Straight Talk Investing

Because the hidden MER charges in equity mutual funds are often over 2.5% per year, a number of well meaning journalists and bloggers have begun to promote the advantages of lower-cost equity ETFs.  Exchange Traded Funds (ETFs) are a newish cousin to mutual funds, and many (but not all) are “index” funds, in which the manager simply picks all of the stocks in one of the several published “indices” (or baskets of “similar” stocks, grouped according to a chosen characteristic such as: country, market capitalization, industry, etc). A well-used Canadian benchmark is the TSX Composite Index, which represents the whole TSX, and is widely considered to be an appropriate benchmark for the whole Cdn stock market.  Such “passive” or index funds are recommended by the bloggers, instead of “actively managed” mutual funds (and some ETFs), in which the fund manager “actively” attempts to select “good” stocks for the fund, because most index-ETFs have much lower MER charges than most active mutual funds – in one case as low as .17%.

The “lazy,” “sleepy” and “couch-potato” index-only-portfolio advocates all choose a handful of index ETFs or Index Mutual Funds to hold “forever”. (This is the basis for their names). The most widely followed Sleepy Portfolio is that promoted by the popular personal finance blogger known as The “Canadian Capitalist”, Ram Balakrishnam. He publishes his present list of investments, and updates their performance regularly, on his popular “Canadian Capitalist” blog, thereby enabling his followers to be identically or similarly invested.

Canadian Capitalist and like-minded blog advocates correctly point out that most most mutual fund managers do not consistently beat an “appropriately” chosen “benchmark”, or index. But the misguided conclusion they draw is as follows: “if most professional mangers of mutual funds can’t beat an index consistently, any non-professional retail investor also has a low probability of doing so”; and the theory goes, “the best we non-pros can hope for is to mimic an index, get mediocre results, and forget vainly trying to beat our chosen index”.

The index-only-zealots call this the “science of numbers”. The theory only has merit if one compares couch-potato performance to select Mutual Funds, which will have poor performance because of the hidden 2% MER charge which kills their performance. The couch potato theory breaks down in comparison to any dividend portfolio or any good ETF picker who can successfully pick good ETFs based on momentum. (See the next chapter). The potato theory “worked” to some extent in the 1990s; but to my mind, it is overly dogmatic, as practiced by most of the index-only advocates, — whom I believe are unnecessarily limiting their arsenal, for the reasons set forth in the last and next Chapter. They are stuck in the glory years of the 1990s, when the baby boomers were creating demand for, and price increases in equities, and driving up almost all stocks; it takes a rising tide like the 90s to lift all boats on an index, but the index-zealots refuse to believe that the go-go 90s, and the glory years are probably behind us.

The proof is that these couch-potato portfolios have achieved a zero rate of return on the equity part of their portfolios for over a decade; but they are undeterred in spreading their gospel of index-only investing to anyone who will listen on the blogoshphere and in Moneysense magazine.

Another problem with the potato-heads is that they refuse to clearly differentiate between equities and Income investments, so as to allow a novice older investor (or with a different risk-tolerance) to easily modify their portfolios from the ones chosen by these 20 and 30-somethings, who are the biggest couch potato advocates; these youngsters simply don’t advocate enough safe income investments for those in their 50s, 60s or 70s.

Moreover, the potato-heads tend to skimp on Canadian stocks because the great advocate of Index Investing, Vanguard’s index fund salesman Jack Bogle, who wrote the Potato Bible, was American.  Plus, Vanguard only sold mutual funds, and the Potato Bible therefore ignores: MICs and high-yield stocks, dividend achievers, preferred shares, covered call ETFs, and real estate. For the potato gospellers, these investments must be ignored in their zealous devotion to Potato worship.

That said, the big advantage of the Canadian Capitalist and other “couch-potato” portfolios is that they are free to copycat. These portfolios are typically updated and re-balanced every 3 months, with an investor selling a portion of those funds that have increased in value, and buying more of those that have fallen, to get back into balance. (This should take no more than an hour or two, 4 times a year).

Nezt week’s post considers a better strategy.

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Equity Investors should read the sub Chapters in Ch 5, and choose at least one equity investment strategy.

Until the mid 2000s most equity strategies focussed on achieving double digit yearly gains which were easy in the go-go 1990s. Then, 20 – 30% annual returns were common. The glory years were fuelled by the great demographic bulge of baby boomers creating much demand for equities by shovelling money into their pensions, 401ks and RRSPs, thereby bidding up equity prices  –   which seemed destined to rise in leaps and bounds forever.  

But sadly, the boomers are now starting to retire, and to spend their pensions, and to get more conservative (investing in Income investments), which creates less demand for equities, and tends to drive down prices.

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 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 general, or specific company stocks or funds in particular. 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”.

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 the best strategy is to be “fully invested” (in equities at all times), and to be diversified between countries, industries and types of equities.

The best equity investing strategy isn’t: sexy; isn’t swinging wildly for home-runs (and thereby likeky to strike out); and contains 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.

Investing in equities means:

buying the stocks of publicly-traded corporations;

either directly,

or indirectly, through mutual funds or exchange-traded-funds (ETFs).

