Control investment costs, increase your net return

Many people don’t pay too much attention to the costs associated with investing. If we look at both your returns and cost of investing, we can create what is called your net return.  Your net return can potentially increase by either improving your return, or lowering your cost of investing.

To illustrate we will use Mr. Lee, a 55 year old investor who has $500,000 in an RRSP account.  Mr. Lee has explored the following four options with various costs of investing (increasing at one per cent increments with each option) and service levels:

Option 1:  Self managing investments through Exchange Traded Funds (ETFs) – often referred to as couch potato investing.  With this approach, you receive no planning or investment advice.  This approach is passive as it holds the investments that are in the respective index and are not actively managed.  The annual cost of investing for this option can be around 0.5 per cent, or $2,500 in the first year.

Option 2:  Working with an advisor owning direct holdings in a fee based account.  The fees for this option can fluctuate depending on the advisor and the amount invested.  The fee often decreases as the account value increases.   The benefit of this option is that an advisor is able to assist you with both planning and your investments.  Option 2 is the most transparent with respect to fee disclosure of all options.  If Mr. Lee put the $500,000 into a balanced portfolio, it would typically be priced at 1.25 to 1.5 per cent.  For our example we will use 1.5 per cent, or $7,500 in the first year.  It is important to note that a good advisor is well worth the additional fee over the ETF approach.

Option 3:  Purchasing mutual funds is another commonly used investment approach.  Mutual funds are actively managed by a portfolio manager that has a specific skill set in the fund(s) that you’re buying.  Mutual funds have embedded annual fees called a Management Expense Ratio (MER).  In addition to the MER, funds may be sold on a front end basis with addition fees of up to 5 per cent initially, or sold on a back end basis where you are typically not charged a fee initially but would be charged a fee if you sell the fund within the applicable Deferred Sales Charge (DSC) period, often seven years.  The fee may be as high as 6 per cent initially if sold in the first year, and declining every year until the DSC schedules is complete. An advisor selling funds may look at Mr. Lee and think his time horizon is ten years and that he may be invested in the funds through the DSC schedule.  If Mr. Lee is sold funds on a back end basis where DSC may apply, he is somewhat squeezed into a corner if he is not happy with his performance, or would like to make a change within the DSC period.  For purposes of this illustration we will assume that the only fees Mr. Lee pays is the 2.5 per cent annual MER, or $12,500.

Option 4:  Mr. Lee has heard about some guaranteed insurance products called segregated funds.   The primary difference between mutual funds and segregated funds is that the later is an insurance product.  Being an insurance product, the investments can be set up with different maturity and death benefit guarantees.  Another feature is segregated funds have the ability to name beneficiaries to bypass probate and public record.  In the case of Mr. Lee the funds he has are registered.  With registered accounts it is not necessary to purchase an insurance product to get this benefit as he already has the ability to name a beneficiary, his spouse, which also will assist them in avoiding probate on the first passing.  There is a cost to have the insurance benefit noted above. For illustration purposes we will assume the annual MER for a basket of segregated funds is 3.5 per cent, or $17,500 annually.

The long term effect on accumulated savings can be quite shocking when different net returns are explored over a ten year period.  To help with the illustration, we will make the assumption that investment returns over the next ten years will be six per cent for all four options.

Option 1:  ETF approach – net return is 5.5 per cent (6.0 per cent less the 0.5 per cent fee). A net return of 5.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $854,072 at the beginning of retirement.  He would have been responsible for all of his choices of ETFs and have no planning advice.  Although costs are low with option 1, there is a high degree of involvement to determine timing of when to buy the ETF and which ones to buy.

Option 2:  Direct Holdings in Fee-Based Account – net return is 4.5 per cent (6.0 per cent less the 1.5 per cent fee). A net return of 4.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $776,485 at the beginning of retirement.  The additional cost of investing over option 1 would more than likely be offset by higher returns with a good advisor.  A knowledgeable advisor is also able to provide you financial planning tips, and service that enables you to do other things in retirement.

Option 3:  Holding a Basket of Mutual Funds – net return is 3.5 per cent (6.0 per cent less the 2.5 per cent fee). A net return of 3.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $705,299 at the beginning of retirement.

Option 4:  Holding a Basket of Segregated Funds – net return is 2.5 per cent (6.0 per cent less 3.5 per cent fee). A net return of 2.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $640,042 at the beginning of retirement.

The above illustrates a one per cent change in the cost of investing for each option – it clearly shows how these small changes can have a material impact on your long term financial success.  The same exercise can be done assuming different percentage returns (i.e. four, five, six, and seven).

Don’t rely solely on pensions for retirement

Retirees have become reliant on their employer sponsored pension plan(s), Old Age Security (OAS), and Canada Pension Plan (CPP) for a comfortable retirement. When these pensions are threatened in any way it can have a significant impact on your retirement. These plans are changing – and not necessarily for the better.

