Investment Strategies for Individuals

June 2017

Everyone, regardless of wealth, needs to examine his or her individual investment situation to make appropriate decisions. This requires a strong knowledge of investing, or a good investment advisor to help you. Even with an advisor, never invest without understanding the risks of what you are buying. I provide you with some guidance below, though I cannot offer specific advice on individual products because I am not a licensed security broker.

When looking at which types of investments to purchase, do an analysis that assesses the following.

How much can you afford to lose?
How much would your planned investments have to decline in value before you exceeded that limit? What are the chances that this may occur?
How hard and how long will you need to work to replace your losses?
Will you lose sleep when the stock market goes down (and it will!) worrying about whether you have lost your money permanently?

Remember that it is better to miss an opportunity than to be over-aggressive and lose your capital. There will be more opportunities, and without enough money, you will not be able to take advantage of them. Follow a specific investing strategy and change it only when you revise your financial objectives. Do not invest for emotional reasons; do not invest in something because it is the current trend (foreign equities and balanced funds are hot in 2016); do not take high risks unless you can afford to so and are prepared to maybe lose some of your capital; and, do not sell because of panic. Above all, always completely understand your investments and the risks you are taking.

Financial Planning 101

I believe everyone should live by some basic financial planning concepts, which I call “Financial Planning 101”

As a first step, you should have an emergency fund of 3 to 6 months worth of living expenses in safe, fixed income and cashable securities. This is to provide for the unexpected crisis for you, or for your loved ones, where you need money right away. Even if you have insurance to cover the emergency, insurance claims take time. Use of a line of credit requires money to repay it, which may not be available if your emergency results in a permanent loss of income. Use of money from an RRSP results in income taxes and a loss of retirement savings.
As a second step, I recommend that any cash requirements that you need within the next 5 to 7 years (or even 10 years if you are retired) should be in safe, fixed income investments. A laddered portfolio of bonds, term deposits, guaranteed investment certificates, etc. would be appropriate. Some financial planners may use a term of less than five years, but I believe that is risky. For example, it took over five years for the Canadian stock market to recover from the 2008-2009 decline of 50%. The purpose of this allocation is to ensure that the money is in place when you require it for needed expenditures, whether it be for car purchases, children’s education, house renovations, travel plans or retirement living expenses. If such money is invested in the stock market, a market decline could temporarily (or permanently) erode your portfolio. In such a case, you would need to incur losses to pay your bills because you could not wait for the stock market to recover. Remember, mutual funds are usually invested in the stock market. Also, time moves on, and remember to revisit your portfolio to adjust the mix as your need comes closer, such as your children’s enrolment in an education course after high school graduation. In my opinion, when your child is 12 or 13 years of age, your education fund should be moved to secure fixed income investments. When looking at guaranteed investment certificates versus a mutual fund bond or balanced fund, understand the difference. See my article discussing these products, Bonds and Bond Mutual Funds Versus GICs – Consider the Risks.
The final step is, if you do not need the money for 5 to 10 years, you can allocate that portion of your portfolio to a balanced and diversified allocation of equities and fixed income. However, this needs to be based on a number of factors, including your ability to take risks. Can you afford to lose money, because investing in the market always has that risk. Can you sleep at night if the value of your portfolio declines by 20 or 30%? Do you understand what you are buying? There are a lot more factors that a professional financial planner will review with you. Look for the education credentials to ensure you are dealing with a professional. Ask how he/she is paid and stays clear of a tendency to sell you something so he/she makes money while you take all of the risk.

Investing Versus Debt Repayment

You should always look at paying down personal debts that are not tax deductible before making other investments, other than establishing your emergency fund. (Your emergency fund should be available for immediate use to meet expenses in the event of an unforeseen problem. I recommend that you always maintain an emergency fund of at least $25,000, and preferably a balance sufficient to replace three months of income.)