The historical rate of returns from equities is over 10% per year, which is far superior to “income-generating” investments such as GICs,

bonds, and MICs, 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 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; excessive debt in Europe and the US could well trigger losses in the short-term.

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, as the great demographic bulge of baby boomers begins to withdraw their savings from the markets to fund their retirements, — and to convert their assets from riskier equities, to lower risk fixed income assets — thereby lessening the demand for, and the price of equities.

Or, maybe not. 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 — (very little) — most of the “better” economic “experts” (including yours truly) 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.

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);

with a lot of short-term bumps in between.

This bumpy ride in equities will result in losses over some calendar years. To be an equity investor, one must accept the risk of losses some calendar years in the expectation of historical double digit 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 4.6 Income Trusts and their replacements — High yielding dividend shares, formerly Income Trusts .

Income trusts are company-like business structures, and are also 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 will now treat trusts like corporations, and most trusts have now, or will shortly convert to corporations. (Real Estate Investment Trust or REITs are the one form of Trust that will remain popular). Income trusts that converted — but which still intend to pay high dividend income to their investors –  and REITs can still be good investments as an alternative to low-interest paying income investments.  But these have more risk of losses than corporate bonds and MICs and the trick is to invest in the “good” companies and trusts.  My StraightTalkInvesting.ca Newsletter recommends several high-yield stocks and REITs, as do many of the Talking Heads on BNN.

Chapter 4. 5     Mortgage Pools (MICs) .

Again, income-generating investments are best presented in a risk/reward hierarchy or continuum. 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), –  can be healthy, because diversification is a good goal in investing, providing protection against any dropped nests not scrambling one’s whole set of nest-eggs.

At about the same point 0n the risk/reward continuum as corporate bonds,   –  (but less risky than high-yield bonds) —  are investors in mortgage pools (MICs).   If you are comfortable with the same risk level as corporate bonds, some long-established and diversified MICs should form at least one-half of the income part of your nest-egg. Well chosen MICs can be expected to pay 6 – 10%  per year, and are typically less risky than most equity and many corporate bond portfolios. In a MIC, your money is pooled with thousands of other investors and lent to shopping center and apartment builders.

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. 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 pooled investments 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 5 – 7%. 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.

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 or 5 year term. Others are more liquid, but most have an early redemption penalty or que.

My StraightTalkInvesting.ca Newsletter always contains 3 recommendations for MICs, and ecommends that MICs comprise one-half of your income portfolio.

Note however, that with one notable exception, many 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 is also now one good  Mortgage pool that trades like a stock on the TSX.  This means that investors in it do not need to be “qualified/aacredited.”

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 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 one MIC that you can buy on the TSX, most MICs to be bought hrough an 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 4.4   Bonds (and Bond ETFs)

In “normal times” — (of interest rates between 4 and 10 percent) — if you want to optimize your income investments, (with medium risk of losses/mistakes) you will probably want some Bond investments together with, or optimally eventually replacing GICs. Government-issued Bonds typically pay a percentage point or two better than GICs, on a long-term basis, but with price fluctuations, and the risk of losses. But these are abnormal times with interest rates at once-in-a-generation-lows. Accordingly, I would wait until the Bank of Canada prime interest rate rises to at least 3% before buying any government bonds or Government Bond ETFs – (see below for the inverse relationship between interest rates and bond performance)..

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 should 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, but Government Bonds are completely safe from default, but still fluctuate oppsoite to interest rate changes.

Bonds can be bought through all discount brokerages. Prices of longer-term 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).

This is why I would not presently buy any new government bonds or ETFs until the Bank of Canada prime rate rises to at least 3%, from its 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, they should buy both a short-duration and a long-duration government Bond ETF, and a corporate bond ETF –  (Exchange Traded Funds are a cousin to Mutual Funds)  –   and 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. With one exception set out below, 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. 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 you should get into a bond ETF portfolio,  only after the Bank of Canada rate is at least 3%, and even then do so:

s-l-o-w-l-y,

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 until you slowly build up your bond ETF portfolio.

This is especially important in times of low interest rates, because when rates rise, bond prices fall, — (see above for how much).  That said, after you have your bond ladder in place, you should be able to leave it alone for a very, very long time.

Over the long term your bond portfolio should pay an average rate of return of something like 5 – 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.

My StraightTalkInvesting.ca Newsletter contains recommendations for when and which bond ETFs to buy and sell, including the tricky selection of corporate bonds and high-yield corporate bonds.

Again, if you are intimidated by the nuances of bond investing, and the possibility of losses and mistakes, GICs are a safe alternative which will pay a percentage point or two less over time. Also remember again to build your bond portfolio, slowly, over a 5 year period, and to avoid government  bonds altogether until our prime rate rises to at least 4%.

Chapter 4.3  Hierarchy of Income investing risk and reward; GICs, Government-issued Bonds, (including ETFs),  Mortgage Pools, Corporate Bonds,  High-Yield Shares, and Preferred Shares

There is no increased potential reward in the investment world, without an increased accompanying risk. The Income seeking investments listed in the Chapter Heading are best considered on a risk/reward continuum starting with the least risky and rewarding category, and ending with the most risky and rewarding.

