Thursday, 20 August 2009

Three Key Investing Principles for Retirees

For investing purposes, retirement is when a portfolio is steadily and systematically drawn down over many years. Retirement presents particular challenges and risks for the investor, most critically:
  • Running out of money due to living to a very old age (known as longevity risk); this forces a delicate balancing act between life expectancy, uncertain investment returns and lifestyle or spending rate
  • Inflation, the year over year increase in the cost of living, which reduces the value of a dollar and can impoverish over a retirement period that can easily span more than a quarter century due to earlier retirement and increasing lifespans
  • Negative market returns during the initial years of retirement (known as sequence of returns risk) which can reduce a portfolio so much at the start that it never recovers, even with subsequent good markets, and eventually causes the portfolio to be depleted 10 or 20 years sooner
Different types of investments may be beneficial or harmful to the retiree in meeting these challenges. For instance, equities provide higher long term returns than bonds, and are thus better protection against running out of money, but as was evident in the 2008 crash, they can be highly volatile, which increases sequence of returns risk. Bonds, cash, GICs and other fixed income on the other hand, are much less volatile but their value is susceptible to inflation and they may not provide adequate returns to ensure long term health of the portfolio in real terms. What lessons arise from such realities?
  1. Equities should form part of retirement portfolios - in his recently published book, Are You a Stock or a Bond?, pensions and retirement planning expert professor Moshe Milevsky estimates that about 60-70% of a retiree's investment portfolio should be in equities. This holds true for a wide range of spending rates (he uses 5 - 9% of the portfolio spent per year) and ages of retirees (he uses 55, 65 and 75).
  2. Diversification is particularly beneficial to retirees - Milevsky's book uses the example of an ultra-simple portfolio comprising only US large cap equities (the S&P 500) and cash (US money market fund) but there is a considerable benefit from this diversification. The portfolio does not include other important asset classes such as government and corporate bonds, real return bonds, real estate, international equities, value equities, small cap equities and commodities, the inclusion of which would drastically reduce portfolio volatility beyond what Milevsky calculates, as CanadianFinancialDIY notes in Benefits of Investment Diversification for Retirees. This can allow the retiree appreciably higher portfolio withdrawal rates or much lower risks of portfolio exhaustion or a combination of the two. One should also not forget the peace of mind that comes from a portfolio with much reduced swings in value.
  3. Taxes can significantly alter actual net amounts available to spend - in Canada net tax rates vary tremendously from lowest taxed dividends to middle rated capital gains to highest level interest (see image below of rates for a net income level of $40,000 from the Ernst & Young 2009 Personal Income Tax Calculator). This factor reinforces the benefit of including equities in a retirement portfolio for the capital gains and the dividends such investments generate. There may be some opportunity to shape a portfolio according to income type e.g. to include a higher proportion of dividend paying stocks or funds, or to hold some preferred shares instead of bonds since they both tend to swing up and down according to interest rate changes to produce dividends instead of interest. A higher net after tax return can allow a lower withdrawal rate to produce the same amount to spend. The tax factor applies only to taxable accounts, not registered accounts such as RRSPs, RRIFs, LRIFs etc. since all withdrawals from registered accounts, however the return was generated inside the account, are taxable at the highest marginal tax rate.

Tuesday, 18 August 2009

Bond Ladder vs Bond Fund? Part 2 - Fund Pluses

This second part of a two part post on ways to hold bonds in a portfolio looks at Bond Funds. Part 1 looked at the Bond Ladder.

Bond Fund
A bond fund holds a collection of bonds. There is a wide variety of investment policies and bond mixes to choose from. Some are passive and indexed, holding a representative sample of the overall market. Some are actively managed attempting to achieve extra returns from trading and anticipating corporate changes or interest rate shifts. Some funds are specialized in government or corporate bonds, some have US or international holdings, others have short duration bonds and still others focus on high yield high risk debt. All charge an annual management fee.