Financial analysts have come out with reports showing how many companies in Canada have real problems with their defined benefit plans and funding benefits. With interest rates at extremely low levels, and uncertain equity markets, it has put many employers in a material pension shortfall position. To address these problems, companies are looking at how the pension is structured and making decisions that do not favour the employees. Employers are also looking to reduce benefits such as health care and dental as a way for companies to save costs.

The biggest change that a company can do with a pension is to change it from a defined benefit plan to a defined contribution plan. Below is a brief description of each type of plan:

Defined Benefit Plan

With a defined benefit plan, the employer is committed to providing a specified retirement benefit. The “benefit” is established by a formula, which normally takes into account the employee’s years of service, average salary and some percentage amount (usually between one to two per cent). The key point to take away is that the employer bears the risk of pension fund performance. Another key point is that the employee is able to calculate their benefit with more certainty than a defined contribution plan.

Defined Contribution Plan

The “contributions” made into this type of pension plan are established by a formula or contract. Many defined contribution plans require the employer and/or employee to contribute a percentage of an employee’s salary each month into the pension fund. The employer does not make a promise with respect to the amount of retirement benefits. This leaves the employee to bear the risk of pension fund performance in a defined contribution plan.

Between the two types above, the defined benefit plan is normally viewed as the better type of plan for employees. As noted above the employer bears the risk with defined benefit plans. Employees have more certainty with a defined benefit plan. Unfortunately, most companies are choosing the defined contribution plan to avoid having unfunded liabilities and shortfalls as a result of low interest rates and market conditions. With the defined contribution plan, employees are generally given a choice amongst different types of investments (i.e. conservative, balanced, and aggressive). It is up to the employee to select their own investments (from the group plan offering), even if they have no knowledge in this area.

In planning for the most likely outcome it appears that pension plans will offer less for retirees in the future. As pensions deteriorate it is even more important to look at other ways to supplement your income at retirement.

Registered Retirement Savings Plans

(RRSPs) should be used by all individuals without an employer sponsored pension plan. Even if you are a member of a pension plan, an RRSP may be an effective way to build additional savings and gain investment knowledge. With defined contribution plans, many employees are required to transfer the funds to a locked-in RRSP upon retirement. If you have both a defined contribution pension plan and an RRSP, we recommend that you periodically look at these accounts on a combined basis to review your total asset mix (the percentage in Cash, Fixed Income, and Equities). This is a wise exercise because it helps in the investment selection for both the pension plan and your RRSP. As an example, you may choose to have the defined benefit pension plan invested 100 per cent in fixed income, and rely on your other accounts to provide the emergency cash reserve and equity exposure.

Tax Free Savings Accounts

(TFSA) are a great type of account to build savings on a tax free basis. How you invest within the TFSA is really dependent on your goal. It is important to note that the funds in your TFSA do not have to stay in a bank account as the name somewhat suggests. What is your current goal for the TFSA account? How does it fit into your overall retirement plan? Is the purpose of this account to act as an emergency cash reserve currently? At some point, these accounts are going to be significantly larger, exceeding most recommended emergency cash amounts. The investment approach in this account should be consistent with your objectives and risk tolerance. If the funds are not required immediately then we encourage clients to have a combination of growth and income. Purchasing a blue chip equity with a good dividend (four per cent or higher) can provide both growth and income over time. If income is not needed today then it can be reinvested until you need it at retirement.

Non-Registered Accounts

are as important as RRSP accounts at retirement. When we talk about non-registered accounts, we are referring to both investment and bank accounts. Both hold after tax dollars that can be accessed with no tax consequence. When I prepare a financial/retirement plan, one of the important areas I look at is the ratio of non-registered to registered funds. Having funds in a non-registered account at retirement does provide more flexibility. If all funds are within an RRSP or RRIF, it becomes more challenging to come up with funds for emergencies (i.e. medical, new roof, etc.)

Retirees that have built up savings within RRSPs, TFSAs, and non-registered accounts will be better prepared to deal with further changes to pensions. Regular contributions and savings into these three types of accounts over time will put more certainty on being prepared for retirement. Relying solely on your pensions and the government for a comfortable retirement could set you up for disappointment.

Staying competitive on a global stage

Downward economic cycles can be frustrating for some people as they generally result in layoffs and declines in average wages. In an effort to stay competitive in a downward economic cycle, companies will sometimes choose to eliminate benefits (such as medical or dental), modify pensions in a negative way, or simply keep wages the same as the cost of living increases. However, when economic conditions improve then the upward cycle of hiring and increased salaries follows. Beyond these normal economic cycles are some considerations for future generations for how the global marketplace will impact their employment and financial opportunities.

