Investing: Diversification

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Diversification is a strategy that can be neatly summed up by the timeless adage “Don’t put all your eggs in one basket.” The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.

A diversified portfolio should be combined with asset allocation. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you’ll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions. For example; a small rise in interest rates would have a negative effect on the value of long term bonds but a positive effect on your cash holdings.

One way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. For example; buy a bank stock, an oil & gas company, a technology company and so on. But the stock portion of your investment portfolio won’t be diversified, if you only invest in only four or five individual stocks. You’ll need at least a dozen carefully selected individual stocks to be really diversified.

To be truly diversified, you also need to invest in other countries as well as at home. Even if your portfolio is small, you could buy companies that are multinational because they get revenue from around the world. An example of a multinational company would be a company like  “Apple”.

Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset category through the ownership of mutual funds rather than through individual investments from each asset category. Mutual funds make it easy for investors to own a small portion of many investments.

Be aware, however, that a mutual fund investment doesn’t necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. If you invest in narrowly focused mutual funds like an energy mutual fund, you may need to invest in more than one mutual fund to get the diversification you seek. .

As you add more investments to your portfolio, you’ll likely pay additional fees and expenses, which will, in turn, lower your investment returns. So you’ll need to consider these costs when deciding the best way to diversify your portfolio.

Risk and reward are inextricably entwined. You’ve probably heard the phrase “the bigger the risk, the bigger the reward”. If you intend to purchases securities – such as stocks, bonds, or mutual funds – it’s important that you understand before you invest that you could lose some or all of your money.

Investing: Asset Allocation

Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. In theory, the returns of the three major asset categories do not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns.

By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. For example; a conservative investor would use 50% of their funds to purchase stocks, 40% to purchase bonds and 10% in cash. While a more aggressive investor might have 75% in stocks, 20% in bonds and 5% in cash.

Re-balancing Your Asset Allocation

Re-balancing is bringing your portfolio back to your original asset allocation mix. This may be necessary if over time some of your investments may become out of alignment with your investment goals. You’ll may find that some of your investments will grow faster than others.

For example, let’s say you determined that stock investments should represent 50% of your portfolio. But after a recent stock market increase, stock investments represent 70% of your portfolio. You’ll need to sell some of your stock investments and purchase some bonds to reestablish your original asset allocation mix. By re-balancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk.

When to Consider Re-balancing

You can re-balance your portfolio based either on the calendar or on your investments percentages. Many financial experts recommend that investors re-balance their portfolios on a regular time interval, such as every six or twelve months. Others recommend re-balancing only when an asset class increases or decreases more than a certain percentage that you’ve identified in advance.

Weaknesses of Asset Allocation

  • Selling your winners to buy more losers not always a good strategy, no guarantee that your losers will become winners
  • Re-balancing too often will increase transaction costs reducing the value of your portfolio
  • Asset allocation alone will not protect your portfolio from raising interest rates or inflation which will affect the value of most asset categories.
  • Offers little protection during a major economic crisis like 2008-09 when both stocks and bonds went down in value.

 

Keep in mind that asset allocation will not protect you from losses in the future if you panic and sell too soon just because markets went down in value. Markets do bounce back; sometimes you just have to wait it out.

Next week’s lesson: Diversification

 

Investing: 101

Investing your savings is the next step in reaching financial success. It is a huge step because of the size and scope of investing in today’s markets. The financial industry has created a massive amount of different products to choose from with complicated fee structures and high levels of risk.

I am going to begin with a three part series on setting up an investment portfolio.

This week’s lesson is on ASSET CLASSES.

