the reputation of the MIC corporation, and it’s track record and asset level are paramount to lowering your risk. The financial pages feature ads for MICs, and a google search of Mortgage Investment Corps will yield many investment corps, but please do a lot of due diligence before investing. Most importantly, ensure that the fund has at least 100 million dollars, and has been around for at least 10 years. Please also review year by year performance # s, — not just a 10 year average, which can hide some bad years.
Diversification is also important with MICs in that some lend primarily to residential owners, and builders. Others lend primarily to bigger commercial projects. Lastly, know that some of the reputable MICs require that your money stays with them for a 1, 3 or 5 year term. Others are more liquid, but most have an early redemption penalty or que.
My StraightTalkInvesting.ca Newsletter typically contains recommendations for MICs.
Note however, that with a couple of notable exceptions, most MICs are available only to “accredited investors”. In Ontario you must be wealthy; in most other provinces, semi-wealthy. The rules between the provinces differ, and continually change. In Alberta, (similar to most other provinces) an investor’s family assets typically need to be disclosed by the investor as exceeding $400,000, — (or self-disclosed annual income of $75,000, or $125,000 with a spouse). Ontario’s qualification rule is self-proclaimed assets of $1million, or $200,000 in income – or $300,000 with a spouse. These rules change continually, and the MIC companies are always well-versed on the differing provincial rules, and will be happy to discuss them you over the telephone, and to try to help you “squeeze” into them. There are also now a couple of Mortgage pools that trade like a stock on the TSX.. This means that investors in them do not need to be “qualified/accredited.” My newsletter sometimes recommends one or two of these.
Please do not confuse MICs with Mortgage Mutual Funds, which you can buy through your deep discount broker, banker or fund-seller, and which are horrible investments. The problem with Mortgage Mutual Funds is that they have a very high hidden management expense ratio, (MER) of about 2% which results in low returns.
Please note also that many of the MIC companies have two main types of mortgage investments. One type is MIC mortgage “Pools”, which invest in dozens or hundreds of mortgages and thereby spread risk (which I sometimes recommend). The other type is high risk “Syndicated Mortgages” — in which the investors invest in only one project. These “syndicated” mortgages are considerably more risky, because all of your money depends on the viability of one project. Therefore, I never recommend these.
With the exception of the few good MICs that you can buy on the TSX, most MICs to be bought in a RRSP or RRIF require a lot of paperwork at the start of your long term investment. (You will need to transfer part of your plan to a non traditional trustee, such as Olympia Trust, (who are reputable) and pay $125.00 or so in yearly administration fees. But the MIC companies want your business and will assist in the paperwork).
Chapter 4.6; Reaching for Yield into Income Trusts and their replacements — REITs (Real Estate Investment Trusts) and Dividend Paying Equities such as Bank stocks
Income trusts are corporation-like business structures, and are a hybrid between equities and income generating investments. They were, prior to 2007, often held by seasoned-life-veterans, for a significant part of their nest-egg, as an extraordinaryly high-yielding substitute for Bonds and GICs.
But, sadly, “wealth-without-risk” was “too-good-to-last” forever. The income trust world changed suddenly in October 2006, with taxation changes that make trusts less attractive than before. These tax changes now treat trusts like corporations, and most trusts have now converted to corporations with one exception. (Real Estate Investment Trust or REITs are the one form of Trust that have remained in tact). Income trusts that converted into corporations — but which still intend to pay high dividend income to their investors – and REITs can still be good investments as a partial alternative to low-interest paying income investments, and as a reasonably safe part of one’s equity portfolio. Depending upon the financial strength of the REIT or dividend driven corporation, these generally have more risk of losses than corporate bonds (in normal interest rate environments\but not right now because they can fall when rates rise) and MICs; and the trick is to invest in the “good” companies and trusts.
With present low interest rates making GIC rates low, and the unattractiveness of bonds, which will lose value as rates rise, many income investors have been lately buying REITs and dividend paying equities, such as bank stocks, utilities, and telecoms, as a full or partial replacement for GICs and bonds. See Ch 5.3 for a full discussion of Dividend payors. The usual list of good dividend-payors pay a dividend of 4-6%, as long as they remain profitable. This is called “reaching for yield” because REITs and dividend payors both have more risk than most income-generating investments, (except for bonds when rates rise). REITs also lose money when rates rise; most other dividend payors do not lose as much if anything.
REITs and dividend payors aren’t even technically Income investments. They are lower risk equities which have an income (dividend) component; and equities are usually riskier than income-generating investments, and their prices fluctuate up and down – often between 10 – 30% per year. Right now, dividend payors are probably less risky than bonds, but they are much more risky than GICs. But these are unusual times, with GICs paying only 2%, calling for unusual methods. If investors take this alternate route, they need to choose only the safest of dividend stocks and REITs. See Ch 5.3. My newsletter recommends dividend payors and sometimes REITs.
Chapter 4.7 Preferred Shares Outside of RRSPs and RRIFs.
