The S&P 500 is up 15.3% year-to-date. The TSX is up 4.3%. Even a basket of non North American stocks is up 15.9%. Those are some gaudy numbers for the stock market. Anyone that is holding an equal weighting of these stock indices would easily be up over 10% for the year up to this point. If you’re holding a Canadian bond fund, it is actually down a little over 1% this year. With such excellent returns in the stock market, it might be tempting to forgo fixed income assets in an investment portfolio, but you shouldn’t.
In might seem logical to our brain that buying a rising asset is better than buying a losing one because we want to make money, but a proper investor would reflect on her investment portfolio and realize that her fixed income assets needs the most TLC. With equities doing so well this year, it might be worthwhile to check the fixed income portion of your investment portfolio to ensure that the proper allocation percentages still hold true. This means that if you wanted to maintain a 60% equity, 40% fixed income split, it might be time to buy some more fixed income assets because it could be down to 37%.
Don’t Chase Gains
Remember that the purpose of investing in a balanced portfolio is to maintain balance. This means that investing shouldn’t be about speculation or chasing what is doing well. The goal is to keep that balance no matter what the conditions are in the stock market. This also helps in the elimination of being an emotional investor, or in other words, to control the greed factor.
This type of thinking is contrary to any active stock manager. In fact, they would say that balancing an investment portfolio is dangerous because you could be missing out on potential gains. Why buy assets that are declining in price? That’s exactly why passive investing is so effective. Buying assets that are performing poorly may seem counter intuitive to an investor trying to make money, but buying assets that are down is a way to dollar cost average. Think of it as buying something on sale and waiting for it to come back to regular price.
The one problem that plagues any good investment manager is that they don’t know when stock market events happen. They can only guess. So when markets are doing well, their bets are doing well. But when things go bad, it goes terribly bad. Most active managers may think they are capable of predicting market crashes using technical analysis or investment research techniques, but many fail. That’s why most active funds don’t last more than a decade. Once a correction comes, most lose their jobs because investors bail.
Need A Counterweight
When building a proper investment portfolio. The goal is not to create an investment portfolio that gains the fastest. That’s the wrong perception everyone has to investing. Most people see investing as gambling, because they try to chase quick wins. That’s not the purpose of building a balanced investment portfolio. The goal is to create a portfolio that is sustainable to our own personal risk tolerance. For the majority of the people out there, this means that an investment portfolio needs to perform within our comfort zone when markets are doing well, as well as maintaining our sanity when markets are doing poorly.
Remember that bonds are the counterweight to stocks. The phenomenon that we are seeing is the proper one. When stocks are going up, bonds tend to go down in price. When stocks go down, bonds will tend to rise. This type of negative correlation is why we want to be holding bonds. It puts the brakes on gains, but also puts the brakes on drops. It’s the strategy that most people should use to reduce volatility and risk. Bonds are a like a parachute. It prevents you from running too fast when you are going forward. When you’re falling, bonds will prevent you from falling too fast, but you will fall.
Other Fixed Income Assets
I’ve written about other fixed income assets like preferred shares. These should also be considered for a good balanced portfolio because they provide regular dividend income to the holder of these shares. Unlike bonds, however, preferred shares don’t have a negative correlation. In fact, preferred shares are most sensitive to interest rates. When interest rates rise, the price of preferred shares, especially rate-reset preferred shares, rise. When interest rates fall, the price of preferred shares also fall. The reason for holding preferred shares is for the preferential treatment of distributions for taxation purposes. Since interest payments to the investor is in the form of dividends, the money received is taxed much more favourably in Canada than interest income from bonds or GICs. For those with a large investment portfolio, preferred shares should be held to increase income.
GICs are also a form of a fixed assets that will offer more interest payments than keeping money in cash. GICs are probably the most popular form of investment that most Canadians make because they guarantee the principal. However, with low risk, the return on investment is also very low. This shouldn’t discount GICs from necessarily being a good short term hold for free cash. At least it generates more income than a regular chequing account that may provide no income, but GICs shouldn’t form the foundation of the fixed income portion of the portfolio. A mixture of bonds and preferreds should be the proper way to go.
Get Fixed Income For Income
Perhaps some people get confused with fixed income assets and what they should really be used for. The main purpose of fixed income is to provide regular income based on the interest rate. This means that it shouldn’t be used for capital gains purposes even though the price does fluctuate.
Don’t worry if the price of bonds or preferred shares drop. What’s more important is that the interest payments continue to be made while holding. When you buy a bond or preferred share you are buying it for the money that gets distributed by holding the share. A 4-5% return on bonds or preferred shares is an extremely good income generating asset and one that shouldn’t be discounted, especially if it has maintained the payout.
Be happy with the income and don’t worry about the capital gains and losses. Treat gains as an extra bonus, and declines as a possible way to get extra shares at a higher interest rate. But regardless of what you do, always keep a good portion of your money in fixed assets to balance out the risk in owning stocks. At least it will give you the comfort to sleep better at night.