At least this pathetic blog is predictable. I write about an investment, asset class or strategy. Then a herd of nihilists thunders in to have a dump. No matter if it’s ETFs, marketable bonds, equities, preferreds, REITs or Lady Gaga futures, we’re treated to a chorus of gnashing and frothing from people who firmly believe what they don’t know.
If there were much doubt why most Canadians are financial basketcases, gaze and behold. In a world of danger and opportunity, it amazes me that people who gladly leverage 95% to buy an overinflated risk-drenched house, cringe and faint at the prospect of owning shares in the bank that financed it. What the hell are they thinking?
In any case, I’ve decided to change the nation, or at least the curmudgeonous farts who read this, with some hands-on advice. So here’s an excerpt from my recent book, Money Road, on how to put together the perfect portfolio. Suck it up. There’ll be a test later.
- Separate your residential real estate from your ‘investible’ assets.
A house is a place to live which costs money to buy, finance and operate – so it’s an ongoing net drain of wealth, not a generator of it. If the house rises in value and provides a capital gain after all the land transfer taxes, commissions, interest payments and maintenance costs, well great. Bonus. But houses can be incredibly illiquid in a lousy real estate market, might be sold at a substantial loss or even turn into a wealth trap as has happened to millions of US families who sank into negative equity. Do not make the mistake of believing houses equal constant and accessible sources of wealth, relieving you of the problem of having an investment portfolio.
- Have a portfolio with balance in it.
That means cash-type investments, as well as fixed income and equities. This will give you liquidity (the ability to turn assets into cash fast), as well as income and growth. There is nothing more crucial than asset allocation to achieve growth and protect what you’ve got.
- How much of each is critical to the overall return your money will earn.
*Keep the cash portion around 5%, so if you’re got $200,000 to invest right now, no more than $10,000 should be in money market mutual fund, or T-bills or a short-term bond. All of those things will give you some income, and can be converted into spendable money within 24 hours.
* Now deduct your age from 100 if you’re a guy, and from 110 if a woman. So, a 40-year old male will come up with 60 and a woman with 70.
* That is the percentage of growth assets, namely equity-based mutual funds or stocks, which should be in this plan. The rest should be invested in fixed-income securities, like investment-grade bonds or preferred, dividend-paying preferreds.
* For a 40-year-old woman (who likely has 50 years to live, 25 of them without employment income), we then get this balance:
o Cash 5%.
o Fixed income 35%
o Growth assets 65%
With a $200,000 portfolio, this means $10,000 in cash, $70,000 in government bonds and preferred shares and $120,000 in ETFs (preferably), equity mutual funds, stocks, segregated funds, commodities or sector funds.
- The fixed-income portion is best made up of the highest quality bonds.
For example, those issued by the Government of Canada, Alberta or Ontario, which have AAA ratings (despite their mounting debts) and a zero chance of default since they possess the power to tax. The best kind are medium-term (three to five years left to maturity), because you can always hang on to them and know exactly what they will pay you when they come to term, plus these bonds are less volatile than long-term ones. Every time interest rates change, the value of bonds also change (although the income they pay you remains constant), which means the longer a bond has before it matures the greater the chance a big hike in rates would reduce its value if you had to sell it before maturity.
- Adding some bank preferred shares to this fixed-income portion of the portfolio is almost always a great idea.
The dividend payments are higher than the yield on the bonds, and this money is taxed at a hugely lower rate, boosting the after-tax return even higher. Since our banks are large, stable and secure, this is a perfect place to look for both income and security.
So far, so good. That’s 40% of your money invested in assets which pay you an income stream and have less risk involved than driving on the 401.
- The growth component’s critical, since the object is to get the best possible return with the most acceptable level of risk.
As I explain in the book, there are mathematical ways to arrive at this, and sometimes theory does help in practical actions. This is why we need to consider the ‘beta’ of any stock or mutual fund – the way it moves relative to the market as a whole – plus the ‘standard deviation’ – which is the amount it varies over time and the volatility compared to similar kinds of assets. Likewise, we want assets in this part of the portfolio which are diversified from each other, giving us negative correlation (so some rise and some fall as the business cycle changes).
Two Nobel Prize winners, William Sharpe and Harry Markowitz, each had landmark ideas about putting a portfolio together. Markowitz believes every investor should go for the maximum return, while Sharpe thinks investors should never strive for any yield that is beyond their own tolerance for risk. And I`m with Sharpe.
The good part of this process is that the risk factor for investments (the ‘beta’) is well known, so what an advisor must do is match stocks, funds and other assets with the goals of the client, given where we are in the business and equity cycle and the obvious challenges ahead.
The result in this case is $120,000 in assets which include cyclical and defensive stocks with varying betas, some sector ETFs to take advantage of pending opportunities (say, with the price of gold or oil), blue chips (banks, utilities) plus proven growth companies (like some of the tech giants), and a small component of higher-risk and higher-return, like a bond bear fund going into a period of rising interest rates (like we now face).
- It all has to be done with tax avoidance in mind.
Obviously the less tax you pay on returns, the smaller the risk the overall there is to the portfolio. That’s why your advisor has to curtail the amount of interest income received, while boosting dividends and capital gains. It also means putting the appropriate amount of this portfolio inside an RRSP (typically that would be the bond component), while sheltering gains inside the relatively new TFSA (tax-free savings account – more on that soon).
So there you have an ideal portfolio. Or the bones of it.
You’ll notice there’s no ‘four easy, sure-thing index funds’ here. No time-sharing condos. No 100% gold or silver. Nothing exotic to blow up. No investments you can’t understand. Nothing that can’t be monitored, modified, changed or improved since these days every week brings a new development. Just a solid machine taking you steadily down the road. Wind in your hair, and at your back. Perfect.
