The longer your investment horizon, the more risk you can take. If your investment horizon is short, however, dial back your portfolio’s risk.
A friend and her husband built RESPs (Registered Education Savings Plans) for their daughter and son. Their daughter is in her third year at the University of Toronto. Their son is in his first year, at York University.
Our friend finds it hard to accept that interest rates are so low these days. Rather than have her children earn next to nothing, she invested most of their RESPs into index funds, against our advice. Fortunately, optimism about a post-pandemic economic rebound has sent the stock market up since March 2020. The RESPs of our friend’s children have gained in value. But what the stock market gives it can quickly take away.
With a short investment horizon, we advised our friend to estimate how much money her children will need over the next two years. Then she should sell enough stocks to cover these expenses. True, this money will earn next to nothing. But at least the principal will remain safe. When the next stock-market setback strikes, our friend will not need to sell stocks at lower prices in order to cover her children’s education expenses. In a year’s time, she should extend the cash holdings for another year. Also, our friend’s children earn too little to pay income taxes on the interest their RESPs earn and pay out.
How old are the children?
Were our friend’s children still toddlers, with a long investment horizon, then investing in high-quality dividend-paying stocks would be more appropriate. The money could grow. When the next stock-market setback occurs, they could ride it out. In fact, they could reinvest dividends to make the most of temporarily-depressed stock prices.
The same idea is true for your other financial goals. Consider retirement. The traditional defined-benefit pension plan is almost extinct in the private sector. These days, only the public sector provides defined-benefit plans. Some private sector employers offer defined-contribution plans. They guarantee to put a set sum into their employees’ plans. If that’s adequate to cover an employee’s retirement expenses, great. If not, that’s too bad for the employee. The employer is not on the hook to make up a shortfall. If the employer goes out of business, employees may get left in the lurch.
Naturally, some employees want to invest in RRSPs (Registered Retirement Savings Plans). If the employee plans to retire far into the future, then he or she can safely invest in high-quality, dividend-paying stocks. Their long investment horizons give them the time to ride out any transient setbacks. People able and willing to work into their seventies or eighties have more time to build up their RRSPs. And they require fewer savings than people who retire early.
Retirement requires cash
As people approach or enter retirement however, their investment horizon shortens. They should reduce their risk. At the very least, they should arrange to have some cash come due in each of the next five years. That way they can continue to hold some high-quality, dividend-paying stocks and still enjoy a secure retirement. Each year, they should arrange to extend their cash receipts for another year.
A friend’s father became a centenarian in January. That’s probably because he still lives in his home, rather than a long-term ‘care’ residence. Given her father’s longevity, we advised our friend to delay taking the CPP (Canada Pension Plan) until she’s seventy. That way she’ll receive much larger guaranteed payments for the rest of her life. And our friend won’t need to worry about the safety of her pension. We advised her to save up and draw on other sources of income until she is 70. Our friend’s investment horizon in this case is 16 years. So she should buy some high-quality dividend-paying stocks.
Many people working from home are buying houses this year. it seems like a good idea to buy a bigger home or upgrade an existing home. Many can also work outside of major cities such as Montreal, Toronto and Vancouver. The trouble is that home prices have jumped, even in many smaller communities.
If you plan to put a down-payment on a home in more than five years, you can likely afford to buy and hold some high-quality dividend-paying stocks. But if you may need the money within five years, your investment horizon is short. Keep the money in cash. While it won’t earn much, at least the cash will be there when you need it.
This is an edited version of an article that was originally published for subscribers in the April 9, 2021, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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