It is clear that the emerging markets, such as China, India, Brazil, etc are outpacing developed countries in the area of growth. The labour market in the emerging countries is significantly cheaper and most manufacturing facilities have moved abroad. Developed countries have also used technologies and automation to work smarter – not harder. The opportunities for increasing employment in Canada with the other emerging global markets are challenging.

Perhaps this decade will be classified as the period of equalization between emerging and developed markets. The decade ahead will likely go down in history as a period of higher unemployment and a stagnant period of growth if we continue on the current path. We are living in a global market place that is becoming increasing competitive. The five biggest obstacles I see with the current employment situation are: 1) Organised labour demanding higher wages and benefits, 2) Attitude towards doing certain type of work, 3) Environmental attitudes, 4) Companies hoarding cash and not taking as much risk, and 5) Continued advancements in technology. 

It seems there are daily announcements regarding how unsatisfied some fully employed individuals are. A common complaint is not having a wage increase that matches the cost of living. Organised labour has become very powerful in developed countries demanding increased salaries and benefits. On the opposite spectrum we know about the poor employment standards and human rights issues in some of the emerging countries and how people are working for a fraction of what developed country workers make. As employees demand more, are they effectively pricing themselves out of the global market? What is the economic incentive for companies to continue their operations in Canada when other overseas markets will allow for lower costs to produce the same goods?

Some Canadians are choosing not to work because they do not want to do certain types of work. Attitude towards accepting certain types of work as well as salary levels should be adjusted if we want lower unemployment. In this period of equalization is it reasonable to force higher minimum wages, or for university graduates to expect six figure salaries immediately. If we want companies in Canada to hire people here, it has to make sense for them, relative to the global marketplace.

There is always a balance between economic progress and the environment. This is especially the case for a country such as Canada, where 45 per cent of the publicly traded companies on the S&P/TSX Composite Index are in the resource sector. It would not surprise me to see this percentage exceed 50 per cent in the next couple of years. There are economic consequences if we put up too many environmental road blocks for companies. As investors we also have to see how this impacts the companies we invest in. Other countries all over the world are continuing to develop their resource sector with less environment regulations. We continue to send raw resources to other countries that create pollution on route and in processing – a prime example of this is shipping coal to Asia.

Investors have to monitor the changing political landscape. Stringent employment and strong environmental standards have an impact on the companies we invest in. The great country we live in was built during a period where environmental and employment standards were significantly different then today. Most people drive a car to work, take a jet on vacation, enjoy lower energy and power costs to run their home, etc.. None of these activities can occur without an impact to the environment. Shoppers are often looking for the lowest price. The lowest price item is often manufactured in a country outside of Canada. The majority of Canadians would buy something made in a country that lacks appropriate human rights and environment standards if they could save money. In many ways Canadians are being hypocritical when they complain too strongly about projects that may impact the environment. If the product is going to be bought or consumed anyways, then one could argue that we should focus on getting the most economic benefit ourselves.

In controlling growth activities in our own county, we have better control over the standards that are put in place. If we continue to only consume goods manufactured abroad then we have limited control. We have people who can analyse project costs, reduce risks, and address the legitimate concerns people have.

One quote that I recently heard that I liked was the problem in North America today is not that we are taking too much risk, it is that we are not taking enough risk. The excitement of corporations expanding in years past with new ideas has largely been replaced by fear and preservation by many companies. Companies are hoarding cash and operating in regions that have fewer regulations, absences of organised labour, less litigation, and fewer environmental complexities.

Advancements in technology can be both a positive and a negative. The obvious negative is that jobs can be lost through automation. There is a cost to automating through machines to replace manual labour. As labour costs rise then companies have a greater long term incentive to automate. Machines do not go on strike to demand more, and do not require pensions and benefits.

Political announcements and regulations are having an increasingly important role to consider when monitoring the economy and picking investments. As the emerging markets continue to outpace our Canadian marketplace, we should expect the employment challenges to continue on the same path unless our attitudes change, and we become more competitive. Might our current levels of unemployment be closer to the new norm? As one wise person once said, “you can not have your cake and eat it too.”

The challenges of buy and hold

Technology has allowed investors split-second trades         – GETTY IMAGES

Technology has allowed investors split-second trades – GETTY IMAGES

As with all things in life, it is important to adapt as conditions change.  Like it or not, we are living in a fast changing, information overload, society.  It is tough to relax if one wants to stay current on all economic, political and financial news.

Different opinions exist with respect to what investment strategy works best in this technology driven environment.  Conventional wisdom has often supported the buy and hold approach with a focus on long term thinking.  Automated trading systems and a growing number of mutual and hedge fund managers with active strategies are on the other spectrum and often look for short term trades – sometimes fractions of a second.

We will look at some of the factors we consider when deciding whether the intention is to hold an investment longer term or shorter term.