Depending on the interest rates involved and the investment returns being realized, paying down debt may be better than investing in securities. For example, consider an individual with an income level between $57,000 and $115,000 in PEI and a loan of $100,000 at 8% where the interest is non-deductible. In order to pay the 8% interest on the loan, the person would need to earn 12.5% in interest income in order to have enough cash after tax to pay the loan interest. Taxes on $1,250 of interest would be about $450, leaving $850 left to pay loan interest of $800. Unless this person can make over 12.5% in interest, paying off the loan is the best choice. If that individual’s income level is above $115,000, the investment would have to earn interest above 14.5% to be a better alternative. The rate of return for capital gains need not be as high, but one must question whether taking risks in the stock market is appropriate for a person with non-deductible personal loans.

Rate of Return

Always consider the returns on your investments after deducting income taxes (and fees), since various types of investments have different rates of tax applied. Taxes are calculated differently for interest, dividends, and capital gains with each form of income having advantages and disadvantages. However, never buy an investment solely for tax reasons. What is reasonable to expect for returns? The FP Canada Standards Council provides recommendations to Certified Financial Planner professionals on what is reasonable for long-term retirement projections in their annual Projection Assumption Guidelines. Review them to see if your advisor is being reasonable, and ask for their reasons if they are being more optimistic than the largest association of financial planners in Canada. With a balanced portfolio of 50% in the stock market and 50% in fixed income, the Guidelines are usually recommending using a forecast rate of approximately 5% for “do-it-yourself” investors, and 3-4% for those using mutual funds or paid advisors.
Examine published reports carefully to ensure you understand the returns. Look at annual returns by year, and average annual compounded returns over time to determine volatility and long-term success, respectively. Watch out for “cash on cash” rates of return (often quoted for Income Trust securities) because these are not based on actual profits earned. Do not include return of capital (i.e. a return of your own principal) in a calculation of a rate of return (take care when looking at income trusts and annuities). Returns that are not annualized may not be meaningful. A 100% return is very bad if it is over 20 years! After-tax returns quoted based on a 50% tax rate are not applicable to you if you are in the 25% bracket.
Compare your returns to benchmarks to evaluate your performance. One benchmark is to compare your rate of return on each investment or type of security (e.g., Canadian, U.S., global) to the average performance of all such securities. Another benchmark is to compare your total portfolio return to your original financial plan prepared by your advisor – this should be done each year to ensure you are achieving your targets. See my article, “Questions to Ask Your Financial Advisor” for more details.

Building Portfolios

Never invest your “emergency fund” in long-term or illiquid securities. These funds should be invested in fixed income products such as cashable term deposits, Treasury Bills, Canada Savings Bonds, Credit Union Deposit Receipts, high interest savings accounts and similar investments.
Build portfolios gradually, starting with safe and liquid products and progressing to a more aggressive and diverse portfolio. Statistics show that a “buy and hold” strategy is usually more effective than trying to “time the stock market”. Timing the stock market means attempting to buy equities in anticipation of a quick rise in value and selling shortly thereafter. Always invest in quality investments, not speculative stocks.
Consider use of “dollar cost averaging” to buy securities on a monthly basis. This creates a systematic savings plan allowing you to increase your net worth gradually without seriously affecting your budget. This method automatically imposes a good policy on buying practices. By depositing the same amount each month (5% to 10% of your income is recommended) you will be purchasing more shares or units of an investment when the price drops, and fewer when the price rises. This method also eliminates the risks of trying to time the market where there is a risk of making a big purchase immediately before a market correction. Use of dividend re-investment plans achieve similar benefits, and eliminate buying commissions.

Leveraging

If you are considering borrowing to invest (known as leveraging), or using life insurance products as an investment vehicle, request a cost/benefit analysis from your advisor showing the worst case scenario as well as the most likely scenario. Optimistic assumptions often hide the risks involved. Obtain an understanding of these risks, a comparison to other alternatives, and then a second opinion. Also make sure that you understand the terms of borrowing, the ramifications if the investment value drops, the repayment schedule, and the income tax treatment. Leveraging magnifies your results, whether gains or losses. Before you pledge your house as security, decide whether you will be comfortable with the debt payments in your retirement years, especially if the mortgage exceeds your portfolio value due to a market crash. Quite bluntly, borrowing money to invest is for rich people, for people with the mortgage used to buy their home fully paid off, and/or for people who can repay the loan without using any of the income or principal from the investment they are purchasing.

