Successful Investing Starts with the A,B,Cs

March 13, 2012

By Heather Compton

Successful Investing – Begin at the Beginning

Particularly at this time of year as investors are wondering how to invest recent RRSP contributions I am asked for suggestions.  Some are certain there is a “magic bean” that will revive portfolios that have lagged their expectations. When I, in turn, ask some basic questions about the current composition of their portfolios most can’t readily answer me.

If we listen at cocktail parties there is always someone who claims to have experienced great success taking the long shot or over-weighting a particular holding they had a good feeling about.  Somehow we never hear from the investor who shot themselves in the foot loading up on Nortel or Bre-X Minerals.

Successful investing for the average investor requires first that we diversify our portfolio – by asset mix, market capitalization, investment style and geographically and then that we reduce investment costs so they don’t put a drag on portfolio returns.  We begin at the beginning, with asset mix – that combination of cash, fixed income and equities that balances our appetite for risk with our need for return.

Cash Isn’t Always King

Cash investments mature in one year or less and are typically viewed as “risk free” if we assume risk looks only at the possibility of the investment declining in value from its purchase price.  Cash investments include money market mutual funds, cash-able Canada savings bonds, Government of Canada Treasury Bills, short term GICs, and bank savings accounts including higher rate accounts.

The key features of cash and the reason to dedicate a portion of the portfolio to it is that it provides liquidity and opportunity.  Liquidity is the ability to get our hands on funds quickly in the event of either emergencies or a serious market decline when we don’t want to be forced into selling equities. Opportunity is having cash on the sidelines that allows us to act promptly to the buying opportunities provided by those declines – I refer to it as keeping some powder dry.

What cash doesn’t provide in this era of low interest rates is return – especially if measured as after tax, after inflation return.  High interest savings accounts such as those offered by ING currently pay 1.5%…a darn sight better than the .25% rates offered by the major banks but none of us will achieve or maintain a comfortable retirement lifestyle at those rates of return.  It may not be king but cash should still have a place in the portfolio, ranging from 5% to 15% depending on your needs for liquidity.

 

Add Some Ballast to the Boat

Fixed income investments are fixed rate investments with maturities ranging one year and longer, in the case of Canada’s bond market, up to 30 years.  They include corporate and municipal, provincial and federal government bonds, 1 to 5 year GICs, non-cashable Canada Savings bonds, and bond mutual funds.

High quality fixed income securities are added to the portfolio to provide stability, reduce volatility and add a measure of income.  It’s the ballast or “sleep night” component, with my clients I referred to it as the “granny money”.  If we purchase a quality bond it will pay interest semi-annually every year until its maturity date and at maturity we will get back the face value of the bond.  If we purchase it during a period of high interest rates and rates subsequently decline, as they have for some years now, we may also have the bonus of a capital gain by selling our bond prior to maturity.

Notice I said high quality.  Some investors take on significant risk on this side of the portfolio – buying lesser ratings, longer maturities, foreign markets or stretching the definition of fixed income to include securities like REITs, preferred shares or other securities that aren’t technically fixed income in order to reach for higher return.  I prefer to take my risks on the equity side of the portfolio and let the fixed income component provide the relative stability.  My inner “Chicken Little’ needs to know that some piece of the sky isn’t falling.

Conventional wisdom used to suggest that our fixed income percentage should match our age – 40% if you are 40 years old, 50% at age 50 and so on – getting more and more conservative as we age.  Knowing I come from long-lived stock that’s too conservative for me, I believe I’ll need more growth to ensure I don’t outlast my money.

 

With Equities We’re Owners

The last component of asset mix is equities – shares of publically traded companies, and for some investors, privately held companies. There are some rights that come with our share purchase; after all, we’re owners now.

It’s on the equity side that some of us lose our nerve as this is also the portfolio component with the greatest volatility.  During periods of large declines like 2008/2009, many of us lose heart and sell equities at a loss, lacking faith or confidence that the market will eventually rally.

Measured over longer time frames equities typically outperform other components of the portfolio and that’s the key reason we add them to our portfolio for growth.  This growth generally comes in the form of a capital gain – the shares rise in value over our purchase price but we may also earn dividends if the company pays out a portion of their earnings to shareholders.

 

Slicing the Pie

Generally it is on the equity side of the portfolio that we slice the pie further into both large capitalization companies – like the big Banks and small caps like junior oil and gas stocks.  Capitalization is a measure of the share price multiplied by the number of shares outstanding in the market.

We tend to favour large cap companies as they are generally stable, solid companies with slow and steady growth but a dash of small caps can provide impressive leaps in share value –  or they can fail spectacularly.

Individual companies and managers of equity funds can exhibit different characteristics or investment management styles, generally referred to as value or growth.  Incorporating both styles or consciously choosing one or the other adds another level of diversification.

We also intuitively understand that not all countries are performing well at the same time and Canadian companies represent only a small percentage of world markets.  We will want to diversify geographically – adding the United States, Europe, theFar East and other countries.

Liquidity, Stability and Growth – We Need It All

It sounds complicated doesn’t it?  I like to take my cue from professionals like those that manage our own Canada Pension Plan or the pension plans of major corporations to see how they diversify.

They typically choose a “balanced” portfolio – in the range of 40% cash/fixed income and 60% equities.  On the equity side a common split is to have the 60% equity allocation split 20% Canada, 20% U.S., and 20% International.  They add large cap/small cap diversification by splitting out a small allocation to small cap – 3% to 5% with the balance going to large cap holdings.

This style of investing will never knock the ball out of the park – that result is dumb luck, not good sense.  This is the solution that a frugal Scot utilizes to sleep at night and keep the game in play.  I call it winning by not losing.  It’s a long-winded answer to “what should I buy”?  My answer to that question is “how are you presently diversified”?

We’ve looked at the “magic bean” part one – diversification, next month we’ll look at the other aspect of the “magic bean” – how to do it inexpensively.

About the Authors: Heather Compton has presented seminars on financial and retirement lifestyle issues for over 30 years. She retired as Vice President and Senior Investment Advisor with a major financial services company. Heather and husband Dennis Blas co-present retirement seminars for a variety of corporate clients and are the co-authors of Retirement Rocks! Canadian Boomers Invest in Life. You can find their book online or in independent bookstores. See more of their advice at Retirement Rocks.

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