Advantage to the Fund:
  1. Funds are better at diversifying away individual organization credit risk because they hold a much larger number of different bonds than most individual investors could buy. With one purchase it is possible to acquire a large number of bonds to cover the whole Canadian market, like XBB . Even investment grade corporate bonds sometimes run into trouble, are downgraded and the price then takes a big hit. This isn't a problem if it doesn't go into default and the bond is held to maturity but the risk rises. One can acquire a subset that apparently acts as a separate un-correlated asset class - real return bonds, like XRB.
  2. Portfolio rebalancing is easier - in a ladder, if it comes to pass that equities have a bad year and the portfolio is overweight in fixed income, there is a difficult choice of which bond to sell and where to put a hole in the ladder. As well, bond buy-sell minimums might cause an asset allocation overshoot and the buy-sell spread/commission on bonds adds to costs. With a fund, simply buy or sell exactly the amount needed to rebalance.
  3. Purchasing small amounts is more cost effective: Individual bond purchases are lumpy - the minimum bond purchase amount is $5,000 so one needs a fairly hefty sum to even build a ladder. A tiny ladder of five bonds would require $25,000 and that wouldn't be very diversified. The larger the bond purchase the lower the price (implicit commissions are less). Purchasing small amounts is really best done through a fund and for really small amounts (under $1000) at a time, mutual funds are best.
  4. One can buy foreign bonds, like the US dollar iShares Aggregate US market AGG, or even international bonds to further diversify. Read this GlobeInvestor article for a rundown of various US and international alternatives.
  5. Reinvestment of interest is easy with bond mutual funds. ETFs and individual bonds pay out cash interest. If the investor doesn't want the cash to spend it sits idle until a sufficient amount is accumulated to make another purchase at reasonable cost. It should be noted that one type of bond - the stripped residual bond (An excellent brief explanation of stripped bonds is BMOIL's on their website at Strip Coupons and Residual Bonds) - solves this problem but it is a small part of the overall bond market.
  6. Funds take less time to manage - no need for watching credit quality, deciding which new bonds to buy to continue a ladder as bonds mature, the managers are doing it for you.
Where to Find

Thursday, 13 August 2009

Bond Ladder vs a Bond Fund? Part1: Ladder Pluses

Bonds, or fixed income, have a place in every portfolio. Two ways to hold bonds are in a fund, either an ETF or a mutual fund, or in a ladder of individual bonds. How do the two methods compare? This post looks at advantages of the Ladder approach while Part 2 will review the advantages of Funds.

Bond Ladder
A bond ladder (more detailed explanation on Investopedia) consists of a series of bonds that mature at staggered, regular intervals, often chosen to be about one year apart. They can be bought online at many discount brokers, though it may be necessary to phone and speak to a representative. The bond price includes an implicit one-time fee charged by the broker - i.e. the bond's price is slightly higher.

Some discount brokers have a better inventory and wider selection of bonds. BMO Investorline seems to have a good inventory from the experience of this writer but check around. The embedded commissions can also vary between discount brokers.

Advantage to the Ladder:
  1. A ladder is more flexible: one can match maturities to desired cash flow, shorten or lengthen the number of years in the ladder or select issuers, whether corporate, municipal, provincial, federal government to control risk
  2. Ladders can reduce price risk (the risk that the bond's price will drop if interest rates rise) - if the bond is held to maturity, the par value will be returned and the investor receives the return/yield promised at purchase. A fund's asset value constantly shifts with interest rate changes, and there is never a maturity date for the fund, so an investor wanting cash may need to sell at a loss.
  3. Commissions and costs can be very low if bonds are held to maturity - though the commission on a bond trade is around 1.25% (according to Shakespeare's bond page) there is no recurring admin or management cost on the bond and, if held to maturity, the cost averaged over years goes down to very small amounts. By contrast the cheapest bond ETFs charge 0.25% annually. Nevertheless, if you start actively buying and selling bonds, your commission costs will be quite high, i.e. my opinion is that a bond ladder is for holding bonds to maturity.
Where to Find
  • Individual Bonds - look under Fixed Income on your broker website; for below-investment grade high-risk bonds or real return bonds, you would need to phone the broker bond desk