Tax Shelters

When considering the purchase of a tax shelter, you should always evaluate the prospect of good investment returns prior to considering the tax benefits. And remember, a Canada Revenue Agency registration number and/or an opinion letter from an accounting or legal firm does not guarantee that the Canada Revenue Agency will accept it for tax deduction purposes or that it is a good investment.
While everyone’s goal is to minimize income taxes, you must also remember your long-term objectives, which require good, long-term investment returns. If you purchase a tax shelter costing $10,000, saving $5,000 in taxes and you never recover the balance, you have incurred a loss of $5,000. If you invest in a fixed income deposit for $10,000, you may pay tax of $500 on each $1,000 of interest earned, but your principal is safe and you will have an increase in your net worth of $500 rather than a loss of $5,000.
When buying tax shelters, you should also be aware that the legal, brokerage and various other fees associated with the product might have inflated the price above its normal fair market value. As a result, it may take longer for you to realize an increase in your investment value.
While not an investment, one of the best ways to save taxes is to donate to charity. Donating cash will save you almost 50% of the donation for donations in excess of $200 per year, and if you transfer your stock market securities directly to the charity instead of selling them first, you will not need to pay any capital gains taxes on them.

Systematic Withdrawal Plan

A plan where regular monthly withdrawals are made from your investment portfolio to provide you with cash flow is called a “systematic withdrawal plan”. If you are planning to use a systematic withdrawal plan to remove money from your portfolio, base the withdrawal rate on a percentage of its fair market value, not at a flat fixed rate. This way, you will sell more shares or units (draw out more money) when the market is up and less when it is low. Selling more when the market prices are higher is good planning. The downside of this percentage method is that your monthly income will fluctuate, maybe requiring periodic adjustments to your percentage withdrawal rate. Some brokers recommend a fixed amount for the monthly withdrawal. Fixed rate withdrawals result in selling fewer shares when the prices are up and more when prices are low. Is this what you want to do? Better yet, avoid systematic withdrawal plans by using a properly diversified investment portfolio to generate regular income for you, and/or withdraw principal only from the fixed income part of your portfolio whenever the market is down.

Diversification

As stated earlier, a portion of your portfolio should be in an emergency fund, invested in liquid safe securities.
Any cash you need within a short-term time horizon (five to ten years) should be invested in safe fixed income products, maturing when you need the cash. Unless you are invested in mutual funds, establishing a “ladder” of five year guaranteed investment certificates with 20% maturing each year is recommended to minimize risks of fluctuating interest rates.
Money you will not need within five to ten years may be invested in long-term securities. This should be a mix of investments ranging from safe guaranteed securities to higher risk products in the stock market, but governed by your willingness to accept risk and your ability to understand your investments. Remember, the often quoted stock market growth rates are averages. Unless you buy something like an Exchange Traded Fund that mimics the entire market, your return will not be the same. With a mutual fund that attempts to beat or match the market, the fund manager must first exceed the market rate by 2 – 3% to cover their fees. See this web site to look at the performance of funds against market averages – click on the heading for “indices” across the top to see historical averages for various investments, including bonds (fixed income).
Both fixed income securities, equity market products and other investments can be diversified to minimize your risks. Risks include losing your money as well as underperformance of your rate of return. Speak to your investment advisor to ensure your risks are minimized.

I wish you well in your investment strategies. One final reminder – if you are working with a financial planner, and preparing projections for the future, you may wish to ensure your planner is using reasonable assumptions. If he/she is not doing so, ensure you understand the reasons and be sure you accept them.

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Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum