Blind adherence to an asset allocation model may not always prove optimal. We suggest a seemingly counter-intuitive, but more flexible, approach.
Many’s the investor who, when faced with retirement and the need to generate a steady flow of cash from his or her investments, turns exclusively to GICs, bonds and preferred shares for yield. We consider that a mistake. And after several decades of declining inflation, it’s a much riskier strategy now than at first it may appear. Inflation near 10 per cent is within memory of many current retirees. And the resulting high interest rates turned bonds into a losing proposition throughout the decades of the 1960s and 1970s.
Without predicting inflation again anytime soon, we recommend investors take steps to assure their own well being in that or any other scenario. That means holding a significant portion of your portfolio in stocks of companies that can operate profitably in inflation, deflation, or any other economic condition. But how, then, can you generate current income?
We’ve steadily maintained that investing in common stocks—even the most conservative kind—does not suit the need for cash within five years. Their prices are simply too volatile. If you’re a nervous investor, or at times following a significant bull market such as we’ve seen recently (the S&P/TSX Composite Index is up more than 80 per cent since it hit a low in March of last year), you might well think longer—perhaps as much as 10 years.
Lock in the short term; invest for the long
Our advice? Prepare all the cash you will need in the short term of five to 10 years through fixed-income securities that mature as you need the cash. With that part of your portfolio in place, you can comfortably invest the balance of your portfolio in growing companies that will almost certainly provide attractive selling opportunities within the five to 10 years you have covered. You can even use a diversified mutual fund, index fund or exchange-traded fund to participate in the ongoing economic growth of Canada’s and the world’s economies.
A portfolio of $100,000 invested in GICs at 1.90 per cent, for example, will provide $10,868 each year for 10 years. We’re assuming you take the full, matured value into income, not just the interest. That might nicely supplement a pension.
Of course your principal in these securities will be gone at the end, so you must have other investments that can grow to replace them. Over the course of 10 years, it is reasonable to assume a compound annual growth rate of 6.5 per cent for an equity portfolio that includes a mix of Canadian (50% of the portfolio), foreign developed-market (40%) and emerging-markets (10%) equities. (Figures for this assumption come from the projection assumption guidelines of the Financial Planning Canada Standards Council.)
As simple as ‘wash, rinse, repeat’
If you start out with an equity portfolio worth $120,000 at the beginning of 10 years, then, a 6.5-per-cent annualized return will result in a portfolio worth $225,257 at the end of the 10 years. That gives you enough to replenish your income portfolio, leaving you with $125,257 in your equity portfolio to repeat the process over again. Or you could give yourself an income raise by adding a bit more equity money to your fixed-income allocation.
This approach to investing for income provides a far better return than do straight GICs or even longer term bonds. And it provides the further benefit of including growth stocks that can help protect you against inflation.
We continually recommend high-quality stocks that pay dividends. Dividend income, however, does not factor into this strategy. Of course, you could use your dividends to supplement your income, provided this does not compromise your equity goals. Or you can reinvest the dividends, particularly through a dividend reinvestment plan or DRIP. That simplifies reinvestment.
This is an edited version of an article that was originally published for subscribers in the July 2, 2021 issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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