Extra due diligence on private investing

The private market is used by public and private companies to raise money. Most of the money raised comes from investment funds and institutional investors. However, a relatively small percentage is used to finance venture companies and start-ups, which can be risky investments for the average retail investor. This is especially true when compared to investing in long-established companies that trade in the public market.

Private start-up companies have a high probability of failure. It’s also possible for fraudsters to exploit investors who don’t understand this type of investment. However, whether a private market investment is a fraud or simply fails, the financial impact is equally devastating. Investors need to be aware of the risks involved in the private market and protect themselves by researching their investments, and understanding their risk tolerance. When it comes to the private market, don’t invest more than you can afford to lose.


The public market is effectively the stock market, where investments trade openly. In order for a company to issue the securities (as part of an Initial Public Offering), they must issue a document called a prospectus. The prospectus includes the company’s audited financial statements, and must disclose aspects of the investment such as relevant risks and material information about officers and directors. The issuance of the prospectus is required for the shares to trade on the stock market. Public companies are also required to make ongoing disclosure of material facts and changes to their business.


Also commonly referred to as the exempt market, this is where companies sell their securities under various exemptions from the prospectus and registration requirements outlined in The Securities Act and Rules. Many private real estate investment corporations and mortgage pools would be considered the private market. The Securities Act and Rules provide for a number of exemptions from the registration and prospectus requirements of publicly traded companies. Some examples of exemptions used by the private market include selling to the following individuals: close family, friends, business associates of a principal, people with a minimum of $1 million in financial assets, individuals with net income before taxes of more than $200,000 (or $300,000 when combined with spouse), and individuals with net assets of at least $5 million. One of the bizarre exemption rules is that if you can invest $150,000, and pay cash at the time of the trade, then you are exempt (even if this means that you pulled every dime together to make the purchase happen).

If someone doesn’t qualify for one of the above exemptions, then there is always the offering memorandum exemption. The “OM” can be used to sell securities to anyone, provided the investor sign a risk acknowledgement form. At times, the people selling private investments have abused these exemptions in order to have the uninformed investor become eligible.


One of the biggest challenges with private investments is trying to sell the investment after you have purchased it. Private investments are normally illiquid and have restrictions on resale. 


When considering a private investment you should ask if the person is licensed with the Investment Industry Regulatory Organization of Canada (IIROC) or the Mutual Fund Dealers Association (MFDA). These can easily be confirmed by phoning IIROC or the MFDA directly. Another method to check registration is to go to the Canadian Securities Administrators (CSA) website (www.securities-administrators.ca). Unregistered salespeople are allowed to sell private securities. Many investors are unaware that unregistered salespeople are not bound by the same suitability requirements as registrants and are under no obligation to ensure that the investment is suitable for your investing needs. You will have very little recourse if the investment goes badly. If you are dealing with an unregistered salesperson then more due diligence is required.


If a client calls with a request to execute an unsolicited buy order on a higher risk stock, I always suggest keeping the position size small. Unfortunately, when it comes to private investments, the above disciplined position size approach is often ignored. Putting all of your savings into one investment is simply not prudent risk management, but this happens more often than it should. The saddest stories involve individuals who were encouraged to take out a home equity loan and use the proceeds to purchase the private investments. It is so important for investors to be honest with themselves about their risk tolerance, and to thoroughly understand the level of risk they are taking on with their investments.


Many private investments do not have audited financial statements provided to investors, although these are required if the investments are sold under an offering memorandum. Compounding this lack of accountability, we often hear of a complex web of companies or transactions that would be impossible for outside investors to obtain a clear picture of the financial stability. A good rule of thumb is to remember that there is rarely a good business case to be made for complexity. If an investment is difficult to understand, or if the person offering it can’t explain it clearly, you might be better to walk away.


Prior to investing, understand where you rank in the hierarchy if the investment fails. Owners of common shares are usually the last investors to be paid if things go wrong. Primary and secured creditors (often large financial institutions or institutional investors) will be first in line to be repaid. Primary creditors may have specific security over the main assets. The individuals or companies that are first in line would force a liquidation event on various grounds such as violation of covenants, if they felt they were not going to get their full piece of the pie. This often leaves nothing for the average retail investor.

Before investing in the private market, I suggest reading the BCSC’s Private Placement Guide and reviewing investright.org, the BCSC’s consumer protection sight. If you suspect that an investment may be a fraud and need assistance, phone the commission at 1-800-373-6393.


Liquidity in investments

Investments that can be bought and sold easily are considered to be liquid. Investments that are difficult to buy or sell are considered illiquid. Liquidity is one of many important objectives of investing. We can actually look at liquidity in several different ways, and for purposes of this article I’ve broken it down to four general discussion items, as follows: Basic Rules of Settlement, Liquid for a Cost, Exceptions to Liquidity, and Ratio of Liquid to Illiquid.