  • Dividend yield is perhaps the easiest factor to look at when considering whether to hold a stock longer term.  If a stock has a dividend yield less than two percent then you’re really not getting paid to hold the stock on income alone.  If you’re buying a stock with a dividend yield less than two percent we feel you should have the belief that the underlying share price will appreciate to an appropriate level over the time horizon you wish to hold it.  Most stocks with a yield below two per cent would be classified as a growth stock and should be traded in our opinion.  Establishing a target price and a sell discipline will assist you in realizing profits.  It can be frustrating to see a low yielding stock appreciate and then subsequently decline without you earning income if the investment wasn’t sold at high levels.  The key with low yielding stocks is to not get too greedy and to set a sell discipline.
  • Sector is a very relevant factor for Canadians to look at when considering how long to hold a stock.  Within the ten investment sectors in Canada, the materials and energy sectors represent 18.4 and 26.7 per cent, respectively.  Combined, these two sectors alone make up 45.1 per cent of the TSX/S&P Composite Index (the “Index”).  Collectively, we refer to precious metals, commodities, materials, and energy as resources.  Resources have been steadily climbing as a combined weighting within the Index over the last decade.   When we review risk and reward charts with new clients resources are at the top meaning they have the highest potential return but also have the highest risk.     We would like to highlight some of the significant factors impacting the resource sector.  Advances in technology have made it easier for companies around the world to discover and extract resources with higher efficiency.  This has created more supply in this decade than previously expected.  Offsetting the supply side is an increasing demand from China and other emerging markets for resources.  A growing population, alternative energy solutions, environmental concerns, as well as political, economic, and natural events have all caused shorter term fluctuations in resources.  All of these factors have created a higher level of uncertainty surrounding both the shorter and longer term demand and supply for resources around the world.  Although Canadians may have a home country bias to investing, many of the investments within the Index are reliant on the world continuing to demand our resources. 
  •  The economy is the toughest component to analyse.  There is no hard number to look at or sector to classify.  What makes this challenging is that political announcements such as a stimulus package distort how people now analyse economic data.  We have seen days where bad economic data is released and the markets increase as people feel that governments will have no choice but to stimulate the economy through what is often referred to as quantitative easing.  Quantitative easing is effectively printing money which is inflationary and often causes materials, such as gold, to increase in price.  The flip side to this is when we have days where positive economic data is released and the markets have declined as the likelihood of quantitative easing is diminished.  With government bodies having provided stimulus in the past it does give investors another factor to consider.  What people actually do is often different from what they should do now that the potential for stimulus and government intervention is part of the decision on whether to buy, hold or sell. 
  • There are many other factors that determine the strategy of whether to hold a stock short term or long term.  Your risk tolerance and time horizon are key components to consider.  Your tax situation is also important as investors have the ability to carry net capital losses back three years and forward indefinitely.  Using strategy in this area often saves investors significant tax dollars.  Certainly it is nice when Canadians can take advantage of the taxation rules where unrealized gains on stocks are not taxed until they are sold.  Tax should always be secondary to making the right investment decision.  

In days past it was easier to buy a basket of dividend paying stocks and interest bearing bonds and hold them for a longer period of time.  A person could design a passive approach themselves and not worry about their investments during retirement.

It is more challenging to do this today given the increased volatility and low interest rates.  Investors have to work a lot harder these days.  Unless a person wants to be active every day monitoring their own investments it is advisable to have a professional you trust assist you.


10 benefits of stock-trade limits

The majority of stock orders are done at “market”.  This means that a person buying a stock is able to purchase it at the lowest price that other people are willing to sell it for at that moment – this is referred to as the “ask price.”  A person wanting to sell at market would receive the highest price that another person is willing to pay at that moment – this is referred to as the “bid price”.

During volatile times we feel that it is increasingly important that people set limit orders rather than market orders.  From the buy side, limit orders enable you to choose how much you would be willing to pay for a stock.  If a stock price hits the limit price, your order to purchase the stock would be filled if there are enough sellers at that price.  From the sell side, limit orders enable you to choose how much you want to receive for your shares.  If the share price does not reach that level you are content holding onto your investment.

Ten points to consider prior to your next buy or sell order:

1.  Discipline:  Limit orders provide the discipline to set prices in advance for orders relating to your investment account.  These orders help reduce the emotional aspect of investing.  The clients we work with appreciate the disciplined approach we use to both buying and selling.

2.  Quarterly Meetings:   Most limit orders are set for no more than three months and are monitored on an ongoing basis.  At every in-person or phone meeting the limit orders should be discussed as these are considered “open orders”.  Open orders are those orders previously entered but not filled.  At any time it may make sense to cancel or change an existing order or add another, depending on market conditions.

3.  Flexibility:  There is no cost to set limit orders, modify them, or cancel them.  If the market is moving in certain directions, then orders can be modified at any time, provided they have not been filled.

