Growing The Pile


By Andy Holloway

Source: Financial Post Magazine

 

Now that you’ve built up a tidy little nest egg, you have to manage and protect it so that it can grow. That’s not as easy as it might sound.

The Market Value of the Toronto Stock Exchange composite index has averaged 5,119 points in its 91-year existence. But during that time it has closed as low as 64.2 points and as high as 15,073.1 points. Interesting stuff for market stat junkies, but what the spread points out is that the value of a diversified stock portfolio, while desired, is largely driven by the whims of the market. That’s fine if someone has all the time in the world, but the reality is we usually need to dip into our nest egg — or take it all out — at specific times. And a lot of investors dropped out of the market during the most recent recession. So many that it seems they may have overcompensated. More than $1 trillion was socked away in GICs, bank accounts and money market funds at the end of June 2010. Further proof of investor cautiousness: Assets held in premium savings accounts grew 25% during the previous 12 months.

To be fair, it’s hard to sit passively by while the value of equity portfolios plummets. The shock of seeing a 10%, 20%, even 30% drop in value on a quarterly statement is enough to spur panic selling. For the steely few, though, such a decline means a chance to double down and buy more stocks, especially those that pay a steady dividend. Take Royal Bank of Canada’s stock (TSX: RY). It was around $60 a share prior to the financial crisis and then dropped to less than $28 in February 2009, although the dividend remained a consistent $2 per year. “When Royal Bank was under $30, the dividend yield was 7%. Here’s a chance to buy a whole bunch more of this stuff at a price nobody had ever seen before,” says John Nicola, founder of Nicola Wealth Management in Vancouver. “Did everybody get excited and buy Royal Bank? Absolutely not.”

The reason for investors’ reluctance was simple: Emotion trumped investing sense. Of course, taking all the emotion out of investing is impossible, but being aware of it can prevent some rash decisions, and minimizing it means you can take advantage of market dips to grow your wealth at rates better than those offered by savings accounts. “People don’t like their net worth to shrink over time, therefore, that makes them net buyers of assets for the rest of their lives,” says Nicola. “If you’re going to be a net buyer of anything over time, you don’t always want the price of it to keep going up. You want things to be on sale once in a while.”

The key to minimizing the impact of market disruptions, says Nicola, is to create a portfolio that has as many income streams as possible. It’s simple in theory: The more cash flows an investment has, and the more reliable those cash flows are in the form of income, the safer the investment. Dividend-paying stocks, healthy bonds, rental real estate and even private equity placements in profitable companies are just a few investments that offer steady streams of income while, with any luck, offering capital gains potential in the future. Nicola calls this a cash-flow portfolio, and about a third of it is devoted to equities — about the same percentage that the very wealthy have, according to the Capgemini World Wealth Report.

Maintaining the equity portion of your portfolio can be a bit of a trick if you’re managing your own accounts. That’s why investors need to establish upfront how much of their asset base will be in equities and then stick to it. “No matter what’s going on around them, how positive or negative things seem to be in the economy, investors really need to stick to a discipline,” says Marilyn Trentos, a portfolio manager and investment advisor at Toronto-based RBC Dominion Securities. “Then when the market does its topsy-turvy thing, it forces you to rebalance and go back into the market.”

Another way to enforce discipline is to buy dividend-paying stocks and then set up a dividend reinvestment plan, which Trentos calls a “magical formula” for building wealth. Trentos also likes preferred shares, although they can be more complicated than owning common stock. Combining the properties of both equities and debt instruments, preferred shares often have fixed dividend amounts, but they tend not to appreciate as quickly as common stock and rising interest rates can make them less valuable over time. They also have five-year rate resets, as well as retraction or redemption features to muddy the waters.

But a big bonus of preferred shares is that any dividend income they yield is treated more favourably come tax time. “The bottom line is you’ll pay less than half the tax on dividends on a preferred share than you would on interest on a bond,” says Nicola. And in the best-case scenario, preferred share dividends can be tax free. Paying less tax means your investment’s real rate of return improves. For Duane Bentley, Investors Group’s regional director in Barrie, tax-efficient investing just makes sense. He simplifies the idea down to the three Ds: defer, deduct and divide (or income splitting). But while RRSPs are one of the few legitimate tax havens for Canadians, Bentley says investors shouldn’t forget about using tax-free savings accounts for both retirement savings and income generation. “More often than not, the files we’re reviewing have short-term cash in TFSAs,” Bentley says. ” It seems counter-intuitive to have a low-yield investment inside a TFSA, because it has the ability to have tax-free growth and tax-free withdrawal.”

Of course, none of these strategies work effectively unless there is an overall plan. “Unless you have absolute definitive goals attached to your investments, it’s just something moving forward with no sense of direction,” says Bentley. And that’s when emotion, not common sense, can take over.

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