Basic Rules of Settlement

When buying and selling different investments, there are specific rules with respect to transaction dates and liquidity. Two dates are often used to describe transactions, trade date and settlement date. Trade date is fairly straight forward to understand. It is normally the day your purchase or sell is first executed. If you spoke to an advisor after cut off times (i.e. market hours) and your advisor entered the order for the next market day then trade date would be the next market day. Settlement is a little more difficult to understand and changes with different investments. The following is a chart with the most common investments and the respective settlement dates:

Common Investments

Settlement Date = Trade Date + (below)

Money Market Mutual Funds

1 business day

High Interest Savings Accounts

1 business day

Short Term Bonds (3 years or less)

2 business days

Long Term Bonds (3 years plus)

3 business days

Mutual Funds

3 business days

Canadian and US Equities

3 business days

European and Foreign Equities

Depends on market

To illustrate trade date and settlement date we will use a typical week with no public holidays. Michelle purchases a stock named ABC Company on Monday – this is the trade date. Settlement as per the above schedule for equities is the trade date plus three business days – settlement is on Thursday. What this means is that Michelle does not have to deposit money into her investment account until Thursday, even though the investment was purchased on Monday. If Michelle already had money in a high interest savings account then her advisor could sell a portion of this investment on Wednesday to cover the purchase. The opposite happens when an investment is sold. Let’s assume that a few months go by and Michelle needs some money and sells ABC Company on Monday – this is the trade date. Although we did the trade on Monday, the settlement date is Thursday. We would not be able to transfer funds to Michelle until the settlement on Thursday. We explain settlement to new clients to ensure they give us a few days notice if they require funds.

Liquid for a Cost

At any time you should have the right to make a change in your investments without it costing you a fortune. Having flexibility with investments ensures you never feel like you are backed into a corner with no options. We recommend asking the liquidity question prior to making any investment decisions – what will it cost me tomorrow if I need to sell. Everyone should know the total cost to liquidate an entire portfolio. When I have sat down with people wanting a second opinion the first thing I look at is the types of investments they have and what it would cost to make any necessary changes. I will use Wendy who came in for a second opinion as an example. Wendy was holding a basket of proprietary mutual funds that were originally sold to her more than two years ago on a deferred sales charge (DSC) basis. I explained that with proprietary mutual funds they can not be transferred in-kind (as is). Her only option was to sell the mutual funds, and transfer the net cash after redemption charges, if she wanted to make a change with her investments. In explaining DSC mutual funds to Wendy, she was shocked to know it would cost her four per cent (or $23,200) of her $580,000 investment account to make a change even though she has owned these investments for more than two years. Immediately Wendy felt she was backed into a corner. I explained to Wendy that if she had sold these mutual funds soon after she purchased them two years ago then the cost would have been $37,700. Although Wendy had liquidity, it was liquidity for a cost – she had no idea. In my opinion, every investor should avoid being backed into a corner with excessive liquidity costs.

Exceptions to Liquidity

Not every investment will be easily converted to cash. Your principal residence is one investment that is not easily converted to cash. Many assets that people buy either have restrictions on when they can be sold or take significantly longer than the settlement dates for common investments noted above. Examples of investments that are not easily liquidated include: infrastructure assets, private real estate investments, antiques, art work, private companies, hedge funds, flow-through investments, venture capital funds, etc.. Some investments have in the fine print that they reserve the right to suspend redemptions under certain circumstances. It can be very frustrating for people who have invested in illiquid investments and would like their money back. Prior to purchasing any investment you should determine if it is liquid, illiquid, or has the possibility of becoming illiquid. If it is illiquid you should be prepared to hold it until key dates are reached or a liquidity event occurs.

Ratio of Liquid to Illiquid

A good exercise for all individuals is to list all of your investments and categorize them in the liquid or illiquid category. In my opinion, everyone should have some liquid investments, including cash as an emergency reserve, or investments to either obtain income, growth, or a combination of both. There is no set rule on what ratio of liquid to illiquid investments people should have. As a general guideline, younger individuals may have more illiquid investments, especially if they have real estate with debt or the higher risk tolerance to invest in illiquid investments. Another general guideline is that as people age, or if they have a lower risk tolerance, the ratio may favour liquid investments.

Timing stock markets is always a challenge

At any point in time the stock market can either go up, stay at current levels, or decline. However, over time the stock market has an upward bias. During the last twenty years the TSX/S&P Composite Index has increased annually 8.19 per cent in spite of volatility during this period. When the stock market takes a sharp downward correction, the natural response from investors is to try to anticipate the decline and sell off before this happens. It sounds easy when you’re looking in the rear view mirror. Timing when you’re in or out of the markets is in essence basing your investment strategy on a speculative approach rather than a disciplined investing approach that incorporates a long term vision and goal. Short term emotional thinking can cloud long term investment decisions.

The best way to illustrate the challenges of trying to time the stock market is by looking at an investor who is currently fully invested. Mr. Wilson has $1,000,000 invested and is currently earning $40,000 in annual income from dividends and interest. In addition to this income, Mr. Wilson’s investments fluctuate in value based on the markets which create either capital gains or losses.

Mr. Wilson decided that he wanted to be a market timer. By market timer, I mean that he felt he could predict the direction of the stock market and would sell his investments if he anticipated a decline in the markets. If Mr. Wilson sells off his investments and converts his portfolio to 100 per cent cash, then his income will drop to $12,500 per year, assuming that savings accounts are earning 1.25 per cent. The downside to savings accounts is that interest income is fully taxable each year. Mr. Wilson currently has the majority of his investments earning tax efficient dividend income with some tax deferred growth. As a result of the difference in taxation between interest income and dividend income, the impact on income would be even greater than 2.75 per cent (4.00 – 1.25). For purposes of this article, we have assumed that both interest income and dividend income are equal.

Mr. Wilson should also factor in that if all of his investments are sold then he would have to report all the realized gains on his investments and lose the deferral benefits that exist with non-registered equity investments. If you have stock that has increased in value, you do not have to pay tax on the capital gain until it is sold. If Mr. Wilson has a stock that has declined in value and he realizes a loss then he has to use caution when timing transactions. He must wait at least 30 days before repurchasing a stock sold at a loss or risk violating the superficial loss rules and having the original loss declined.

