Gold: the Why, What and How of Investing in It

The Chinese government is apparently now buying gold in a big way. Is it time for the individual investor to do so? You decide.

Why Invest in Gold?
A couple of reasons are often suggested:

• safe store of value - gold is a substance that has been sought after for thousands of years and will probably continue to be so for a long time yet; it is very durable, in limited supply and does not decompose or disappear when made into jewelry or put into industrial products. Unlike paper money, governments cannot arbitrarily print more of it out of thin air and thus gold may serve as protection against currency crashes and inflation.
• portfolio diversification as another asset class - gold's price has varied considerably over the years and is observed to be uncorrelated, or even negatively correlated with other investments (i.e.when stocks or bonds go up or down, gold is doing something very different), which reduces the variability and risk of a portfolio. See the chart and article Asset Class Correlations on Seeking Alpha and Gold: a Different Asset Class on Gold News.

How to Invest in Gold
There is a myriad of ways of varying degrees of risk, volatility and convenience. Most of these are available to a self-directed investor at discount brokerages. A good introductory description of the options is the Moneyweek Beginner's guide to investing in gold. All types of gold investments are eligible to be held in an RRSP or other registered account.

• Coins, bullion and bars - generally obtained through a gold dealer (e.g. Bank of Nova Scotia is well-known one) not through a brokerage though some like Questrade do offer them (however note that taking delivery from a registered account means de-registration / withdrawal of the gold's value)
• Certificates - are claims backed by physical gold stored in a bank or other secure location. You cannot take delivery of the gold but it solves the challenge of secure storage and facilitates buying and selling, which is usually done by phoning the brokerage's trading desk e.g. BMO Investorline sells certificates in USD (the usual currency conversion from CAD to USD if buying with Canadian dollars), the transaction fee is USD$35 flat plus $1 per ounce with a 5 oz. minimum purchase and no on-going storage fees, though other brokers may charge for storage.
• Stocks of companies that produce gold - highest risk since there is the effect of company competition, uncertainties of mining added to the varying price of the metal - see the huge fluctuations of the TSX company index vs the price of gold bullion on this TMX Money chart. Canada is one of the world leaders in gold production and there are a number of major companies to choose from - Kitco.com has a table with quotes and stock symbols of the twenty gold companies in the TSX Gold Index.
• Specialised ETFs and Mutual Funds - collective investment securities in either physical bullion or gold company stocks, or a combination of the two; GlobeInvestor has a filter to list Precious Metals mutual funds. TMX Money includes the nine currently available gold ETFs traded on the TSX within the comprehensive list of Canadian ETFs.

What Proportion of a Portfolio to Invest in Gold?
Most commentators suggest that gold should form a small percentage - 5 to 10% - of a diversified portfolio. Those who buy a Canadian equity market index fund should keep in mind that gold companies form a significant portion of that index, e.g. they represent 10% of the TSX 60 index.

Further Info and Gold Investing Websites:

• Kitco.com
• Gold Investments
• World Gold Council
• Shakespeare's Gold and Precious Metals page
• Gold and Silver Investments
• The Power of Gold, book by Peter Bernstein

Investing for Children: Building a Portfolio from Scratch with Regular Small Savings

Most portfolios for children start out small and are built up with savings, gifts and government grants or payments that come in month by month or year by year. In that circumstance, there are a couple of important practical challenges to building a portfolio which also conforms to the principles set out in early posts of this blog - controlling costs and diversifying for risk reduction through asset allocation.

Challenge #1 - Initial Purchase vs On-going Costs
Investing a small amount poses the practical problem of gaining effective diversification at reasonable cost. Even with low fees at discount brokerages, a $10 trade on a $100 purchase is a 10% cost - much too great. And buying only one stock or bond provides no diversification.

Option A - Buy Mutual Funds
There are many, many choices of stock and bond funds which allow purchase at no fee but the annual on-going fees may be too high. There are Index funds with low on-going fees of around 1% as well as actively managed (which try to outperform the market) equity funds whose fees are typically around 2.5%.

