Balancing income, growth in volatile market cycles

There are good reasons to work with a qualified investment advisor when the markets are so volatile.  The ups and downs of investments are not only time consuming, but also emotional draining.

It is essential to design a tax-efficient income portfolio to generate investment income, which helps with cash flow needs to work through market cycles.

GICs, term deposits, and bonds pay interest income.  Preferred shares pay dividend income.  Many common shares also pay dividend income.  Creating the right balance of investments that generate both growth and income comes down to risk tolerance.

Looking for investments that pay income – rather than just growth alone – is a successful approach.

Income is often a key component for the decision to invest.  If a $500,000 portfolio is generating $20,000 of interest and dividends, this provides a buffer, even if markets are flat or decline slightly in the short term.

Periods when investments are generating income and the markets are doing well reward patient investors.  When your portfolio has hit a new high, it is natural to mentally calculate this as part of your overall net worth.  This maximum value is known as the high-water mark.  But it is health to remember the dollar amount you started with initial to avoid th emotions when values drop from the highest market value.

If you have given an advisor a lump sum several years ago and have made no withdrawals or deposits, then keeping track of overall returns is straight forward.  It gets a little more complicated if you have deposited funds or withdrawn funds over the years.

Many people have purchased investments either to create long term growth (during working years) or for the income component they generate (during retirement).   The term “unrealized” refers to investments that you have purchased and you continue to own.  Investment statements often have a term unrealized gain or loss, which is the difference between what you originally paid for the investment and the current market value.

Until investments are sold they are not “realized”.  Positions that have been sold are removed from the statement, making recalling what you started with more difficult.

Investors who have investments that generate investment income should factor this into the total return for an investment.

Let’s assume a year ago you purchased $10,000 of a large company paying a five per cent dividend.  Today the position on your statement is showing a book value of $10,000, which represents your original cost.  The market value is showing $9,840 and the unrealized loss amount is $160.  However, this $160 amount is not the total return on an investment.

During the year, you received $500 in dividend income from this investment which does not change the original cost or the current market value.  The total return (before tax) on this investment is really $340, not an unrealized loss of $160.

The above example is quite simple because we have used an investor who has held an investment for exactly one year and the dividend was constant for the period.  What happens if you have held an investment for many years?  What happens if the dividend rate has changed or you have set up the dividend reinvestment plan (DRIP)?  Some people have kept track of the total income paid to them for each investment on an annual basis.  This will assist investors in calculating the true return on an investment during the total holding period before tax.

The next challenging part to the above is that some investors will have to factor in the tax component if the investment is held in a taxable account.  For investments paying income report taxable distributions on T3 and T5 slips in which you pay tax on even if you have not sold the investment.  Tax from T3 and T5 income has to be paid even if the underlying investment has declined in value from your original cost.

If you hold foreign investments then you may also have to factor in a currency gain (loss) once the investment is sold.  This becomes more complicated if dividends have been paid, especially if withholding tax has been applied.

Another important point to review is that realized capital losses can generally only be applied against realized capital gains (not interest income or dividends).

You are permitted to carry net capital losses back three years and forward indefinitely.  Upon death, net capital losses convert to non-capital losses and can be applied against all sources of income.  If a person passes away with both unrealized losses and realized losses, there likely is some tax planning that should be considered, especially if the deceased had a registered account.

If you have a non-registered account, it is important to understand the tax differences between interest income, dividend income, capital gains, and deferred growth/return of capital.  Total return should factor in the change in underlying market value of the investment, income received, foreign exchange gain or loss, transactions charges, and tax consequences.