An asset class is simply a grouping of similar types of investments. The three most common assets classes are: Equities (stocks), Fixed Income (bonds) and Cash (cash equivalents). We need to categorize them in even greater detail. Each of these can be broken down into sub-classes by size, industry, location, risk etc

Equities /Stocks

  1. Location – domestic market, foreign developed markets, (like Europe or Japan) foreign emerging markets (like India or China)
  2. Market capitalization – how big is the company (small-cap, mid-cap, large-cap)
  3. Domestic or multinationals- does the company’s revenue come from one country or from around the world
  4. Value or growth- Is the company well established with predicable revenue or is it new with lots of potential

Fixed Income / Bonds

  1. Government or corporate bonds
  2. Foreign or domestic
  3. Investment grade or high yield (junk bonds)
  4. Time of maturity- short term (under 3 yrs.) mid-term (up to 7yrs) long term (10 yrs. & longer)
  5. Bond like – preferred shares, convertible debentures
  6. Other – mortgage back securities, commercial paper, multitude of interest paying products

Cash / Cash equivalents

  1. Savings accounts
  2. Canada Saving bonds
  3. Treasury bills
  4. Guaranteed investment certificates (GIC)
  5. Money market mutual funds

Alternative investments are another asset class for sophisticate or high net worth investors. The following are just a few examples;

  • Real Estate
  • Commodities – natural resources like oil & gas, agricultural like wheat & corn, metals like copper etc
  • Precious metals – gold & silver
  • Currencies
  • Stock Options
  • Future Contracts
  • Collectables

Determining which assets to hold in your portfolio  will depend largely on your time horizon and your ability to tolerate risk.

An investor with a longer time horizon, like saving for retirement, may feel more comfortable taking on riskier investments. (More stocks than bonds) By contrast, an investor saving to buy a house would likely take on less risk because they have a shorter time horizon. (Short term bonds & GICs)

Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor is more likely to risk losing money in order to get better results. A conservative investor tends to favor investments that will preserve their original investment.

Next week’s lesson: Asset Allocation

Tax Planning: Your Marginal Income Tax Rate

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Most people have never come across that financial term. The marginal tax rate is the combined federal and provincial income tax that an individual will pay on the next dollar of income.

Many financial planning and investment decisions are made based on the individual’s tax situation. Here are some typical financial questions that I was asked when I was working as a financial adviser

  • Put money into a RRSP or pay down the mortgage?
  • Invest in a dividend paying stock or buy a bond?
  • Contribute money into a TFSA or RRSP?
  • Contribute money into your RRSP or your spouse’s?
  • Buy a cottage or a vacation property in Florida?
  • Apply for CPP early or wait until age 65?

The answer to those questions and many others depends on your tax situation. It isn’t always about how much money you earn but how much you keep.

Here is an example of why knowing your marginal tax rate is important. One of my former clients was a retired teacher. He was collecting a pension of $70,000 and his wife was working part-time earning $10,000 a year. The teacher’s marginal income tax rate was 31% but his wife’s rate was only 20%. By transferring $25,000 of his pension to his wife, he would reduce his income tax by $7,750. However, his wife at a 20% tax rate would have to pay $5,000 on the transfer of pension income. The couple reduced their total tax bill giving them an extra $2,750 to invest or spend on a vacation.

How to find your approximate marginal tax rate:

    1. Go on-line to the CRA web site and print off Schedule 1
    2. Print off your provincial tax schedule (AB428, BC428, ON428)
    3. Take your gross annual income from your T-4
    4. Add the appropriate tax brackets together

For example; an income of $70,000 is in the 9.15% tax bracket in Ontario and the federal Schedule 1 is in the 22% tax bracket for a marginal tax rate of 31.15%. However, if you live in Manitoba the $70,000 falls in the 17.4% tax bracket plus 22% federal tax equals a marginal tax rate of 39.4%!

The tax man is always there picking your pocket. Some taxes are visible; they are added to the purchase price of things you buy. Some are hidden in the price, like in the price of gasoline. I goggled “Tax Freedom Day in Canada” and found that the average Canadian family pays 43.5 % of their income in taxes. If you had to pay all your taxes upfront, you wouldn’t be free of paying tax until June 9, 2014!