Option B - Accumulate Savings and Buy ETFs
Save up $1000 in cash and the $10 commission now only costs 1%. ETFs compensate for this cost by typically having much lower on-going annual fees as low as 0.1% (for whole of market equity index funds). In addition to the original passive index funds, ETF choices have expanded to many varieties of stock and bond groupings: industry sectors, countries/regions, size of market cap, strategies (dividend, growth, bearish, leveraged etc) (see Stock Encyclopedia listing)

Challenge #2 - Diversification and Portfolio Size
Within a small portfolio, having a multitude of tiny holdings will probably be costly, difficult, time-consuming and not worth the effort to keep the asset classes in the proportions of the intended asset allocation.

Option A - Individual Holdings of Fewer Asset Classes
Keep it simple. Start with fewer asset classes, adding as the portfolio grows.

Account / portfolio of < $10,000
Four asset classes provide effective diversification:

• Fixed Income - such as a total market bond fund
• Canadian Equity
  
• US Equity
• International Equity - e.g. a fund based on the MSCI Europe, Australasia, Far East (EAFE) index

Portfolios of $10,000 - 25,000
Consider adding:

• Real Estate - typically done with a REIT fund
• Emerging Market Equity - the MSCI EAFE excludes dramatically growing but risky markets such as India, China and Russia

Portfolios of $25,000+
Individual stock and bond holdings become feasible as a large enough number can be bought to achieve reasonable diversification. Additional asset classes to consider:

• Real Return bonds
• US Fixed Income
• Commodity - again through various funds
  
• US Small Cap Equity
• US Value Equity

Option B - Buy Portfolio Fund of Funds
In this case you buy only one holding. The fund company does all the work of buying the different asset classes and keeping them in balance. The issues to examine: is the extra fee charged, anywhere from 0.25 to 1%, worth it (on a $10,000 portfolio that's $100 in extra fees per year) and is the asset allocation what you want. Both mutual funds and ETFs are available. See Bylo Selhi's list of ETFs here and no-load indexed portfolio mutual funds here. CanadianFinancialDIY compares two ETF growth portfolio funds from iShares and Claymore and finds both are reasonably good.

Investing for Children: RESP or In-Trust For Account?

Suppose parents or grandparents want to set aside money for a child. Or suppose a minor child (under age 18 or 19 depending on the province) receives a significant inheritance, or has part-time or summer job earnings that you think should be put away to grow, perhaps for higher education or an eventual house purchase.

The money will be safe in a bank account but not earning much. GICs are also safe but grow slowly. If the intended spending is many years away, investing is an attractive option but there is a problem - legal restrictions prevent minors from opening an investment account in their own name.

Two options may provide a solution. Both are typically available at discount brokerages. The new TFSA is not an option since only those 18 and over can have one in their name.

Registered Education Savings Plan (RESP)
This is a special plan created by the Government of Canada to assist savings for post-secondary education by allowing tax-free growth inside the plan and by providing extra grants, the Canada Education Savings Grant (CESG) for everyone and the Canada Learning Bond for lower income families (details at CanLearn.ca).

Informal Trust aka In-Trust For - (ITF) Account
In such an account, a parent or other adult acts as trustee to manage investments on behalf of the child, who becomes legally entitled to take over at the age of majority. In this type of account, there is no restriction for how or when the funds may be withdrawn and spent (Invesco Trimark describes the basics here).

There are many important differences between RESPs and ITFs in terms of control, ownership, flexibility, grant availability and especially taxation, some of the key ones of which are summarized in the chart below. RESPs and ITFs are essentially equal when it comes to investing itself as all types of stocks and bonds are allowed in both and in allowing virtually anyone to contribute.

