Thursday, September 20, 2012

Rule #19 No Fixed Income.

When the topic of portfolio asset allocation comes up in discussion with financial folks, they will often talk about the ratio of equities (stocks) to fixed income (bonds).  Some advisors recommend a 60/40 ratio adjusted either up or down depending on your age and risk tolerance.  They often use bonds as a type of a hedge against big drops in the market.  If stock values drop, bonds tend not to drop the same amount under the same market conditions.  The opposite is also true in that bonds tend not to rise anywhere near as much as stocks do during bull markets.  Once you take the market value gains or losses out of the picture as we do, are fixed income investments a good fit for our model? Not the way we look it.

We have no fixed income in our investment portfolio and we won't be adding any anytime soon.  Fixed income is defined by InvestorWords.com as: A security that pays a specific interest rate, such as a bond, money market instrument, or preferred stock. This sounds pretty good on paper. Its essentially a near-guaranteed return on your investment over a set amount of time.  A GIC (Guaranteed Income Certificate) is another form of fixed income with the word "Guaranteed" right in the name of the investment instrument. Wow! Guaranteed sounds pretty good, doesnt it?  


Because of the low interest rate environment in recent years, fixed income yields have been historically low.  GICs are currently paying about 1-3% annually depending on the term, and bonds are not paying much better.  These numbers are so low that they dont even keep up with inflation after considering both taxes and inflation.  Outside of Registered accounts, fixed income such as GICs and Bonds are taxed similarly to employment income so the tax rate can be as high as the 49% depending on what province you live in and what marginal tax bracket you occupy.  Corporate bonds pay better, and can be closer to 4-6% but most advisors would say that corporate bonds tend to be higher risk and if you are looking for safety, going to corporates are not the way to go.  They are also still taxed at potentially very high rates where up to half that higher rate is sent to government.  If you are looking at corporate bonds in general, you may have the appetite to go with either preferred or common shares that pay dividends instead.  

Canadian Preferred shares with dividends are the only types of fixed income that we would currently consider since the yields tend to be high and the dividend is taxed the same as Canadian eligible common share dividends which have a significantly lower tax rate.  Preferred shares tend to be a little more risky in their "secureness" compared to bonds, but if you screen your preferred shares with proper due diligence, they are a pretty safe alternative to bonds.

The main reason we do not invest in fixed income is because of the "fixed" nature of the gain and how your gain actually gets smaller over the term of the investment because of inflation.  The amount of gain you get as a percentage is the same at the end of the term as it is at the beginning.  If you buy a 10 year $1000 bond that pays 4% annually, 10 years later you are still getting 4% (pre-tax remember... in after tax dollars its much worse) on your $1000.  40 bucks per year at the beginning of the term and 40 bucks per year on year 10.  In the mean time, inflation is chugging along and all your money (both principle and income) has less and less buying power.  This means that in year 1 your gain might be able to buy a case of beer, but in year 10 will that same gain of $40 get you a case of your favourite ale? Probably not. 

It should come as no surprise that I prefer conservative Canadian dividend-paying stocks as a replacement of fixed income in our portfolio. A company stock with a healthy yield and a record of increasing its dividend at or above the rate of inflation would be a reasonable substitute in my mind with the potential for capital price growth to go along with the tax efficiency of the dividend.  An example of a stock like this would be Fortis. Fortis is in the electricity transmission business mainly in parts of Canada and the Caribbean.  People can't do without electricity, so its one of the safest industries to invest in and the need for energy transmission will continue to go up in the future so there is even the potential for modest growth.  Fortis currently has a dividend yield of about 3.6% and the company has a history of increasing its dividend, mostly at or above the rate of inflation.  Another great thing about Fortis is that with the increasing cash-flow comes an increase in the stock price as well.  As the cash-flow goes up, so too does the stock price.  Bonds do not have that kind of relationship as the yield never changes as you hold the investment.  To us, in comparison to bonds, the upside potential on a stock like Fortis well out-weighs the risk of keeping your money in this type of equity.  