Tuesday, 11 August 2009

Controlling Your Own Investing Over-Confidence

Question: What’s the difference between God and an actuary?
Answer: God doesn’t think he’s an actuary

This old joke (quote above taken from Making Actuaries Less Human) has appeared with many substitutes for the word actuary. And with good reason because overconfidence in one's abilities, knowledge and judgement is a widespread tendency among humans as academic research (see citings in the above article) have confirmed time and again. Investors are no exception (not even professional investors and analysts) - for proof, read excellent books like Richard Deaves' What Kind of Investor Are You? and Terry Burnham's Mean Markets and Lizard Brains or references on the Overconfidence page of

Investors over-estimate their knowledge, under-estimate risks and exaggerate their ability to control events, including their own reactions. The result is bad decisions that lose money - excessive trading, taking on too much risk, under-diversification, over-estimating possible returns, thinking a bad outcome can't happen, panic selling.

What to do to Control Overconfidence?
Simply saying to yourself "I won't be overconfident" isn't likely to work. Specific techniques are required. Here are some techniques to try:
  1. Find a contrary opinion to your own - read and listen to the argument; as Larry MacDonald's post 11 Trading Tips from Soros relates, legendary billionaire investor George Soros recommends doing this.
  2. Write down the reasons you could be wrong in a pros and cons list for an investing idea
  3. Estimate a range of possible outcomes e.g. stock price, portfolio return, then subtract 25% from low number (the one that will hurt you) as recommended by Gary Belsky and Thomas Gilovich in Why Smart People Make Big Money Mistakes and How to Correct Them.
  4. Set a benchmark or comparator for returns then do a review and ask yourself what you did wrong - bad luck is to be excluded as an explanation since the mistake of thinking "good result = my skill, bad result = bad luck" is the delusion that keeps people from learning and improving as investors
  5. Test the waters with a small pilot investment, then wait to see how it evolves for a while, then invest more only if it shows signs of success (another Soros tip)
  6. Tie yourself down with a strict, numerical set of rules in an investment policy for the funds that are essential to your financial goals and have a separate "money to gamble and lose" pot to indulge your investing macho
  7. Admit you are incorrigibly overconfident and design a totally passive diversified index portfolio and accept the average results that will produce
As the actuaries recognize, we cannot stop being human, we can only take steps to minimize and control overconfidence. At least we can avoid being the cat in the photo "This is going to end in disaster, and you have no one to blame but yourself" from

Thursday, 6 August 2009

Insider Trading: Using It to Get an Edge, Legally of Course

Insider trading - the illegal kind
Stock trading by insiders - the top management and directors of a company - normally makes the headlines when the insiders exploit their inside knowledge to unfair and illegal advantage by buying or selling based on material information that is not publicly available. Securities regulators and police step in to bring criminal charges with fines and possible prison as sanctions. CBC's "Insider Trading - What's the problem?" explains in more detail about illegal trading.

Legal insider trading - why should an investor care?
Stock ownership by a company's top executives is desirable for public investors - it aligns their fortunes with ours. Insiders are allowed to buy and sell shares of their own company and they are allowed to, and do use, within the rules, their intimate knowledge of the company to their advantage. Paying attention to what they do is worthwhile.