4.  Open Orders:  One item to watch is the total of all open buy orders.  If the market declines significantly, and all open buy orders are filled, you should ensure the account has enough cash to cover.  If not, you should consider cancelling some of the open orders.

5.  Lump Sum:  Often when people receive transfers from a pension, inheritance, selling real estate, there may be the temptation to invest the entire amount immediately.  We encourage people that are new to investing to take it slowly.  Limit orders allow the process to be slowed down and to ease into the market over various cycles.

6.  Limit Orders Within One Sector:  One strategy that has worked well for investors looking at three stocks in one sector is to prioritize the three by preference.  Stock A is your first pick, Stock B is your second pick, and Stock C is your third pick.  Consider purchasing Stock A at market, enter a limit order to purchase Stock B at two per cent below its current market price, and enter a limit order for Stock C at four per cent below the current market price.  If the market goes up, you own Stock A only.  If the market declines further then you could possibly pick up both Stock B and Stock C at lower prices.

7.  Sell Discipline:  After a buy order is filled, then consider a subsequent sell order at your desired profit level.  If you would like to set your target at 20 per cent profit then a stock you have bought for $20 could be entered with a limit sell order if the stock reaches $24.

8.  Intra-Day Swings:  The majority of people see the end of day values for indices and possibly look up the closing prices for the individual investments they own.  Stock price volatility has been extreme at times.  Even within a one day trading session we are seeing large swings in the indices and specific stocks.  Limit orders may assist with taking advantage of this volatility.

9.  Low Volumes:   Some stocks have very little trading on the exchange.  The finance term for low activity is thinly traded.  It is always riskier entering market orders on thinly traded stocks.  The spread between the bid (what buyers are wanting to pay) and ask (what sellers are wanting to sell for) is normally much wider on thinly traded stocks.  Often a better strategy for these types of securities is to set limits on what you would be willing to pay for the stock or what you would be willing to sell it for.  That way, you do not have to worry about the spread or watching an illiquid position continuously.

10.  Changing Position Size:  Another great use of limit orders is to use them for increasing or decreasing your position size.  Lets say you have 500 shares of ABC Company that you purchased for $20 per share.  The initial position size is $10,000.  If the share price increases to $25 then the market value of your investment would be worth $12,500.  One strategy may be to set a limit order to sell 100 shares at $25.  If the order is filled then your investment would drop down to the $10,000 level (400 shares x $25).   This same investor could have used a more conservative initial approach by purchasing 250 shares at $20 for a half position size of $5,000.  At the same time, a limit buy order could have been entered to purchase another 250 if the share price drops to $18.00 (a ten per cent decline).  If the price goes up then the investor is making an immediate profit.  If the price goes down then the investor is able to dollar cost average by buying the same number of shares for a lower price.

Rating your portfolio for the year ahead

If you had all your savings in cash today what stocks would you buy?   This is perhaps the best way to look at investment decisions.

People have the tendency to cling to losing stocks because they want to recover their initial investment back.   This is really not a healthy way to position a portfolio for the future.  Setting up for the year ahead involves selling your weakest names and looking for the best opportunities with the proceeds.

Let’s start by creating a five star ranking system for the stocks you currently own.   If you were to rank each individual investment with a star ranking (one being the least favourite and five being the best), how would your portfolio look?  To help with this exercise, rank the stocks on how you feel they will perform over the coming year (not on how they have performed).  Below is an example of how you could design your star categories.

One Star

Characteristics of this category would be stocks expected to lose money in the upcoming period.  The company doesn’t pay a dividend.  Analysts have either dropped coverage or have a predominately high sell ranking on the stock.  Stocks in this category may be in jeopardy of being removed from key indices because of declining market capitalization.  No clear direction from management on how the company will turn itself around.  Environment or conditions are not favourable for the company.  Investors should be concerned about the stocks long-term viability to remain as a going concern.  Recommendation for a one star stock is to sell immediately.

Two Stars

These stocks will have declining earnings in the upcoming period.  If the company is currently paying a dividend, it may be in jeopardy of being cut or cancelled.  Stocks in this category may have significantly declining fundamentals.  Companies in this category often have low cash levels or a high debt to equity ratio.  Recommendation for a two star stock should be to sell.

Three Stars

Stocks with earnings that are not expected to grow or decline significantly in the coming year.  In some cases these stocks may have been four and five star funds but have lost their shine.  In other cases they could have fundamentals that are improving.  People who are looking for longer- term stocks may see opportunity in this category, but likely not in the year ahead.   In other cases, this category may include stocks that have increased in value and you see very little additional opportunity in the year ahead.  Recommendation for a three star stock would be to consider mapping out a sell strategy.  Setting a limit order at a slightly higher price may be one strategy, or a stop loss order to protect profits.  We recommend you begin looking for switch ideas.