From an income standpoint, Mr. Wilson will immediately see his income drop $27,500 a year ($40,000 – $12,500). The potential tax liability, superficial loss rules and loss of income are the easy components to quantify for Mr. Wilson. Has Mr. Wilson made the right choice to liquidate? If the markets increase then Mr. Wilson clearly made a mistake. If the markets remain flat then Mr. Wilson still made a mistake as his income will drop $27,500 a year.

If the stock market goes down it’s not necessarily a given that Mr. Wilson will benefit from having liquidated his account. If Mr. Wilson makes a correct prediction that the stock market declines then for him to benefit he has to also make another correct timing decision to buy back into the market at lower levels to potentially be better off. If the markets decline and Mr. Wilson does not have the insight to buy back in (before it rises back to the level that Mr Wilson originally sold at) then he would still be worse off. In essence Mr. Wilson has to make two correct timing decisions: (1) selling before the markets decline, and (2) buying back before they rise.

Mr. Wilson should also factor in the timing in which he feels his predictions for the market will unfold. To illustrate this component we will assume no transaction costs and no tax impact to the trades for simplification purposes. The difference between the current income Mr. Wilson is earning of 4.0 per cent and the new income of 1.25 per cent if he converts everything to cash is 2.75 per cent. Depending on how long Mr. Wilson is out of the market impacts how much the stock market would have to decline to make the strategy of going to cash successful. Let’s assume that Mr. Wilson waits six months, one year, two years, and three years before buying back into the stock market. If every year Mr. Wilson is losing 2.75 per cent in income then the longer he waits the greater the stock market has to decline. At the six month point the markets would have to decline 1.38 per cent (2.75 x .5) or greater, at the one year point the markets would have to decline 2.75 per cent (2.75 x 1) or greater, at the two year point the markets would have to decline 5.5 per cent (2.75 x 2) or greater, and at the three year point the markets would have to decline 8.25 per cent (2.75 x 3) or greater.

Making two right short term timing decisions against a stock market that has a long term upward bias is not as easy as it may seem.

Retiree’s glass half full when interest rates rise

Since the early eighties interest rates have been on a general descent, with a few small variations along the way. For anyone who purchased annuities years ago, or owned longer term bonds, the returns were much higher than today. In July 2012, the Government of Canada 30 year bond rate fell to 2.2 per cent – a historic low. We are beginning to see longer term interest rates beginning to climb from these historic lows. One question I have been asked many times is why existing bonds decline in value when interest rates rise, and vice versa. This inverse relationship is confusing for investors not familiar with bonds.

To illustrate this inverse relationship we will use two 30 year Government of Canada bonds with a face value of $100,000. Let’s assume Bond A was issued one year ago with a coupon rate of 2.20 per cent, and Bond B was issued today with a coupon rate of 2.95 per cent. Unlike common equities, once the coupon of a bond is set it does not change. When bonds are initially issued they have a par value of 100 and will mature at 100 par value. Throughout the life of a bond it will trade at either at a discount (below 100) or at a premium (above 100). All else being equal, if current market rates are higher than the bond’s coupon, it will trade at a discount. If current market rates are lower than the bond’s coupon, it will trade at a premium.

Going through the calculations will also help with understanding the inverse relationship of bonds. Bond A pays income of $2,200 per year. For a 30 year bond, this equals $66,000 (30 x $2,200) in total income during the full term. Bond B pays income of $2,950 per year. For a 30 year bond, this equals $88,500 (30 x $2,950) in total income. Bond B will pay $22,500 more in interest than Bond A ($88,500-$66,000). In order for someone to sell Bond A today they would have to accept a price of 77.50 par value, or 77,500. The second buyer of Bond A would purchase the bond for $77,500 then receive $100,000 at the end of the 30 years. The second buyer of Bond A would have a capital gain of $22,500 plus interest income of $66,000 which would equal the $88,500 in interest income that the holder of Bond B receives. These calculations are overly simplistic and do not factor in the time value of money or taxation items, both of which are important concepts in bond valuations. The time value of money is the notion that a dollar today is worth more than a dollar tomorrow. The calculations above would be different if these items were factored in.

The number of years that a bond has before it matures may be referred to as “term” or “duration”. The longer the duration of a bond, the more it will fluctuate in value if interest rates change. Let’s use Bond A and B again but assume that the term is ten years and not 30. Bond A pays income of $2,200 per year. For a ten year bond, this equals $22,000 (10 x $2,200) in total income during the full term. Bond B pays income of $2,950 per year. For a ten year bond, this equals $29,500 (10 x $2,950) in total income. Bond B will pay $7,500 more in interest than Bond A ($29,500-$22,000). In order for someone to sell Bond A today they would have to except a price of 92.50 par value, or 92,500. The second buyer of Bond A would purchase the bond for $92,500 then receive $100,000 at the end of the ten years. The second buyer of Bond A would have a capital gain of $7,500 plus interest income of $22,000 which would equal the $29,500 interest income that the holder of Bond B receives.

The loss on the value of Bond A incurred in the ten year example is $7,500 after one year, which is significantly lower than the $22,500 loss on the 30 year bond. Investor A only lost $5,300 if the interest income of $2,200 received in the first year is factored in. When investors feel that interest rates may rise, one strategy is to execute a switch trade and simultaneously sell longer term bonds, and purchase shorter term bonds. The downside to this strategy is that short term bonds have lower current yields and rates may not rise. Investors shifting to shorter term bonds will sacrifice a lower yield today to lessen the risk of an even larger decline in value of the bonds if interest rates rise.