The rules require insiders to disclose both their holdings and their inside trades. When doing research on a company to decide whether to buy or sell shares, an investor is well advised to check out both aspects of insider stock ownership:
  • number of shares owned - if the managers and directors don't own many shares, don't have much "skin in the game", one has to wonder about their confidence and commitment
  • buying and selling - if the insiders are buying, it cannot be bad; if they are selling, it could be they feel prospects are bad, or perhaps they need the money for some other purpose; the rules don't require them to give a reason for the sale; another question is to look at is how many shares are being traded as large amounts would likely be more significant
Where to get insider trade info
  • SEDI (System for Electronic Disclosure by Insiders) - the regulator database, searchable by company and by insider for Canada
  • United States Securities and Exchange Commission EDGAR database
  • Toronto Stock Exchange Insider Trade Summaries - lists companies with the most active recent trading
  • CanadianInsider website - free search of Canadian companies plus purchasable reports that consolidate and present the data graphically.
  • - similar website covering US stocks, including Resource page with links to books and education sites.

Tuesday, 4 August 2009

Three Reasons to Love Dividends

Dividend stocks are an attractive proposition these days for several reasons, though such attractions are always tempered by potential downsides.

1 - High Yield
Despite the tremendous drop in share prices many solid companies are still making profits and are continuing to pay out some of those profits as dividends. As a result the return from dividends alone, defined as the Dividend Yield (the annual dividend / current price as a percentage) has gone up to historically high levels. For instance, Bank of Montreal shares (symbol BMO) are paying out $0.70 per quarter or $2.80 per year, which yields over 5% on recent prices around $51 per share. The iShares TSX 60 Index ETF (symbol XIU), a combination of the 60 largest companies on the Toronto Stock Exchange yields about 3%.

Risk: The big unknown is whether the dividends will be maintained or cut in response to the recession. Companies may state their intention to keep paying out but the investor is wise to check outside commentaries, read financial reports and form an independent opinion.

Tax Advantages
When investing in a non-registered taxable account, one needs to be aware of how income taxes affect dividends. There are strong pluses but a few caveats and potential downsides exist too.

2 - Low(est) Tax Rate Type of Income
For all but taxpayers in the highest income brackets, dividends have a lower tax rate than interest and capital gains. The effect is most pronounced at lower income levels and peters out in most provinces as taxable income (total income, employment earnings plus investment income minus deductions like RRSP contributions, child care, moving, education, union and other expenses) exceeds $70,000, though that varies considerably by province. Some like Alberta, Ontario and BC still show a much lower tax on dividends at $100,000 income while in Nova Scotia the superiority ends at around $90,000. Enter your 2008 income in the Ernst and Young Personal Tax Calculator to see what it is for your province.

3 - Extra Dividends Can REDUCE Taxes for Lower Income Taxpayers
Tax rates on dividend income are less than zero, i.e. negative for the lowest tax bracket of $36-37,000 (in 2009) in most provinces, except Nova Scotia and Newfoundland at c. $30,000 and the real outliers of BC at $71,000 and Quebec at $0. Detailed tables are available at's Provincial Personal Rates page. When filling in your tax form, there is a dividend gross up and tax credit that can offset other income taxes so that you end up not paying any tax on the dividend and paying less on other income. explains with an example here.

Tax professional Tim Cestnick wrote a column titled How to take advantage of the dividend tax credit in GlobeInvestor in which he noted that a BC taxpayer with no other income but dividends could earn up to $70,000 without paying tax. shows how much in dividends could be earned tax-free in other provinces.

Risks: Several realities may temper the benefit of the "use dividends to get tax-free income" idea.
  • Alternative Minimum Tax may kick in - note on the page cited above, said that at around $50,000 in dividends and there is no other income, you may have to pay tax anyway ... but at 3% yield, that would mean having a taxable portfolio of almost $1.7 million, which excludes most individual investors.
  • the dividend gross up procedure increases net income, which is used in calculating government benefits like OAS, GIS and Child Care and could cause loss of some portion of benefits, i.e. reduced income
  • the federal government has announced the progressive reduction in the tax credit for dividends such that by 2012 the negative tax rate on dividends will disappear - again has a handy table with the numbers. Dividends will still be taxed less than capital gains or interest however.
The above is for information only and is not to be construed as advice. When in doubt consult a professional to ensure you get it right.