Four Stars

Analysts typically come out with a buy, hold, or sell recommendation on the stocks they cover.   In my opinion, the four star classification would be comparable to a “hold”.  Stocks in this category may have good earnings and growth; however, the valuation of the stock price may not justify this being a four or five star stock.  It is important that investors look at the market price of their stocks in this category to determine if it is amongst the best priced stocks to currently own.  Even great companies become over valued.  Recommendation would be to monitor the stock and possibly set a higher sell limit order if the stock continues to appreciate in value.

Five Stars

This category would include those stocks you feel are the best to own for the year ahead.  Be careful not to just include stocks that have done well in your portfolio in the past. Characteristics of this category are stocks that have a high overall expected rate of return for the year ahead.  This could be through both an increasing stock price and dividends.  It is typically a good sign when you are projecting that a company may increase their dividend.

Hopefully your portfolio has more four and five star positions.  The exercise helps maps out those stocks that you should sell either immediately or map out a plan to sell.  You will also be able to determine the estimated cash proceeds from those sells.

We also recommend you look at the tax benefits or consequences of selling.  Tax loss selling is something that every investor who has non-registered investments (cash or margin account) should look at this time of year.  You may be able to obtain some tax benefits by selling your under-performing positions.  When you do this analysis you should first look at whether you can reduce current year taxes, and second whether you can recover taxes paid in the previous three years (if you have net capital losses in the current year).

Whether you are dealing with current cash on hand, or proceeds from sells, the next step is to look at the best stocks to buy for the upcoming year – we will call this your wish list.  If we use the same classifications as above, then your focus should be on five star positions.  Investment advisors can discuss investment ideas that meet your investment objectives and risk tolerance.  Advisors also have various tools including access to fundamental and technical analysis screening tools, and internal and external (third-party) research.  Advisors also have the tools to map out expected income, sector analysis, risk levels, and how certain choices would be correlated to the stocks you continue to hold.

Comparing your current stocks to what you would buy today if you had 100 per cent cash is a great exercise.  The decisions on what stocks you sell can be as important as what you buy.  Creating a five star ranking system today can help you on both the buy and sell sides.

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.


Choosing the best long term investment options

Everyone would like high returns and no risk.  But having both is not realistic with all the economic news and market volatility.

It certainly makes it a challenge for people who are looking for the best option for investment savings and retirement cash flow.  This is especially the case for people who have retired and would like to have income without working any longer.

I’ll use a recent discussion that we had with a business owner who sold her company for $1 million.  She approached us to discuss her investment options with respect to the proceeds from the business.  We provided her with the pros and cons of each:

Option 1

Keep the funds in cash equivalents.  The main advantage of this approach is that she would not risk losing any of the capital.  Currently she could invest these funds in cash equivalents ranging from 1.3 to 1.5 per cent.  Assuming a return of 1.4 per cent on the combined amount, her annual income would be $14,000.  One con to this approach is that the funds she has to invest are all non-registered and investing it entirely in interest bearing investments means that the amount is fully taxable each year with no deferral ability.  Another con is that if inflation is 3.1 per cent, then purchasing power is being lost each year if the after tax returns do not exceed the rate of inflation.

Option 2

Invest in a five-year GIC ladder with $200,000 invested in each year (two different GIC issuers each year with $100,000 in each).  We estimated this would result in annual income being approximately $21,040.  One pro to this approach is that all investments would be Canadian Deposit Insurance Corporation (CDIC) and that total income would be approximately $7,040 a year higher than holding cash.  A con to this approach is that GICs generate interest income that is fully taxable and have no deferral ability.  Another con is that the before tax return of 2.10 per cent is still well below inflation.

Option 3

Invest in corporate bonds and convertible debentures.  The yields on these investments can fluctuate and is dependent on the level of risk assumed.  Let’s assume the average yield is five per cent.  The advantage of this approach is that corporate bonds and debentures can be sold at any time (at the current price) and can be purchased with longer term maturities.  Another pro is that coupon rates are higher than GIC options.  The con of this approach is that corporate bonds are not CDIC insured and debentures are unsecured.  Similar to GICs, bonds and debentures generate interest income that is completely taxable. Corporate bonds and debentures have a market value that fluctuates (and are often traded), especially when interest rates change.

Option 4

Invest in dividend paying preferred shares with an average yield of five per cent.  A pro of this approach is that equities generate dividend income which is tax efficient.  If the average yield is five per cent then the income would be approximately $50,000 annually.  Dividend income is taxed less than one half of what interest income is taxed after factoring in the dividend tax credit.  If times get difficult, companies would have to fully cut the dividend on the common shares prior to cutting the dividend on preferred shares.  Preferred shares should see less volatility than common shares, especially if interest rates stay low for an extended period.  Prior to investing in preferred shares it is important to understand the specific features of each type – they are not all the same.  One risk is that many preferred shares today are perpetual, meaning that they have no maturity date.  This means that they are very susceptible to changes in interest rates, especially if they do not have a reset feature.  Many of the new issues of preferred shares have reset features every five years that should be fully understood before purchasing.  It is important to note that some of these preferred shares could be reset at lower rates if interest rates continue to stay low.  Nearly all preferred shares can be called at specified dates; this is a benefit to the issuer, not you the purchaser.