Much attention has been placed on the negative impact on existing bonds if rates rise. If we flip the conversation and discuss the benefits for investors – the glass is half full when rates rise. To illustrate we will use a recently retired investor named Charlie who has a corporate bond portfolio valued at $500,000 today and is yielding 3.5 per cent. Annually Charlie is currently earning interest income of $17,500. If interest rates rise to the point where Charlie can earn 5.0 per cent on his corporate bonds then Charlie is clearly a winner in the long run as his annual income jumps up to $25,000. For Charlie to benefit in the long run with rates rising it is important to ensure that he does not incur a significant loss on his existing bond portfolio in the short term.

After a thorough discussion with Charlie we mapped out a few trade ideas. We sold a couple of his longer term bonds and reduced his overall fixed income by ten per cent. With the proceeds from selling the fixed income, we allocated some to increasing cash and the remainder to equities. We explained to Charlie that the downside to increasing cash is that it currently earns only 1.25 per cent. After Charlie pays the 30 per cent tax on the interest income his after tax rate of return of 0.875 per cent is less than the rate of inflation. On this portion of Charlie’s portfolio he will not be earning a real rate of return; however, Charlie understands that this is intended to be a shorter term strategy. In managing risk, we felt that a small after tax return would be better than a negative return on his longer term bonds if rates rise. As Charlie requires income from his investments some of the proceeds from selling two of his bonds went to purchase lower risk dividend paying equities. Charlie was pleased that these trades actually increased his after tax rate of return once the dividend tax credit was factored in. The potential for the value to increase through capital gains was also appealing. The downside that needed to be weighed is that equities and the stock market could decline.

Switch trade strategies

In the last column I talked about model portfolios and how many advisors establish a uniform basket of stocks for their clients. Most advisors have two sets of lists for their model portfolios: one that has the stocks they are considering buying and another that has the stocks they are considering selling. One trading tool that advisors use in developing and keeping their model portfolio basket of stocks up to date is switch trades. A switch trade occurs when a position is simultaneously sold from a model portfolio and another position is bought.

Mr. Jones is retiring and now requires income from his portfolio. Mr. Jones came to us for a second opinion. Currently he holds $500,000 in mutual funds that are not generating any income, while also paying the management expense ratio that costs $12,000 annually. We suggested he sell these mutual funds and switch into a basket of direct holdings containing dividend paying blue chip equities that would pay him a minimum of $20,000 in dividends annually. This would increase his income substantially. Moreover, he would save $7,000 annually since direct equity investments through a fee-based account would have lower investment costs than mutual funds. His investment costs for the blue chip equities would bring his cost of investing down to $5,000 annually.

When an individual is fully invested, such as Mr. Jones, switch trades are effectively the only way someone can purchase securities. Initially, Mr. Jones will be executing switch trades on a macro level as he is completely remodeling his portfolio from entirely mutual funds to all direct holdings. Once his portfolio contains direct holdings, switch trades will be executed on a micro level. Essentially, you sell the weakest name to purchase what you feel is a stronger name. These switch trades can be done for many different reasons, some of which will be explained below.

Changing Objectives

As your investment objectives change, certain securities may no longer be appropriate for your current situation. Switch trades can be used in these circumstances to better align the portfolio with your needs, investment objectives and risk tolerance. For instance, a switch order could be placed to liquidate a higher risk holding for a lower risk holding and vice versa.

Changing Yield

To increase the overall yield of the portfolio, you may wish to substitute one position for another with a higher yield. As stated above, if you are fully invested, you may not have funds available or the liquidity necessary to act on a trade quickly which could increase your portfolio’s yield. Therefore, by executing a switch trade, you will be able to purchase a new holding and increase the income. On the other hand, if you have a net capital loss carry forward, or if you want to defer growth, a strategy could be implemented to focus on growth stocks with little dividends. Investors can benefit from switch trading both by changing to a lower or higher yield, depending on their unique situation.

For example, Mr. Jones is trying to increase his yield to provide retirement income. He currently holds a growth stock with a yield of 1.2 per cent; however, he is looking for a higher yield and is interested in switch trading his growth stock for a value stock that pays 4.6 per cent. If Mr. Jones holds a position of $20,000 with the growth stock’s yield of 1.2 per cent, he will make $240 in dividend income. If Mr. Jones switched to the value stock with a yield of 4.6 per cent, his annual dividend income would increase to $920 (a $680 increase) on that one holding of $20,000.

Sector Rotation

Due to market variations, each of the different sectors may be either underperforming or outperforming others during any given period. Switch trades can be useful in these instances for re-balancing a portfolio to overweight or underweight a different sector. By using a switch trade, investors are able to rotate between sectors with relative ease, allowing them to overweight a sector that is expected to outperform and underweight a sector expected to underperform.

For example, the value of Mr. Jones’s stocks of company ABC have appreciated nicely; however, he believes their sector will soon decline and he is now looking to sell those stocks. With the proceeds, Mr. Jones is looking to invest in stocks of company DEF, which is in a sector that he believes will outperform in the future. A switch trade can be done to execute this order. Mr. Jones holds 200 shares of ABC, currently selling at $50 a share. As ABC is sold, the switch trade simultaneously buys DEF with the proceeds. Since DEF is currently selling at $25 a share, Mr. Jones is able to buy 400 shares. As a result of this switch trade, Mr. Jones is now overweight in a sector expected to outperform, and has minimized his holdings in a sector expected to underperform.

