Emphasizing safety in your portfolio goes beyond trying merely to preserve your capital. You should also try to preserve your purchasing power against inflation. High inflation can steadily erode your standard of living, of course.
Preserve purchasing power against inflation
Whether your main investment objective is growth, income, or a combination of the two, it pays to emphasize safety in your portfolio. In fact, smart investors try to do more than just safeguard their capital—they aim to offset inflation and preserve their purchasing power.
To do this, you must keep a number of factors in mind when you build or evaluate your investment portfolio. These factors include inflation, income taxes, interest rates and risk, among others. All of this will be easier if you begin with these four common-sense steps.
Start with these four steps
1. Set up a plan and stick with it. You should set out your investment objectives to start with and carefully weigh each potential investment against them. That gives you a big advantage over those who invest haphazardly.
2. Emphasize quality. Over the years, we’ve found that you do better if you concentrate on bigger, better-established companies in your portfolio. These are stocks that we rate ‘Very Conservative’ or ‘Conservative’. Their large size can carry them through longer periods of depressed earnings than most lower-quality stocks. They also tend to pay attractive dividends that they raise year after year. This helps you to keep up with, or even beat, inflation.
3. Keep trading to a minimum. If you switch constantly from one stock to another, your broker is apt to make more money in the long run than you. Even if you pay no commissions, you may end up outside of your areas of competence, with stocks you know little about.
Then, too, you need to overcome the bid-ask spread (selling at the lower bid price and buying at the higher ask price). You could wait for other investors to accept a price you set. But the chances are you’ll miss out on some of your best trades, especially on the NASDAQ exchange in the U.S. Even then, to the extent that you succeed in overcoming these costs and making money, you’ll face capital gains taxes—unless you invest in tax-deferred accounts such as a TFSA (Tax-Free Savings Account), a RRSP (Registered Retirement Savings Plan) or a RRIF (Registered Retirement Income Fund).
4. Remember your own temperament. The idea is to take on only as much risk as you personally feel comfortable with. After all, a worried investor is more likely to act rashly.
Safety for income investors also means taking into account the future path of interest rates. This is often a difficult matter, though it’s likely that rates will stay high in the short run and stay higher than before in the long run. You can protect yourself from unexpected changes in rates by staggering or laddering the maturities of your fixed-income investment. That way, you’ll likely earn at least an average interest rate.
You may also opt for shorter terms when rates begin to rise and switch to longer terms when rates begin to fall. These days, in particular, we advise against maturities of more than five years. Otherwise you could lock yourself in for a long time at a rate that may later become unattractive. Particularly if high inflation persists.
We recommend income investors stay away from fixed-dividend preferred shares for the most part. You can do better with common shares that have demonstrated a willingness and ability to raise dividends over the years. Besides, common share dividends offer the same tax advantages as preferred share dividends.
Going for growth
Investors who aim for growth are also wise to emphasize a sound record of earnings and dividend increases over vague long-term promises. The idea is to invest in stocks that offer the securest hope for long-term gains, after all. If you’re investing for growth, it’s also a good idea to keep some money in treasury bills, money-market funds or high-interest bank accounts.
This will give you a liquid reserve to cover financial emergencies (a car repair, for instance), or to take advantage of special investment opportunities that you may encounter from time to time. If nothing else, this reserve will keep you from having to sell some of your stocks for the wrong reason—to meet unexpected costs, for instance.
To avoid income taxes on your interest income, keep these funds in your TFSA. In short, whether you seek income or growth, you should emphasize safety.
This is an edited version of an article that was originally published for subscribers in the August 19, 2022, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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The Investment Reporter •10/4/22 •