Assuming that the possibility of further education is a goal and other things being equal, my take on how RESPs and ITFs shake out are this:

• it is worth contributing enough to the RESP to get the full government grant money, which means making contributions over a period of years, instead of all at once
• if there is enough money, put the max CESG amount in the RESP and the rest in an ITF
  
• to keep things simple, parent or grand-parent money should go into the RESP before it goes into the ITF
  
• put the child's own money into an ITF; in this case, the tax attribution complexity doesn't arise; there will be no taxes for the child to pay unless the sum to invest is very large and produces more than the basic personal tax-free allowance in income every year (e.g. in 2009 the personal allowance is $10,320, which is equivalent to 6% on $172,000)

Of course, things are never exactly equal or the same for every person, so it behooves readers to think carefully about the various factors before deciding what to do. Form-filling and trustee arrangements (separate persons to be trustee and contributor) in compliance with laws and regulations, especially with regard to the ITF option, is critical if the tax benefits are not to be denied by the Canada Revenue Agency. This blog post is not advice. It may well be worth getting proper accounting or legal advice.

More Background:

• Formalizing Informal Trusts by Teresa Gombita on CA Magazine
• Don't let trust accounts be a taxing issue by Arthur Drache at the Financial Post
• Comparing education savings options at Investored.ca
  

How Long Till the Stock Market Recovers?

From time immemorial astrologers have been foretelling the future. They are still at it. Back in January, Vedic Astrologer said the stock market will be good in March (correct), bad in April (wrong), good in May (correct) and June but "A New Moon Solar Eclipse in July 2009 will not be good for Stock Market; there may be some crisis in Stock Market."

Those with a more rationalist bent may discount such prognostications but the question of how long it will take before the stock market regains former highs or even begins rising is an important and valid issue. Various methods propose an answer.

The History of Past Downturns and Recoveries
There have been dramatic stock market downturns associated with severe economic slumps similar to the current episode in the past. The most extreme example is the the 1929 crash and depression that followed. Crestmont Research's Stock Matrix Options chart shows that a taxable US investor who had invested at the peak in 1929 would have had to wait 22 years to break even after inflation with an investment in the S&P 500. Will it be as bad this time?

Fund provider IFA's Probability of Portfolio Recovery page graphs in figure 9-B the chances that portfolios with various mixes of stocks and bonds will recover within a certain number of years. The graph says two significant things:

• full recovery will probably take a long time - e.g. a portfolio of 50% stocks and 50% bonds is 90% sure to fully recover in 14 years, though there is a 50% chance it could be only 7 years
  
• portfolios with a lower proportion of stocks will likely recover more quickly than one with just stocks since they will not have fallen so much in the first place
  

Secular Market Cycles
This approach maintains that stocks markets go through long term cycles in which stock prices rise unduly compared to earnings and thus the Price to Earnings Ratio (P/E) goes above the normal long term average of about 15x. John Mauldin in While Rome Burns graphs the excessive rise in P/E in recent years and shows that in past cycles, the inevitable correction drove prices and the P/E down below the average. The suggestion is that the correct market downturn may not be over yet and a new bull market probably won't start till the middle of the next decade, after which returns climb strongly again.

Robert Schiller, the author of investing book Irrational Exuberance, expounds a similar view in this Yahoo Finance article and video clip, saying that the S&P 500 P/E is likely to go down to 10x from its current 14x before climbing again.

Credit Crises, Real Estate Slumps and Market Crashes
A third method of trying to figure out when bad times might end and good times return comes from economic studies. International Monetary Fund researchers posted Global Financial Crisis: How Long? How Deep? over at Vox EU in which they summarized past episodes of such crises - yes, they have happened before, though not on a global scale - and found that recessions could last up to four years with stock market declines of up to 50%.

Lessons for an Investor:

• stock / equity investing is for the long term, at least ten years, better 15 years;
• reasonable expectations will increase patience in the downturn, avoiding the error of selling after the downturn; cautious expectations will also improve investment planning
  
• a portfolio approach is the way to go: mixed portfolios of stocks and bonds cope better with market cycles
• portfolio composition needs to be aligned with investment objective time frames
• markets do recover, even extreme downturns are eventually followed by upward cycles
  

Investing for Children: Getting the Goal and Timing Right for Education

A successful plan to invest for a child's post-secondary education must address:

• the cost of the education
  
• the timing of the studies to determine when funds will be required
  
• the variability of various types of investments and their respective returns in the short and long term - stocks do best over long periods but may suffer severe ups and downs in the short term

Total Cost of Education
Develop an estimate of how much you will need to save using the excellent Investored.ca Calculator, where you can enter many variables such as: number of children, current age, duration of post-secondary program, age to start post-secondary studies, live at home or in residence with or without meal plan with actual recent costs for tuition for both college and university and room and board by province. You can select to add in or not the Canada Education Savings Grant.