Asset Mix Rebalancing

Your asset mix is not static; rather, it is always fluctuating depending on the current state of the markets. With time, it’s not uncommon for an investor’s portfolio to stray from its prescribed ranges due to market movements. Switch trades can be used to rebalance your portfolio, keeping it consistent with your initial asset mix weightings and risk tolerance. For example, over time Mr. Jones’s portfolio has become unbalanced, and he is now overweight in equities and requires more fixed income. To solve this, a switch trade can be executed selling equities and buying fixed income. Alternatively, if Mr. Jones was underweight equities, he would sell fixed income and buy equities through a switch trade.

Tax Planning

For tax planning purposes, switch trades are ideal for ensuring you are minimizing the amount of tax you pay. As an illustration Mr. Jones has experienced a capital loss in a particular stock in the energy sector; however, he wishes to keep the same weighting of energy in his portfolio. An option for Mr. Jones in this situation is to place a switch order. By selling the energy stock he currently owns and simultaneously buying another similar energy stock, Mr. Jones is able to use the capital loss to reduce his tax payable for that year while still maintaining the same weighting in that sector. By keeping the same weighting in a sector, an investor will benefit from any sector recovery.

Models underscore risks and rewards

A model portfolio is a basket of holdings – cash, fixed income and equities – an advisor combines to achieve an investment objective or risk tolerance level.

Not every adviser uses a model portfolio approach.

The ones that do will often have more than one model portfolio to reflect the appropriate investment objectives and risk tolerance of each person. Objectives are usually classified as income, long-term growth, and short-term growth. Risk tolerance may be as simple as low, medium and high. Investment objectives and risk tolerance help establish which model portfolio is most suitable.

Our model portfolio approach includes three different broad options – income, income and growth, and growth. The best way to illustrate this is to use the situations of three individuals. John, Wendy and Alex each have $500,000 to invest and fall into a different model portfolio. The chart below summarizes the asset mix and number of equity holdings within each model.



  • John was referred by his accountant. He is 60, recently retired and withdrew the commuted value from his pension plan, valued at $500,000. In listening to John’s investment objectives and risk tolerance, it was clear the income model portfolio was the most appropriate for his needs. He did not have a lot of experience with investing and was nervous about investing too much in the stock market. He also wanted to immediately withdraw a monthly amount from the account to live on. The income model portfolio would have an optimal asset mix of 60 per cent fixed income and 40 per cent equities. The fixed income would have a larger short-term component to meet his cash flow needs. Within the equity portion, the number of individual companies John would acquire is 20 and the targeted position size is $10,000 per company. These 20 equities would all be large blue-chip equities, diversified by sector, and that pay dividend income. We were able to give John an estimated income report for the income model portfolio along with a discussion regarding risk and reward.
  • Wendy recently received an insurance payout of $500,000 from an accident she was in three years ago. She is 50 and planning to work for the next 10 to 15 years. It was apparent the income and growth portfolio was most suitable. Given that Wendy was moderately comfortable with assuming risk, her portfolio would have 40 per cent in fixed income and 60 per cent in equities. The number of individual companies Wendy would own is 25 and the targeted position size is $12,000 per company. These would be large companies that have both growth and income components. Wendy did not require immediate income, so we set up the dividend reinvestment plan on the equities she will be holding longer term.
  • Alex sold his shares in a private technology company and netted $500,000 after tax. He’s 40 and looking for tax-efficient growth and is comfortable assuming more risk to achieve greater long-term rewards. The growth portfolio is the most suitable for Alex and has only 20 per cent in fixed income and 80 per cent in equities. The number of individual companies Alex would own is 30 and the targeted position size is $13,333 per company.

Model portfolios help new clients understand the total investment costs, income, sector weighting, and structure like the number of holdings and position size.

Without these models it can be difficult for people new investors to visualize how their money can work best for them. The ranges shown above are important as it allows customization for each client.

If an investor wishes to invest in something that is not within the model portfolio, it is still be possible. We establish ranges outside of the optimal position size. For example, if a person transfers in a large position from an employer they may purposely want to overweight that name and have a greater position size than the optimal amount.

Another example is a person who has large gains on some stocks and wishes to continue overweighting them.

Some investors may wish to purchase investments that are not within a model portfolio. The ranges above usually provide flexibility to do this. A person may phone us for an unsolicited trade to purchase small companies or emerging markets which may not be part of any model. Or a person who chooses to overweight a particular sector which can also increase the risk of a portfolio.
Models help set the parameters for the portfolio within reasonable ranges while still allowing customization for each client. It assists an advisor in establishing a methodology to manage and explain risk and reward. By comparing all three models, new clients can work with advisors to select the portfolio that they feel best reflects their wishes.

Rebalancing investments in two steps

A disciplined investment process begins with determining the asset mix that is right for you. By asset mix we refer to the portion you have in one of three broad categories of investments, including cash, fixed income and equities. Fixed income includes guaranteed investment certificates, term deposits, bonds, bond exchange traded funds, debentures, preferred shares, etc.. Equities are what many would refer to as the “stock market”. Life, markets and your asset mix all change with time. Decisions you made yesterday may not hold true with new information tomorrow. This is the reason that your investment strategy is not just about the markets. When you buy a house, have a child or approach retirement, your investment goals will change. As your goals change, so might your asset mix. For example, the asset mix of a very aggressive investor would not be suitable for someone who is retiring in the coming years. Just as major life events change us, we can also look at major market events as changing the way we look at our portfolio. For some investors this may be an opportunity for reflection. You may ask yourself if your “normal” asset allocation is still valid once you have considered any changes in your life. If that answer is yes, then when markets change as they do, it may also be time to consider rebalancing your portfolio back to its original mix.