GICs historically have paid 2-5%, and 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. However, government bonds can be expected to pay a percentage point or two higher than GICs on a long term basis, (historically 6-8%) but carry a bit more risk, and prices (and losses) vary inversely with interest rates – see below. MICs (Mortgage Pools) have paid considerably better, (8-12%) but carry more risk yet, 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 risk as MICs. Prefereed Shares and high yielding stocks like Real Estate Investment Trusts are technically not pure income investments and carry the most risk and potential reward.

Chapter 4.1  Fixed Income Investing General Principles

When thinking about fixed income investments, you should think about buying and holding your investments for several years.  FI investing is “buy and hold” investing exemplified.

Whatever investments you pick, please do not be fooled into buying any:

   Bond mutual funds,

   Balanced Mutual Funds,

   Wrap accounts,
   
   Segregated 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, but they pay a poor rate of return to anyone who does not live to at least age 90. (See Appendix 6.3).

Chapter 4.2;  GIC Investing, The Super Simple Fixed Income System

If you are an investor who likes to keep things real simple, FI investing can be as simple as asking your discount broker (or GIC broker) to:

   invest you in equal amounts of the best available (highest-interest-rate) 1 year, 3 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 long term expected rate of returns from GIC’s is about 2-5%, slightly lower than bonds (by about 2 %), but to many investors who like to keep things simple, (and mistake-free), this is perfectly acceptable, and better than suffering with “balanced” or bond funds with their high, hidden, performance-killing fees.

GIC rates vary widely, so you should ask your discount broker to quote you the best rates. (You can probably get an extra quarter point in your returns by using a dedicated deposit broker such as GICbroker.com, especially if you have more than $50,000 to invest).

Also, 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”).

If you are “keeping-it-simple” as a GIC-only investor, you can perhaps skip or skim almost all of the information in this Chapter on other FI products, but I encourage you to read on, in order to achieve better success. 

FI alternatives are best considered in a continuum (or hierarchy) of risk/reward, starting from least risky GICs.  Next along the risk continuum are Bonds, followed by Mortgage Pools.

Chapter 3.1;  Determine your own unique Risk Tolerance, and make it the driver of your asset allocation/mix, between riskier and less risky investments.

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 Fixed Income;

Equities, (which have more risk of losses)?

The “problem” with taking no risks (of losses) with your investments, is that loss-risk-free investments all pay minimal interest, which may not (or just barely) keep up with future anticipated inflation. Only the uber-wealthy can afford to earn a rate of return less than (or just above) inflation, and still meet their future-inflated-dollar-needs, many years down the road of life. (For example, a car that today costs $40,000 will likely cost $80,000 in 20 or 25 years; and earning a low return will then not buy a replacement vehicle). This is called “inflation-risk”. The best way to illustrate this is to spend a round or two on retirementadvisor.ca, with “inputs” of  “expected rates of return” equal-to, or just higher than “inflation.” (See Appendix 1.1).

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 the 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 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 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 this attractive asset class, except for Appendix 1.7. We will accordingly differentiate primarily between fixed income investing, and equity investing, as we go forward.

Equities, considered from high-overhead, tend to move in price-cycles between:

longer growth period swings (up or bull markets);

and short and sharp unexpected busts (corrections, or bear markets).

Because: (1) 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); and, (2) because most forms of portfolio insurance are too expensive and time-consuming for the average Canadian with a job or life — 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.

Accordingly, most investors should only invest a portion of their nest egg into equities and equity funds. A big chunk of most Canadians’ nest eggs should be invested in fixed income products such as:

GICs,

Bonds or Bond ETFs,

and Mortgage Pools (MICs).

Why? Although most sensible investors believe that equities will generally rise in value for the foreseeable future, we could be wrong. (See Ch 5.1).

Accordingly, 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; — some with low risk, and lower potential reward. 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 mostly in Fixed Income products, because a large stock market melt-down on the eve of, or just into retirement can be particularly devastating to a retirement projection. 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 fixed income, — 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. 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.

Many financial planners boldly state that:

“the equities’ percentage of your portfolio should be 100 minus your age,

and conversely, that “the fixed income 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) — 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 1987 and 2008.

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 1.1and/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 3% 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 or better, you need a good proportion of equities, with the risk that accompanies it.

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, the 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 are comfortable during those cycles, to go with that asset mix between equities and Fixed Income, while tending more towards FI as you age. If in doubt where to start your search for the level of risk right for you, use the “age-rule” noted above. After some trial and error, I came to use it myself.

Because Fixed Income investments should be a feature of almost everyone’s nest-egg, the next full Chapter (4) deals extensively with FI. The Chapter after that deals with equity investing strategies, and independent support systems available to self-directed equity investors. But the next sub-chapter (3.2) deals with tax implications for those that have both registered and unregistered assets. If this applies to you please read it and analyze your own portfolio carefully.
Otherwise, you can conveniently ignore it.