Investors should skip this Chapter untill the Bank of Canada prime rate rises to at least 3%, and only to invest in them outside of registered (RRSP, RRIF, RESP) accounts. Prefs vary in price with interest rates, similiar to bonds, and should be avoided altogether untill interest rates hit 3% plus, because they fall in value when interest rates rise.
Even then, this Chapter 4.7 will only apply to you if your RRSPs, RESPs, TFSAs are all maxxed out, and your mortgage is at zero. (prefs) are:
not technically Income-Generating investments;
a special class of equities that behave more like bonds,
are usually considered as “hybrids” between Income investments and equities.
These are poorly understood investments, and suitable only for “sophisticated” investors. If your RRSP/RESP/TFSAs are not maxxed out, and/or you still have a mortgage, please ignore this Chapter 4.7. Remember that for tax reasons, investors with non registered assets generally want to concentrate their income investments inside their registered accounts. (See Ch 3.2). However preferred shares qualify for the dividend tax credit, and are therefore typically held by investors outside of their registered accounts. If your registered accounts are full, and you have the time and expertise to take on the tricky regime of Preferred-share investing, read on.
“Prefs” are not Income-generating investments in a technical sense, — (although they are often considered to be more Income-like than equities in many ways). Investment grade “Prefs” are preferred shares issued by top Blue Chip corporations, and if they are issued by a Canadian company, the investor gets the benefit of the dividend tax credit if the shares are held outside of an RRSP, TFSA, or RRIF. Prefs pay an expected yield which is typically paid unless the company gets into real financial trouble. The dividend paid is worth about 1.4 times the amount paid to the investor on an after tax basis, because of the Dividend Tax Credit which you complete on your income tax return. The exact benefit depends upon your province and tax bracket. You only get the Dividend Tax Credit for prefs of Canadian corporations.
Pref share prices fluctuate, based primarily on interest rates, to which they move in inverse fashion, like bonds, but choosing individual pref shares is tricky business because there is also risk of default. Those prefs issued by Canadian Banks often pay about 5-6% per year before considering the dividend tax credit, which bumps the effective return up to over 8%. Prefs are generally considered to be more risky than government bonds, but about on par with Corporate bonds and MICs, depending on the financial strength of the payor corporation. As with bonds, you need to build up a portfolio slowly, over a few years, and only after interest rates hit at least 4%.
Then, serious investors with large unregistered portfolios should subscribe to a newsletter, by James Hymas, which is devoted solely to identifying good preferred shares. That publication is entitled “Prefletter.com.” Lesser investors, or Do-It-Yourself investors could then invest in an ETF called I-shares S & P/TSX Canadian Pref- ETF (symbol TSX-CPD) which mimics the performance of a large basket of pref and high dividend producing shares, mostly of Cdn Banks and Financial companies. Even after interest rates normalize, don’t rush into a pref position all at once; with the share price fluctuations you should build it slowly, over a 2 or 3 year period.
Chapter 5.1; Equity investing in general.
Investing in equities means:
buying the stocks (shares) of publicly-traded corporations;
or indirectly, through mutual funds or preferably exchange-traded-funds (ETFs).
The historical rate of returns from equities is over 8% per year, which has been far superior to “income-generating” investments such as GICs, bonds, and probably superior to real estate investing in most markets.
But foretelling the long-term future is a dangerous game, even based on history, and there is no such thing as trying to achieve superior returns without some risk that reasonable investors will be dead-wrong in our prophecy that equity markets will continue to be favorable, most of the time, for the foreseeable future. There is always the small possibility that equities will become unfavorable investments for a long time, as they have been in Japan for over two decades. A flu pandemic, hyper-inflation, great depression, terrorist event, or other unforeseen event could turn our economic world and equity returns upside down. I don’t see any such catastrophe on the horizon, but there is a low probability that past success with equities could end, abruptly, without any warning.
Moreover, over the next few years (and to an ever-increasing extent) equities can probably be expected to be less-and-less-of-a-great-investment for two reasons. As the great demographic bulge of baby boomers in the western world retire, our economies are not fully replacing the retiring workers with new youngsters from the baby bust generation, with the result that our economies are not growing as rapidly as they did from 1980 until 2009, and this makes it hard for our companies to grow their profits. If they can’t grow their profits as easily as in the past, it is hard for their share prices to gain as easily as in the past because share prices rise and fall with profits and dividends paid to the shareholders. Worse yet, as the great demographic bulge of baby boomers begins to withdraw their savings from the equity markets to fund their retirements, — and to convert their assets from riskier equities, to lower risk fixed income assets — they thereby lessen the demand for, and the price of equities. (That is, as the demand for equities falls, so do the prices of most equities tend to fall, or not rise at a minimum). Most economists call a less profitable equity future the “new normal” for equities, and sadly, I agree that we are not likely to see as many 10% plus yearly returns as we have in the past.