Interest rate changes and market movement results in fluctuations between asset mix. From the day you begin investing, your asset mix is constantly changing. To illustrate, we will use Thomas and Heather Bennett who invested in a portfolio with the following asset mix: Cash 0 per cent, Fixed Income 40 per cent, and Equities 60 per cent. Asset classes do not change at the same rate. Over time, stocks may grow faster than bonds making the growth in your portfolio uneven. For example, the Bennett’s portfolio that started with 40 per cent bonds and 60 per cent equities could drift to 30 per cent bonds and 70 per cent equities if the stock markets rise, or alternatively the other way to 50 per cent bonds and 50 per cent equities if a stock market correction occurs. Regardless of the direction of the change in your portfolio, it is necessary to remember the importance of the reasoning behind your original asset allocation. Although it may seem counter intuitive to sell an asset class that is doing well or buy one that is not, however that is precisely what is required if the fundamental principle of “buy low – sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk.

Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counterintuitive. When markets are down, human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.

Although at times, the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit to doing so can be significant over the long run with compounding returns. It is important to talk to your advisor initially to determine your optimal asset mix that you are comfortable with, often documented in an Investment Policy Statement (IPS). Once you have a documented IPS then your advisor can establish a customized portfolio that matches your IPS.

Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review you IPS to ensure that you’re comfortable with the asset mix. Changes in market conditions and interest rate outlook are factors to discuss with your investment advisor when revising the asset mix within your IPS. Your personal goals, need for cash, and knowledge level may also result in your asset mix needing to be adjusted.

The asset mix is the macro decision within the IPS and is the first step in rebalancing. Step two of rebalancing is looking at the micro items, such as sector exposure and individual companies you have invested in. It also may involve looking at geographic exposure, credit quality and duration of fixed income, and mix between small, medium, and large capitalized companies. Up above, we noted that the Bennett’s initially wanted 60 per cent in equities and started with total investments of one million. The equity portion of $600,000 was divided into 30 companies with approximately $20,000 invested in each company. Over the last year, the Bennett’s now have a portfolio valued at $1,080,000 with 63 per cent in equities and 37 per cent in fixed income. Step one for the Bennett’s rebalancing of the asset mix would result in them selling three percent of equities, or $32,400, and allocating this to fixed income.

Step two in the rebalancing process highlighted that several stocks performed very well and are above the new individual recommended position size of $21,600 ($1,080,000 x 60 per cent divided by 30 companies). We also noted that stocks in two sectors performed very well and have resulted in the portfolio being too concentrated in those sectors. Step two of the rebalancing process resulted in the Bennett’s selling a portion of the star performers in the overweight sector.

When significant deposits and withdrawals are made then this is an ideal time to look at both macro (step one) and micro (step two) rebalancing. This could be when you are making an RRSP or TFSA contribution or when you have to decide what to sell to raise cash for your goals. If no deposits or withdrawals are made then periodic meetings with your investment advisor should have ‘rebalancing your portfolio’ as an agenda item. Some people may want to rebalance quarterly while others may feel an annual check up is sufficient.

Watch costs when buying real estate

Real estate is a popular topic for discussion when it comes to investments.   While real estate investments are appealing for their rental income and property value appreciation, most people seem to forget that their own personal residence can be another investment opportunity. 

We make decisions whether to rent or own, and we also make decisions whether to sell or hold.  Just like selling equities, before making the decision to sell your home, or even if you are looking to buy a new home, timing is everything if you hope to realize a gain.  If you feel real estate will decline in value, then it may be prudent to sell your home and rent until market conditions improve.

Another factor to consider in deciding whether to buy, sell or hold is to consider the transaction costs of buying and sell.  These costs are high and should always be factored in when looking at options.

You’ve heard the terms “good debt” and “bad debt.”   Bad debt would be credit cards and other debt associated with purchases of goods that are expected to immediately decline in value.  Good debt is the type of debt assumed on purchases that are expected to appreciate in value greater than the interest rate that you are paying on the debt.

Julie and Brent have saved up a little money and have also gone to the bank.  They have decided to purchase a home for $560,000 with a 10 per cent down payment.  In addition to the purchase price, they had other costs:

  • On a $560,000 home, the property transfer tax is one per cent of the fair market value up to $200,000, plus two per cent on the portion of the fair market value that is greater than $200,000.  The total property transfer tax is $9,200.
  • As Brent and Julie are only putting 10 per cent down (or $56,000) on the home, it is considered a high-ratio mortgage and they will have to cover the costs of Canada Mortgage and Housing Corp. insurance at two per cent of the loan amount.  The cost of the insurance is $10,080 ($504,000 x two percent).
  • The legal fee for buying the house is estimated at $800.
  • The building / house inspection is $500.
  • The bank also charged $400 for the house to be appraised for financing.
  • They will also have to purchase all the landscaping and gardening tools, including a lawn mower, weed-eater, garbage cans, hoses to name a few in order to maintain the yard.  They have set aside $840.
  • Household appliances are a significant cost.  Brent and Julie have estimated the cost of a fridge, stove, microwave, washer and dryer at $3,800.
  • The house Brent and Julie purchased was an older home that required some immediate basic repairs and maintenance.  They have set aside $800.
  • One of the additional costs for being a home owner is the insurance costs required for this significant asset.  The bank required home owners insurance which resulted in an initial cost of $800 for basic coverage.  Earthquake insurance was declined to reduce insurance costs.
  • Although Brent and Julie are only moving 19 kilometres from where they are renting, they’ll incur an additional expense to move their personal possessions.  They have hired professional movers for the day costing $690.
  • In addition to the initial cash outflow they needed funds to cover the upcoming annual property taxes of $2,480 and other utility bills.
  • Brent and Julie had to budget a further $1,150 to purchase curtains.