Option 5

Invest in dividend paying common shares (referred to as blue chip equities) with an average yield of four per cent with growth potential.  Similar to preferred shares above, many large companies also pay tax efficient dividend income.  Unlike preferred shares, the dividend is not guaranteed and can fluctuate.  In good times a company may periodically increase the dividend and in bad times you hope they maintain the current dividend.  In some cases, companies are forced to cut or eliminate the dividend.  In addition to the dividend not being certain, the value of the shares on common shares can fluctuate considerably.  One benefit to investing in equities is that growth can be deferred until sold (realized) in the future.   If the average yield is four per cent, then the income would be approximately $40,000 annually.  The dividend component on a basket of common shares (i.e. four per cent) is normally lower than a basket of preferred shares (i.e. five per cent).  Common shares also participate in the success and failure of the company’s operations.  When purchasing common shares it is important to reduce risk by monitoring position size and sector exposure.

There is no easy option today when it comes to picking the right investments.  The best investment option really depends on the individual’s risk tolerance, time horizon, and other sources of income.  Generally looking at a long term balanced approach is the best.  A balanced approach refers to having a combination of all or some of the above.

Look long term when setting goals on return

Historical financial information on individual stocks and indices always show returns are unpredictable.

The last decade of annual returns from the TSX/S&P Composite Index range from a loss of 35 per cent to a gain of 31 per cent.

It can be a challenge to set return expectations with so much volatility in the short term.  Financial plans map out expected returns over a longer period of time.

When we begin working with a client we feel it is important to set reasonable expectations at the beginning of the relationship.  No advisor can guarantee returns on an investment portfolio.

It is reasonable that in some years your portfolio will do well and in other years your portfolio will have a negative return.  With increased volatility, projecting returns for financial planning has become more difficult.  Everyone would like clarity on whether they will reach their future financial goals.

A great question to discuss is what you feel is a reasonable return for your long-term financial plan.  This may be a tough question to answer during an introduction meeting, especially if risk tolerance and investment objectives are not known.

The first step we use to estimate returns is to look at asset mix, the percentage you would like to have in cash equivalents (savings accounts), fixed income (bonds, GICs, debentures, coupons, etc.), and equities.  The second step is to determine the types of equities you are interested in (low, medium, or high risk).  The third step is to set reasonable percentage returns for each category.  As an example we have outlined below some investment categories with projected returns.                     

Category Projected Return %
Cash Equivalents


Fixed Income


Equities (low risk)


Equities (medium risk)


Equities (high risk)


The above projected returns for cash and fixed income are easier to determine in the short term.  Projected equity returns are based on longer term historical performance but should also factor in current and projected future conditions.  Cash equivalents and fixed income are on the low side currently because interest rates are low.  Equity returns, as well, are on the lower side of historical averages given current economic conditions.  It’s also important to note that these are only projected and therefore, not guaranteed.

The fourth step is to map out what type of investment portfolio is most suitable for you.  Below we have outlined five options with projected long term returns, investment objectives, risk tolerance, expected volatility and a description of typical holdings.

Option 1:  Asset Mix: 25 per cent cash, 75 per cent fixed income.  Projected return is:  3.75 per cent [(25% x 1.5%) + (75% x 4.5%)].  Primary investment objective:  capital preservation.  Risk profile:  low.   Expected volatility:  positive returns every year.  Description:  holdings would be primarily Canadian money market investments, savings accounts, GICs, and bonds.  Investor Profile:  preservation of capital is primary goal and you would sacrifice some income and return potential to protect existing capital.

Option 2:  Asset Mix:  75 per cent fixed income, 25 per cent low risk equities.  Projected return is:  4.88 per cent [(75 per cent x 4.5 per cent) + (25 per cent x 6.0 per cent)].  Primary investment objective:  income.  Risk profile:  low to medium.  Expected volatility:  low to medium volatility, such as negative returns one in every eight years.  Description:  holdings would be primarily GICs, bonds, preferred shares, and lower risk common shares.  Investor Profile:  the provision of a steady income through interest and dividends is of primary importance, rather than growth of income or capital preservation.

Option 3:  Asset Mix:  25 per cent fixed income, 75 per cent medium risk equities.  Projected return is:  7.13 per cent [(25per cent x 4.5 per cent) + (75 per cent x 8.0 per cent)].  Primary investment objective:  growth and income.  Risk profile:  medium.  Expected volatility:  medium volatility, such as negative returns one in every six years.  Description:  holdings would be primarily corporate bonds, preferred shares, and low to medium risk common shares.  Investor Profile:  income requirements are low and the emphasis is on total portfolio return from both capital appreciation and income.

