Where and how to invest?

The eternal question for investors is: How and where should they invest their money?

More specifically, how should they divide their investments between equities, fixed income, and cash? Regarding stocks, should they focus on dividend stocks? Should they invest strictly in their home country or should they diversify internationally? Where can they find trustworthy advice? How much risk is appropriate? Can stock picking and frequent trading beat buy and hold index investing?

To fully answer all of these questions would likely require a thick book and perhaps a book customized for each individual. Nevertheless I can offer some brief basic guidance on these questions.

To lay the groundwork, let’s start with a few basic definitions. My definitions may or may not precisely match textbook definitions but are intended to provide an accurate and basic understanding.

Definitions:

Equities represent ownership shares in corporations. Investors can directly purchase shares in individual corporations whose shares trade on various stock exchanges around the world. Another way to invest in equities is through equity mutual funds. Equity mutual funds purchase shares in a relatively large number of companies and then sell units of the fund to investors. This can provide a convenient way to invest in a broadly diversified fashion without having to buy shares in many individual companies. However not all equity mutual funds are broadly diversified. Many of them target only very specific types of companies. Others target, for example, only European companies, or even, as an extreme example, only small companies in South Africa. Equity mutual funds charge fees ranging from about 1% to about 3% annually. The annual fees are taken out of the fund and investors may not be aware of them. These fees go to the fund managers and a portion usually goes to the individual investment advisors who encourage their clients to purchase a particular mutual fund. There are some mutual funds that strictly emulate a broad index such as the S&P 500 index and which do not pay fees to advisors and which therefore have much lower annual fees. A third way to invest in equities is to purchase exchange traded funds (ETFs). These usually have (much) lower annual fees than mutual funds. Like mutual funds there are ETFs that emulate broad market indexes and also ETFs that invest strictly in extremely specific companies such as only in mining companies in Australia.

Fixed Income refers to investments that “promise” to return a fixed amount of dollars per year and which usually also return the original investment at a known future date. Two broad categories of fixed income are government and non-government (corporate). Another way to categorize fixed income investments would be those issued in the currency of your home country versus those issued in other (foreign) currencies. Yet another way to categorize fixed income is short-term versus medium- and long-term. Common types of fixed income investments include individual corporate and government bonds, bond mutual founds, bond ETFs and bank guaranteed certificates of deposit (GICs). Fees apply for bond mutual funds and bond ETFs. Not all promises associated with fixed income investment are created equal. Government bonds of “first world” countries are usually considered risk free in terms of delivering the promised cash flows. The risk associated with corporate bonds depends on the current and future financial strength of the corporation and ranges from extremely low risk to extremely high risk in terms of delivering the promised cash flows. The risk associated with bond mutual funds and bond ETFs depends on the underlying investments they hold.

In addition to the risks associated with delivering the promised cash flows, many fixed income investments also subject investors to the risk of price declines. These can be associated with changes in interest rates and changes in the credit worthiness of the issuer.

Cash refers to investments in cash deposit accounts or in near-cash investments such as a 30-day government treasury bills (government bonds of less than one year maturity are usually referred to as treasury bills). Money market mutual funds are also usually considered to be classified as “cash”. Short-term corporate “commercial paper” is effectively a very short term loan to a corporation and may be considered to be “cash”. In general, an investment should only be considered to be “cash” if it can be converted to actual cash on very short notice and if it is virtually risk-free. Investors hold cash in investment accounts for various reasons such as to provide stability to a portfolio, for upcoming spending needs, or to provide the ability to make investments if an attractive opportunity arises.

The Asset Allocation Decision

The division of your investments between the three broad categories of equities, fixed income and cash is referred to as the asset allocation decision. The appropriate allocations differ greatly for different individuals. In rare cases it might be appropriate to hold 100% of the the investments (assets) in cash. This might be the case if the investments are shortly going to be spent to buy a house for example. In the case of a young person just starting out investing and who who is prepared to accept volatility a 100% allocation to equities could be appropriate. For an elderly person who is relying on the income stream from the investments and who also has a very low emotional tolerance for risk it may not be appropriate to include any allocation to equities.

Equities are generally expected to provide the highest return in the long run but can be extremely volatile in the short term. For example, a 50% decline in the value of even a very diversified index such as the S&P 500 may be rare but is never out of the question. 10% declines occur frequently enough that they should really not even be newsworthy. Individual stocks can fall to zero in the event of bankruptcy.

Fixed Income is generally expected to provide a lower long-term return than equities while being less volatile. However, long-term fixed income investments can decline precipitously in value if interest rates soar. But, such a decline will usually be recovered by the time the investment matures. Also an individual corporate fixed income investment can fall to zero in the event of bankruptcy of the issuing corporation.

Often, fixed income investments will not fall at the same time as a decline in equities and this provides diversification and stability to a portfolio. But sometimes both equities and fixed income investments can fall at the same time.