Timing of Spending
18 years is the usual youngest age when post-secondary education starts, but it can be delayed which may warrant keeping more of the investment assets in more volatile stocks longer. This is a difficult call since young people can change their minds quickly and decide suddenly that they do want to go back to school after all. Such delightful news to a parent should not be marred by discovering that the stock market is in a downturn and the required funds are less than a year previous. There does come a time when the education goal, having not yet been pursued, becomes unlikely and it is best to shift investment goals.

Higher education lasts two to four years, perhaps longer if higher, higher education is pursued. The cash needs to be made available over that span, so investments that mature in time with each new school year make sense.

The Time-to-Spending Asset Mix
The longer there is before the funds will be needed, the greater the proportion of the investment asset mix should be in stocks, which provide higher long term returns than bonds, GICs, money market funds or plain old cash earning interest. One critical caveat - if a large lump sum (like an inheritance) sufficient to fully fund any higher education comes along, then merely protecting that capital against loss and inflation may well be the wisest approach. Most people do need to take advantage of higher stock returns (e.g. 4.5-7% for stocks vs 2-4% for bonds vs 0-2% for T-bills; see these summaries of past and future expected returns at CanadianFinancialDIY and the Bogleheads forum)

Example Asset Mix Over a Childhood
Birth: 80% Equity & Other, 20% Bond
Age 13-14: Child still headed for higher education?

• Yes - shift to 40% Equity, 40% Bond, 20% Cash (incl GIC, Money Market Funds, T-bills)
• No - maintain asset mix to serve different long term goals (e.g. house purchase)

Ages 15-18, assuming still headed for higher ed

• Shift another 10% a year into Cash till it is 100% Cash

Variations of the percentages and ages of shifting are possible but the idea is that as the time for spending approaches less and less should be in riskier, more variable investments and more in the stable, safe, liquid investments.

Corporate Bonds for an RRSP or TFSA in 2009 - an Opportunity?

Investors may be wondering what to buy in the new Tax-Free Savings Account (TFSA) that started up January 1st or in their RRSP account. One intriguing possibility right now is corporate bonds. Why?

1. Tax - the tax-exempt status of the TFSA or the tax-deferred RRSP makes it reasonable to hold within them such bonds, since they produce income in the form of interest, which is taxed at highest marginal rates
   
2. Higher Returns Than Usual - compare current rates

• Cash deposit rates of about 2% and 5-year GICs of 2-3% (see rates on Canoe)
  
• Government of Canada bonds at just over 2%,
  
• Yields on bonds of the highest-rated corporations > 4%, e.g. Bank of Montreal as of February 5th maturing April 30, 2014 yields 4.2% (see rates for 2014 maturity on Canadian Fixed Income).

The credit crunch crisis that started in 2007 and reached a peak in October 2008 caused severe market dislocations and has created this potential opportunity.

The chart below of two ETFs that track Canadian government bonds (iShares XGB on TSX) and corporate bonds (XCB) illustrates a dramatic change in relationship.

Up to mid 2007 the price of the two funds closely followed each other. Then XCB began to fall - a fall in bond prices means the yield has gone up (see Investopedia's Bond Basics: Yield, Price and Other Confusion) and now there is a huge gap. The lower the quality of the bond (as measured by ratings of bond rating agencies such as Standard and Poors, DBRS and Moody's, the higher the yield. Lower-rated but still investment grade Bell-Aliant's 2014 bond now yields 6.7%.