Option 4: Asset Mix: 100 per cent medium risk equities.  Projected return is:  7.0 per cent [(100 per cent x 7.0 per cent)].  Primary investment objective:  moderate growth.  Risk profile:  medium to high.  Expected volatility:  medium to high volatility, such as negative returns one in every five years.  Description:  holdings would be primarily Canadian, US, and international blue chip equities.  Investor Profile:  primary objective is growth of capital.

Option 5:  Asset Mix:   100 per cent high risk equities.  Projected return is:  8.0 per cent (100 per cent x 8.0 per cent)].  Primary investment objectivemaximum growth.  Risk profile:  high.  Expected volatility:  high volatility, such as negative returns one in every four years.  Description:  holdings would be primarily higher risk equities, including precious metals, small capitalization stocks, and emerging markets.  Investor Profile:  goal is to generate maximum long-term capital growth.

The above options highlight that equities typically outperform cash and fixed income in the long term; however, investors who venture into equities have to deal with increased volatility.  From a financial planning perspective, estimating investment returns is more challenging as you increase the equity component.


Managing emotions, money during volatility

Financial planning would be easier if markets returned a steady percentage each year.  Unfortunately this has never been the case for the stock market – and never will be.

The Elliott Wave Principle reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific and measurable patterns.

Illustrating how the markets have had their ups and downs can easily be looked at by summarizing the year-to-year returns for the S&P/TSX Composite Index for the last ten years:

2001 -13.9% 2006 14.5%
2002 -14.0% 2007 7.2%
2003 24.3% 2008 -35.0%
2004 12.5% 2009 30.7%
2005 21.9% 2010 14.5%

Even within the current year we have experienced a bit of a roller-coaster ride in the stock market.  To deal with these bumps, it comes down to your underlying belief about the current economic conditions and your long-term outlook.  Some people may feel that the current times are difficult and they do not see investment opportunity.  The other extreme is that any market pull back is an opportunity for long term investors. Having both bears (sellers) and bulls (buyers) really is the essence of what creates a market.

After nearly every period of volatility we read about how the wealthy are getting wealthier and the poor are getting poorer.  Some of the reports can be read through the economic data on the Conference Board of Canada website.   Historically the stock market has recovered from the problems of the day.  Knowing the history of the stock market and reading some of these reports, makes us reflect that it generally pays to be on the optimistic side when times get rough.

A lot is riding on a stable stock market.  Government bodies require returns on their investments and benefit from stable and growing markets.  Pension plans require returns on their investments to pay out benefits to retired employees.  Insurance companies collect premiums that must generate a return to fund future payouts (annuities, death benefits on life insurance).  Companies require stable markets to raise both debt and equity.

People who are able to survive best during periods of market volatility are those who have saved a little extra for retirement.  This buffer is becoming increasingly important during periods of volatility.  Some people are simply not saving enough for retirement.   Compounding the problem is that many of these same people have to take on too much market risk to generate the retirement income they need.  When times are challenging, the lack of proper retirement planning means some people are going to feel more anxious about their financial situation.

Being aware that the markets are volatile, and interest rates are low, means that investors are best advised to factor this into their financial plans.  Ensuring that you have a balanced portfolio with cash, fixed income, and equity investments at retirement is a critical step.  An example of a balanced portfolio at retirement is 10 per cent in cash, 30 per cent in fixed income, and 60 per cent in equities.  If you are able to generate sufficient income at retirement with this asset mix then weathering volatility should be easier.

Prior to retiring I feel it is critical to know how much income you require from your investment portfolio.  Knowing this in advance and communicating this to your financial advisor should enable them to map out the right asset mix.  Ensuring cash is available at the right times, will ensure that you are not selling equities at the wrong time in the market cycle.  Cash will protect you against bad timing in the short term to fund your cash flow needs.

There are different rules of thumb regarding how much cash you should have at retirement.   As a guideline, one year should be used as the minimum. Some investors are more comfortable with two years.  This cash component can give you the reassurance that investments do not need to be sold at the wrong time.

Purchasing fixed income investments that are laddered – like a bond maturing yearly for the next 10 – can assist in replenishing cash when needed.  With a laddered bond strategy it may be necessary to periodically rebalance asset categories of cash, fixed income, and equities.

As an example, we will use a couple who have income from pensions, CPP, and OAS.   In addition to this income they feel they will need to generate $30,000 per year from their $600,000 portfolio.  The cash flow needed for this couple is five per cent of their portfolio.  At a minimum they should have five per cent in cash at the beginning of the year, possibly up to ten per cent if they want to have extra security.

A downside to having this cash component is that the return on this portion in the long term is lower than other asset classes.  This is one of those sacrifices we feel investors should factor in to their retirement plans to protect against volatility.