Cash, as of 2015, can be expected to provide very little or no return. But it also remains perfectly stable in monetary value and therefore provides stability to portfolios. An allocation to cash also makes available cash for spending or to quickly make investments if an attractive opportunity arises.

It is risk tolerance that has the largest impact on an appropriate asset allocation. A higher risk tolerance argues for a higher allocation to equities. Risk tolerance is often thought of as purely a matter of emotion and temperament. However, I would divide risk tolerance into financial risk capacity and emotional risk tolerance. A person with a very secure job, an employed spouse, a company pension plan and a paid-for house and who is some years from retirement has a high financial risk capacity in regards to their retirement investments. And this is true no matter what their emotional tolerance for risk. Emotional risk tolerance refers to how one feels about and reacts to losses in the market. It is not a good idea to be heavily weighted to equities if your reaction to a stock market decline is likely to be to sell the equities. It is my belief that many people can and do learn to increase their emotional tolerance to risk over time as they gain experience. It is also true however that people often over estimate their ability to be calm during market corrections. That is, they have a high emotional tolerance for market declines until it actually happens and then suddenly they realize they actually have very little emotional risk tolerance.

One of the main factors that influences financial risk capacity is the length of time before any or all of the money is needed for spending. A longer investment time horizon increases the financial (though not necessarily the emotional) tolerance for short-term volatility in the portfolio and therefore allows a higher allocation to equities. Age is often used as a proxy for the time horizon but it is not always an accurate proxy. Most elderly people would be considered to have a short investment time horizon. However, a wealthy person of age 95 who has a large portfolio that is intended to be left for a foundation to make charitable donations for decades to come actually has a very long investment time horizon.

The fact that investors’ financial and emotional risk capacities and tolerances can vary widely and that they are not easy to identify is why registered investment advisors are required to explore and document these matters for each individual client.

Advisor Based or Do-it-Yourself Investing?

Almost all beginning investors and even most experienced investors need and appreciate help with their investments and will choose to use some type of advisor. There are those that will argue that all financial advisors are basically unneeded parasites sucking fees from client accounts and not adding any value. They are wrong. In fact, many investors would never even have got started investing if some advisor had not encouraged them to do so or at least facilitated the process.

The following are some of the main types of financial advisors:

Mutual Fund Advisors – This includes junior investment advisors at bank branches, and advisors from InvestorsGroup (there may be other large outfits like this but I can’t think any), it also includes many independent mutual fund advisors. These advisors are typically licensed only to sell mutual funds and cannot put your investments into individual stocks or ETFs. This category would also include various independent insurance brokers and financial planners who are licensed to sell mutual funds. These advisors usually have access to software that will assist in the asset allocation decision. They can usually provide financial plans. These advisors are often the best choice for beginning investors who will usually start out with a small amount and add to that monthly or annually. The fees may be relatively high as a percentage of assets but tend to be low in terms of absolute dollars paid because the portfolios tend to be smaller. In some cases it is reasonable to remain with these advisors even as the portfolio grows large especially if a reduction in the fee percentage applies.

Advisors Licensed to Sell Stocks – Full service brokers and some senior bank advisors are licensed to invest clients in individuals stocks and, importantly, ETFs. These advisors are more suited to those with larger portfolios and could lead to lower fees.

Portfolio Managers – These advisors are licensed to make discretionary trades in a client’s account. They may charge a 1% to 1.5% flat fee and then basically take care of everything and just report to each client periodically how things are going. They will typically accept only those with large portfolios.

Fee-Only Advisors. – These are relatively rare. These are independent licensed advisors who will complete a financial plan for you and or will meet periodically with clients on a flat fee basis. They will not invest money for clients but provide advise only.

Do-it-yourself investors, as the term implies, basically do not rely on advice. These investors use a discount broker (there are many choices and all of the large banks offer a discount broker service). These investors can easily access stocks, ETFs bonds and mutual funds through their discount broker. They are on their own as far as developing a financial plan and determining an asset allocation and deciding which investments to make. However, they may also get be able to get a financial plan and a suggested asset allocation free from a bank financial advisor. Do it yourself investors typically source investment ideas from many places including reading the financial news, watching financial television shows, and/or subscribing to various investment newsletters and magazines. Ultimately they are on their own as to the individual investments selected. This can be a good approach for some people. Others however may unfortunately ultimately end up feeling that in acting as as their own advisor, they have a fool for a client.

Country and Regional Allocations

Some investors will choose to invest in companies (and in fixed income and cash) strictly in their own country. Others will include one or even many other countries. Most Canadians will invest part of their funds in United States companies and some invest globally.

Investing outside of your own country provides diversification of the performance because in any given year the stock markets of various countries perform differently. And in general it is not the same countries that out perform each year. It also can provide diversification of investment choices. This is true for Canadians because the Canadian stock market is lacking in certain segments such as large consumer product brand name companies and is lacking in, for example, large pharmaceutical companies. It can also provide the opportunity to invest in high growth countries such as China or in emerging markets.