Recession and Default Risk
Recessions are bad times for ordinary people and they are bad for business too. Profits disappear and corporations fail, resulting in some bonds going into default with an investor having to face whole or partial loss of capital. The big question is whether markets have over-reacted and the risk of default has now gone up to the extent prices seem to suggest. Is it likely the Royal Bank or Bank of Montreal will go under, or Bell-Aliant? These companies have continued to pay handsome dividends yet they are legally bound to pay bond interest before dividends. If there isn't enough money down the road, dividends will be cut first.

Though the past is never an absolute guide to the future the table below from a memorandum published on the website of the Canadian Institute of Actuaries and covering periods of past recessions shows that from 1989 to 2007 there has not been a default by a Canadian corporation rated A or higher. .... There's always a first time though.
Corporate Bond Choices
There are several ways to buy bonds. All are available through discount brokerages.

1. Individual bonds - under trading or quotes sections, look for fixed income and narrow the search to corporate; minimum purchase is usually $5000
   
2. ETFs - iShares Cdn Corporate Bond Index Fund (TSX: XCB) with 252 different bonds of varying maturities, all of investment grade; currently yielding 5.7%
3. Mutual Funds - only a few seem to specialize in corporate bonds as most hold a balance of government and corporate bonds; some that do specialize - Bissett Corporate Bond Series A (mostly Canada, some US), Quadrus GWLIM Corporate Bond (holdings with "high level of coupon interest income consistent with reasonable of safety of capital")

Of course, the above is not investment advice from me, it just input for you to consider in making your own decision, as all self-directed investors should do.

Going on Autopilot with Dividend Reinvestment

What do you do with the cash received in your investment account from dividends and distributions from stocks and income trusts? These days the interest paid on cash balances isn't very high. Perhaps you would as a long term investor rather have the money plowed back into the companies you hold already?

A Dividend Reinvestment Plan (DRIP) offers that possibility. Instead of sending you the dividend, the company buys more shares for your account, usually at the prevailing market price, sometimes at a discount (e.g. Bank of Montreal has recently announced that it is offering DRIP shares at 2% discount). Two big pluses - 1) it's automatic after you set it up through your brokerage, a great convenience in time and effort saved, especially with multiple holdings and, 2) it's free - you pay no brokerage commissions.

Broker Offerings
Brokers differ quite a bit in what they offer:

• purchase only whole shares at a time (in which case you end with small amounts of residual cash) or even fractions of shares
• enrol stock by stock for DRIP or for the whole account
• number of stocks which can be DRIP'd (some publish the list like BMO Investorline's here, or you must call the broker to find out)
  

Stingy Investor has compiled an excellent list of Canadian brokerage DRIP offerings (of course, be sure to double check accuracy with the broker).

Some brokers even offer what is known as a "synthetic DRIP" service, whereby the broker will purchase for free extra shares with the dividends even though the companies don't offer it themselves. This can extend an investor's DRIP capability to things such as ETFs, as described by CanadianFinancialDIY in this post.

Canadian shares and trust units with DRIP programs
Stingy Investor publishes here a list, as does blogger Canadian Dividend Reinvestment Plans here. Note that the lists are not identical, no doubt because of timing and thoroughness of updates, so again, check with your broker on a particular company.

US Shares
There are apparently over 1300 securities in the United States with DRIP programs - see the Directinvesting.com search page. Once again, Canadian brokers differ in what they offer regarding DRIPs for US holdings.

How to Set Up the DRIP
Simply phone up your broker and go through the accounts and shares you want on DRIP.

Resources
Stingy Investor's Intro
Robert Gibb's DRIPs 101: DRIP Classifications on the
DRIP Investing Resource Center - Articles, Forum, Tools, Recommended Books, Links
Financial Webring discussion thread on DRIPs/SIPs/Synthetic DRIPs

Normally, a drip is cause for a headache at home, as leaking taps and pipes cause damage and annoyance. Not so with the uppercase acronym DRIP, whose slow and persistent operation can build the wealth in a portfolio while saving effort and cost.