The total estimated costs incurred prior to moving in are $591,540.

Before even buying the home, Brent and Julie should budget for all of the initial costs.  They should also be aware of the breakeven number for some reason they wished to sell it.  The legal fee for selling the property is estimated at $660.  There can also be some harsh penalties for prepaying a mortgage early.  In the above case we will assume no early prepayment penalties.   Real estate fees are generally the biggest cost when selling.  As an estimate for Brent and Julie, a realtor could charge seven per cent on the first $100,000 of the sale price, plus 2.5 per cent on the remainder.   In this case, if Brent and Julie hoped to recover the total costs they initially put into the home ($591,540 they would have to list for $612,000 before commission.  The listing would include all appliances.  If they got the list selling price then the commission would be $19,800 which would be shared with their agent and the buyer’s agent.   If they subtract the real estate commissions and legal costs, the couple breaks even.

The above numbers highlight that to break even, the real estate market would have to increase 9.3 per cent or $52,000 ($612,000 – $560,000). Another factor that Brent and Julie should be aware of is that an increase in interest rates is typically negative for real estate in the short term.  After thirty years of declining interest rates, the best case scenario for Julie and Brent would be if rates stayed low for an extended period.

If interest rates rise then this typically results in fewer buyers being qualified to buy homes and a greater number of home owners defaulting on mortgages – both of which could cause real estate to decline rather than rise in price.   When it comes to selling or buying a home, use some caution, factoring in all transactional costs to ensure you’re able to protect your home as a good investment.

TFSA equities can yield big dividends

Many people are still keeping their Tax Free Saving Account in cash or in a low interest bearing vehicle, not realizing there are other options available.

There are plenty of advertisements this time of year encouraging people to open new accounts with the promise of teaser high interest rates for six months or a year, or a $50 bonus. Seems like a no brainer to sign up for the new account, right?

Regrettably, many are missing the fine print where it is disclosed there is a $125 fee should you decide later to transfer. Those teaser rates don’t last forever, and the firms offering the teaser rates may have limited investment options.

Your TFSA is not limited to just cash. There are other investment product options available, such as equities. Managing equities in your TFSA is a little riskier, but the potential for bigger dividends should offset this risk.

You can have as many TFSA accounts as you wish provided they do not go over the annual limits. The Canada Revenue Agency is on top of people who over-contribute. When the TFSA was first launched, the CRA were more lenient on waiving interest and penalties for those who inadvertently over-contributed. The penalties and tax are severe and could quickly wipe away any benefit of the TFSA if you make an over contribution.

My advice for anyone with a TFSA is to have only one and to have a strategy for the account.

By maintaining one TFSA, you can easily manage the amount you contributed and you don’t have to remember all the details of each of your other TFSA accounts. I also recommend that the TFSA account is with the same advisor and financial firm as your other investment accounts. The investments within the TFSA should have a strategy and should compliment your other investment holdings. Your financial advisor will also have the financial planning software that has been updated in recent years to include the impact of contributing to a TFSA over time.

On March 23, 2011, I wrote an article about having a conservative blue chip stock in the TFSA. I illustrated this using Clare, who purchased TransCanada Corp (TRP). In the article, we assumed that Clare purchased shares in TRP with her maximum contribution limit at the beginning of each year. The maximum contribution amount for 2013 was raised to $5,500, so as of February 28, 2013, Clare’s TFSA is valued at $34,103.

Back in 2009, Clare’s husband, John, chose to buy Royal Bank of Canada (RY) shares instead of TRP. Every year, John has added to his Royal Bank shares in his TFSA by simply transferring shares that he already owns in his non-registered account. He understands with each transfer from his non-registered account that he has to pay tax on the realized gain from the shares transferred into the TFSA. Similar to Clare, John has built up a sizable TFSA using one stock. The strategy was suitable for John and Clare as they wished to hold equities within their TFSA, have combined investments of $1 million, and wished to assume the concentration risk in one account.

Together John and Clare have seven accounts – two joint with right of survivorship non-registered (one with John as the primary, and the other as Clare as primary), two TFSA, two RRSP, and one locked-in RRSP (resulting in the transfer of a registered pension plan from John’s former employer).

John and Clare could see the benefits of having their TFSA accounts at the same institution of their other holdings. We were able to ensure that the investments in the TFSA are complimentary to the other holdings they have and to manage overall position size of each investment.

Sixty per cent of John and Clare’s total investments are in equities, or $600,000. For John and Clare’s combined portfolio we have recommended 30 equities with initial positions being approximately $20,000. John and Clare’s TFSA accounts have investment risk tolerance set at high on both accounts as a result of their concentration in one holding.

If the position exceeds five percent of the portfolio, we would recommend reducing the position, also called rebalancing. If John and Clare wish to continue holding an investment that exceeds five per cent or $50,000, we would have them sign a specific letter stating that they understand the risk associated with more concentration in this investment..