Investing outside of your own country also necessarily introduces currency risk (although for mutual fund and ETF investors it is often possible to choose funds which hedge away the currency risk). Accepting currency risk may be beneficial if the currency of your home country tends to fall relative to foreign currencies over time.

Canadian investors often have a natural hedge when it comes to U.S. currency investments since most will at some point wish to spend time and money in the U.S.

Most investors achieve country diversification through broad mutual funds and ETFs rather than by attempting to select individual stocks in foreign countries.

In regards to fixed income it is generally not important to diversify by country. The main reason to do so would be if one suspected that the currency of the home country was going to fall relative to foreign currencies.

Index investing versus selecting individual stocks or specialized mutual funds and ETFs

All investors, including those invested strictly in mutual funds, should consider whether they wish to be passive index investors or instead wish to skew their investments towards certain segments of the market or (except for mutual fund and ETF investors) to certain individual stocks and bonds. Skewing your investments away from the broad indexes is known as active investing. Many investors have made this choice without really thinking about it or their advisors have made the choice for them.

By “index” I refer to broad indexes such as the S&P 500, the Toronto stock exchange index or a world equity index. These equity indexes measure the average return from investing in the stock market of a particular country, a region of the world or even of the entire world. There are also indexes that measure the average performance of fixed income investors in a particular country or the world. When I refer to investors beating the indexes, I refer to an investor’s return being better than a strategy of passively investing in broad indexes with the same asset and regional allocations. Anyone attempting to beat the indexes is by definition, to some degree, an active investor.

In thinking about this choice between passive and active investing consider the following:

It is a mathematical fact that the average passive index investor will make the same return (before fees) as the average active investor. This is so because the index is by definition the average of all investors, and if passive investors earn the index amount then, on average, so must the remaining investors, the active investors. Since active investing involves higher fees, the average active investor will under perform the average passive index investor. And this is true over every time period – every minute, every day and every decade.

It is also a mathematical fact that the top achieving individual investors over every time period will always be active investors. There are always some people beating the index. Equally, however, there are always some active investors trailing the index. Most active investors will tend to beat the index some years and trail it other years. On average, active investors experience more volatility in their portfolios than do passive index investors. There is some debate as to whether anyone ever beats the index in the long term except by luck. I happen to be of the view that some people can beat the index in the long run through skill in market timing and skill in selecting (and selling) individual investments. However, I do recognize that it is difficult to do and that only a small percentage of active investors will succeed in beating the indexes over the long term.

Beating the index, if it can be done, is very rewarding in the long term. Consider that $100,000 compounded at 7% for 35 years grows to just under $1.1 million. But at 10% it would grow to $2.8 million.

My conclusion based on the two mathematical facts above is that most people should choose to be passive index investors. This will lower their investment fees and reduce the volatility of their portfolios. Only those who are convinced that they have the personal skill and knowledge, or the access to superior advice, that results in a rational expectation of beating the market indexes over the long term should consider deviating much if at all from a strategy of passive index investing.

It is true that investing in individual stocks is simply more interesting and exciting than passive index investing. There can be a certain psychological joy or benefit in, for example, owning shares in some of the businesses where you shop or that you hear about in the news. For that reason many investors may decide to allocate a certain small proportion of their portfolio to active investing even if they have no good reason to expect to beat the indexes.

Dividend versus non-dividend stocks

Some investors elect to favor or even to invest exclusively in dividend paying companies. Investors should be aware that this is implicitly an active strategy that attempts to beat the equity index.

In some cases, this is done because investors believe that capital gains on stocks are somewhat arbitrary and do not represent “real” returns. In fact the stocks of profitable companies tend to rise, albeit very irregularly, over time as they retain and invest part or all of their earnings for growth.

These dividend-stock-only investors should also keep in mind that even dividend paying stocks can fluctuate greatly in value. The fact that a stock paid a 3% dividend will provide cold comfort if it declines by 50%.

Dividends provide cash for withdrawals. But a non-dividend paying stock can also be sold at any time to provide cash.

Dividend paying stocks have their place. But investors should be cautious about avoiding all non-dividends paying stocks simply on the basis of incorrect but common statements such as “only dividend returns are real”.

My strategy is to invest in the stocks that I believe will offer the best returns regardless of whether they pay a dividend or not.

Conclusion

This article has provided general information about how and where to invest. For those do-it-yourself investors that are looking for individual investment ideas, (despite my indication that beating the indexes is difficult) we have a service that rates selected Canadian and U.S. stocks and some Canadian fixed income choices as Buys or Sells and provides our full and detailed reasons behind the ratings, Click the link for more information about this product.

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January 12, 2015 (with minor edits to September 26, 2017)

Shawn Allen, President

InvestorsFriend Inc.