Or, maybe we will. Nobody knows for sure. The other side of the “what will happen in the future” coin is that we might enjoy wonderful double digit gains forever. No-one knows, and those that pretend that they do are either liars or fools, — or they use enough vague “weasel-words” that they can never be proved wrong. For what it is worth, most sensible forecasters believe that equities should comprise a significant part of most investors’ portfolios, because the solid returns historically achieved from equities may well continue; moreover Income Investments are paying poorly right now with low interest rates, which tends to keep demand for equities higher.
Equities, viewed from the “big-picture” perspective tend to move in cycles between:
growth (bull) periods of a few or more years;
and short and sharp unexpected busts (known as corrections or bear markets such as 2008, 2001, 1987, and 1929);
with a lot of short-term bumps in between.
This bumpy ride in equities will result in losses over some calendar years, with the small probability of forever. To be an equity investor, one must accept the risk of losses some calendar years in the expectation of historically better gains most future years.
As indicated in Ch. 3.1, Equities should not comprise 100% of most investors’ nest-eggs, especially those in or near retirement. That said, most of us will continue to be equity investors with that portion of our nest-eggs which we find comfortable, and within our unique risk-tolerance level.
But can we successfully be part-time equity investors, only investing in Bull markets, and sitting out the Bears? The answer is “No.” That is the topic of the next sub-chapter.
Chapter 5.2; The Futile Tempation to “Time the Market” by trying to only invest when the prognosis is “favourable”; and to “get-out” when it is not.
No reasonable expert believes that they, or anyone else, has a good enough set of tools or crystal ball to both:
consistently “time” the big, stock market turn-arounds to get “in” on them;
and, to also consistently “get out” of the market in anticipated future down cycles.
The probability of success is so small because, to get this right, an investor’s predictions need to be exactly right, not once but twice in each and every market cycle. It is not enough to jump out at exactly the right time; the timing of the jump back in must also be exactly right. Sadly, we don’t have a bell that clearly announces future turn-arounds. I have looked hard for 3 decades to find either a good forecasting guru, or a tool-box to build my own turn-around-in-the-big-picture-forecasting machine, and have come up empty.
Sadly, there is no “market forecaster’s hall of fame”. Most so-called “expert” economists and market analysts have worse batting averages than “extra-long-range” weather forecasters. And worse yet, there are more market experts and supposedly ”perfect” prediction tests than weather forecasters.
Some pundits claim great success in their “market calls” based upon past ultra-vague prognostications capable of many meanings, such as, “with certain caveats the outlook for ABC Company is generally favorable”.
I also have disappointing news for anyone hoping to read the financial pages, Investor’s Digest, the Blogosphere, or BNN for much useful wisdom on the future of stock markets in general. (Although you might get some good stock specific tips). If you read enough, or listen to enough “experts”, you will find several completely contrary forecasts, sometimes on the same page, or within the same hour of TV. The most that reasonable “experts” can say with a straight-face is something like, “the market is likely poised for a turn-around, sometime in the not too distant future” – (which could be a year or longer), based on the prices of shares measured in relation to their historical earnings – their price/earnings (p/e) ratio”. They can also say that the market typically falls 70% of the time in Sept/October, and that most of the really big crashes tend to happen in the fall. (See Chapter 5.5).
For me, attempting the dangerous game of market timing, based on what I have read, would have kept me out of the market almost all of the time, over the past 20 years, based upon all of the eye-catching bad-news-headlines and gloomy “expert” “fear-casts”, which are always prominent in the media.
Other magicians, — (some of whom want to sell technical charts, or seminars on how to read charts,) — like to point only to their “greatest hits” of past accurate calls, or individual company stock picks that went through the roof, without also disclosing their dog-predictions. Technical analysts often claim that they can read charts of stock prices and read patterns that reliably tell the future. As hard as I try, I can’t “identify” the break-out patterns, even with the benefit of hind-sight. I believe that investing is part art, and part science; but to me, technical analysis, — (and the glossy ads for expensive seminars to teach you the secrets), — are more voodoo, than either art or science.
Some investors and analysts try to practise a less objectionable form of Market-timing by “lightening up” on equities when the market appears “overbought” based on yardsticks like P/E ratios, which are thought to be useful prognostication tools. In theory, this sounds sensible enough. But none of these gurus publish their batting averages, and conflicting opinions are easy to find; wisdom is not. The result is that I believe, (as do most experts), that the best strategy is to be “fully invested” (in equities at all times (except perhaps Sept/Oct) for that part of your nest-egg that is suitable for your age and ability to sleep); and to be diversified in your equities between countries, industries and types of equities.
The best equity investing strategies are not sexy; they don’t swinging wildly for home-runs (and thereby likely to strike out too often); and they contain enough rules to ensure discipline.
This discipline is needed to prevent investors from the common mistakes of:
(1) panicking when markets drop and selling their equities, and then too-long waiting in vain until a “consensus of pundits” pronounces the outlook as better;
(2) too long hanging-on to their losers because of the emotional attachment they have in hoping to eventually being vindicated;
(3) willy/nilly buying a grab-bag of products, from time to time, that don’t fit into a well-thought-out-plan for risk reduction through diversification.
It is now time to study some useful equity investing strategies. See Part 3.