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Uncertain times for investments

Overview

Published: 01/29/2012

by Warren MacKenzie

Over the past few decades, we’ve come to expect that our diversified investment portfolios will yield an average return
of 6% to 8% or higher.  Times have changed, but many still cling to this hope. If lower returns become the norm, what can an investor do when interest rates are insufficient to offset inflation and tax? How can we invest to get a higher return and still sleep at night?

 

Let’s assume the debt problems in Europe (or the potential problems in the Middle East) get worse and a crash causes the
stock market to drop by 50%. If we knew this was going to happen, but did not know when, what should we do?

 

The answer is quite clear, if we can make two assumptions.

 

1.  We assume there will eventually be a recovery. It might take five years or even 10 years, but we will eventually get back to normal. The investing world as we know it will not end. Of course, if we’re into riot and revolution, then it may
not matter what we do.

 

2.  We assume that those profitable companies that have been steadily increasing their dividends over the past 10-20 years will stay in business and will at least continue to pay a dividend, even if they stop increasing the dividend.

 

If we can make these two assumptions, then it makes sense to have at least 30% to 50% invested in Canadian blue-chip,
dividend-paying companies. Why is this so? There are several reasons:

•   A portfolio of dividend-paying companies is currently paying dividend income of 3% to 4%. This is about 50% higher than the return from a portfolio of bonds or GICs.

•   If the money is outside of your RRSP or RRIF, you will get the benefit of the federal dividend tax credit, which means a higher ‘after tax’ income than from interest income.

•  In the longer-term, inflation will be the greatest risk and equities provide better inflation protection.

 

But why not just wait for the market to crash and then invest when the price of the shares is lower? The simple answer
is that human nature gets in the way. Our natural tendency is to look at recent trends and assume the current trend will continue. Unfortunately, most investors who move to the sidelines now, with the idea of moving back into the market
when the crash is over, will never do so.

 

If the market hits the bottom, the news will be so bad, and the economists will be so negative, that investors on the
sidelines will thank their lucky stars that they had the foresight to move to cash before the crash. Given this negative outlook and the belief that the market is about to go even lower, they’ll continue to sit on their cash.

 

Eventually the market will start to recover. They’ll see this as a ‘dead cat’ bounce – to be followed by an even bigger drop. When it eventually becomes clear that we are indeed in a sustained rally, the investors on the sidelines will decide it’s too late, they’ll say they missed their opportunity and will decide to stay on the sidelines for a while longer.

So if we compare the diversified investor with the investor on the sidelines, we see that the diversified investor saw the value of his portfolio fluctuate.

 

It took a significant drop and it has now recovered, but the key point is that he continued to earn income, which was about 50% higher than what was earned by the ‘bond/GIC’ investor. During that period, the diversified investor earned about 3% per annum in tax-friendly dividends, while the investor in cash and bonds earned about 2% in fully taxable interest.

 

This may not seem like a lot – but it is a 50% improvement on this part of the portfolio. A word of caution: Even though dividend income currently provides a better yield, don’t be entirely in dividends – a diversified portfolio is always the safest strategy.  

 

Warren MacKenzie, CA, CFP, CIMA, is president of Weigh House Investor Services of Toronto. He can be reached at
warren.mackenzie@weighhouse.com or 416-640-0550.

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