During our March meeting, we suggested that John and Clare each consider selling half of their shares and buying a second stock in a different sector that compliments the total portfolio. Individuals that wish to have equity exposure within their TFSA accounts should understand the associated risks of concentrating and different options of investing.

Investors with less capital than Clare and John or who have a lower risk tolerance, should look at a different approach for the TFSA. Once investors obtain a total portfolio of $250,000 or greater, then I encourage people to look at the benefits of direct equities within a TFSA.

Let’s use a household with total investments of $250,000 with 60 percent in equities, or $150,000. In this case we would recommend 20 equity holdings at $7,500 each. The TFSA would likely have three to four companies. Capital gains and income are “tax free” in a TFSA. Losses within a TFSA cannot be claimed.

In other words, if an investment goes down in value more than the income it has generated, it would have been better off to hold it in a non-registered account to be able to have the loss carry-forward.

Planning for 30 years in retirement

Imagine that you have just retired and have booked a meeting with your financial advisor to share this exciting life event. After sharing the news you spend time talking about your first big travel plans and all the things you want to do – things that cost money. The conversation naturally shifts to your investments and whether or not you should change strategy.

When it comes to investing in retirement, the period can be thirty years or longer. This is a long period in your life and for many people, they require some growth during this period as well. When interest rates were higher it was definitely advised to shift to a more conservative asset mix with a higher percentage in fixed income investments, such as corporate bonds, provincial bonds, federal bonds, coupons, GICs, term deposits, debentures, notes, and preferred shares. Many of these interest bearing investments today do not exceed the rate of inflation, and certainly the estimated return would be on the low end of any financial plan prepared in the past.

It may be a daunting task to plan the next thirty years of your life in retirement. By planning we are really looking at how you see everything in retirement unfolding and then looking at the associated costs of the things you need and want. Breaking this thirty year period into three decades is perhaps more manageable. Let’s refer to the first ten years as the Early Retirement Years (ERY). The second ten year period will be referred to as the Middle Retirement Years (MRY). The last ten years of retirement will be referred to as the Final Retirement Years (FRY).

Before you enter the ERY, it is useful for you and your spouse (if applicable) to have a clear understanding of the costs of the things you need. These should be the amounts that are clearly outlined in your financial plan. Ideally before the ERY starts you should also look at the things that you want. Putting plans down on paper really helps map out options and the associated costs of each decision. One couple may want to purchase a sailboat of their dreams. Another couple may want to purchase a motorhome and explore North America. Possibly flying to a warmer climate every winter or travelling the world is the agenda. Planning the first ten years of your retirement before it begins will better ensure that you focus your resources in the best areas and that you make the most of your time. Once options are discussed then it is easier to communicate this to your advisor and determine the cash required for the things you want to do. Again, this is different from the things you need. Before, and during, retirement it is important to let your advisor know what cash you require for both the things you need and the things you want.

A recommended approach is to create a cash reserve, also known as a cash wedge, equal to the amount of cash required for the upcoming year. With increased volatility it may be prudent to increase your wedge to two years to cover your cash flow needs.

Using Mr. Wilson as an example, he is 60 years old and has $1,000,000 to invest. He would like $5,000 a month transferred from his investment account to cover his needs. Annually this is equal to $60,000. In the next year Mr. Wilson feels he will need a new car, which he estimates after the trade-in to be a difference of $25,000. Mr. Wilson’s cash wedge should be in the range of $85,000 – $145,000. The lower end of the range is calculated by his needs $60,000 x 1 year plus his wants $25,000. The upper end of the range is calculated by his needs $60,000 x 2 plus his wants $25,000. This wedge will ensure that cash is available when required.

As a general rule of thumb, you will spend more money on an annual basis in the ERY then the MRY. The reason for this is that you may have capital purchases and more expensive plans during this period. This is the period in which most people have good health and the desire to do things. This period has lots of changes, including beginning to receive CPP, OAS, and other pension income. You may find that you want to volunteer or work part time, or spend time with new grandchildren. Certainly you will likely have to adjust to spending more time with your spouse. Developing new interests, hobbies, and friendships are important, especially if you’re planning to spend your retirement close to home.

The MRY is generally the decade with more stable cash flows when compared to both the ERY and FRY. By this time you have a clearer understanding of your cash in-flows and out-flows. During this period you will be required to convert your RRSP to a RRIF. We also advise during the MRY that you should ensure that all your legal documents are in place (powers of attorney, representation agreement, and updated will). This is important to be done when you have your health and have the capacity to make decisions. It is during the MRY where you may sell your personal residence or begin thinking about selling it. The decision about whether to sell your personal residence during the later part of this stage is often linked to your health.

Depending on your life expectancy, the FRY may be shorter or longer. Generally during this stage, the costs are mostly associated with the things you need. The FRY are the toughest to plan before retirement begins. It is more in the late MRY where you will begin thinking in greater detail about where you want to live as you age. Some people may have a home that is easily accessible and suitable for growing old in. Others may look at other options including: modifying/renovating home, buying another home with lower maintenance, renting, or moving into an assisted living arrangement. Provided you have a home that is fully paid for, the equity that you have built up in your home should cover the costs associated with the Final Retirement Years. I’ve seen many creative ideas, such as building a suite in a home to have a caregiver, or family member, living in the home for assistance. Planning for thirty years in retirement will help you prepare for all three stages and the associated financial costs of each.