(Full disclosure: I do not currently own any Fortis, but it is on my watchlist and would look to add some to our portfolio if the yield got to be over 4%.  I am not making any recommendation to either or buy or sell Fortis)




By: TwitterButtons.com

Wednesday, September 19, 2012

Rule #18 Don't Diversify... too much.

This one goes against what most Financial Advisors will tell you.  They will tell you that you should diversify among various sectors and investment products because it allows you mitigate the risk of losing all your money if one event wipes out one of those sectors.  This is the "Don't put all your eggs in one basket" approach, except advisors tell you to put your money into lots and lots and lots of baskets by investing in multiple Mutual Funds or ETFs.  I am not a fan of "blanket across the board" diversification like this.  I would rather invest in 3-5 things or sectors that do I understand rather than hundreds that I don't - which is what most people are doing when they buy a broad-based mutual fund or an ETF.

I'm not against diversification per se, but I think hundreds of stocks are too many and is investing "not to lose" rather than investing "to win".  I also have the ambition to learn how all these companies operate and run their businesses, and invest in the ones that meet my risk tolerance level and long term investment plan.  I want the best companies for us, rather than buying a basket of stocks that include both the good and the bad.  Also, since I focus on cash-flow and not capital appreciation as the backbone of our strategy, I prefer to track financial statements of specific companies rather than of indexes where the data is more difficult pick out exactly whats happening to individual stocks.

Here is my rationale for taking a more focused approach.  It works for us, it may not work for everyone.  Have you ever heard of folks who invest solely in "Bricks and Mortar" Real Estate?  I have, and they often do quite well for themselves.  They have focused on learning the ins and outs of real estate investing and put all/most of their eggs in that basket.  Thats how real estate barons like Donald Trump make their fortunes.  They focus on one sector and do it very well.  I know other people who work in the High-Tech sector and they are constantly checking out their competitors and are aware of all the new trends developing within the sector.  Should they diversify in things they dont know or should they invest in what they know and live every day?  Mining Geologists I know invest in precious metals because they understand the supply and demand dynamics of the commodities industry better than anyone else.  All of these types of focused investors leverage their day-to-day professional knowledge towards their personal investments.  They have become experts in their fields and then apply that expertise to further their personal wealth through continuing to investing in their field of work.  Another way to approach or look at this is to invest in what interests you or what you understand based on your day-to-day experiences.  Does it makes sense to invest in hundreds of stocks that you don't understand or a select few that you do? I choose the latter.

I spent 17 years studying and working in the technical side of the Oil and Gas industry. I worked as a specialist for a Super-Major Oil and Gas Operating Company that explored for, and developed, hard-to-get-at resources.  Its a highly competitive industry and there are lots of players in both the Operating Company side as well as the Service Company side.  I understand many of these aspects of the industry because I lived it day-in and day-out for many years.  I still know people working at many of the companies and I am in communication with many of them on a regular basis.  Would it not make sense that I leverage that knowledge towards my investing practices?  I would think so.  I am also generally interested in money management, economics and wealth creation... and I am continually reading up on books about this kind of stuff, because thats what I'm genuinely interested in.  I am also interested and have some experience in the real estate market as we have owned 3 different properties in the past, and made offers on three other real estate deals that did not go through.  I've seen how these industries operate, studied them more, and understand them better than others.

Based on my expertise and interests I have chosen to invest in about 15-20 stocks in 4-5 sectors with respect to equities.  Those main sectors are: Oil and Gas, Commercial Real Estate, Energy Transport and Transmission (pipelines and electricity), Consumer Staples, and Banks/Financials.  I specifically do not invest in a number of sectors because I either don't like the sector itself, or because I don't understand how the businesses work or what their prospects are in the future.  Those sectors would include high-tech, retail, pharmaceuticals, consumer discretionary, transportation, commodities and agriculture.  I am slowly educating myself on a few of these sectors but until I understand them, I am in no rush to buy into them.

So as you can see, I am not against diversification because my portfolio is diversified, just not diversification to the point where I can't tell whats going on.  I like to invest in things I understand, and not invest in things that I don't.  Every investor has to determine what level of diversification is comfortable for them and how much they really need to know.


Tuesday, September 18, 2012

Rule #17 Save/Invest ALL windfalls or bonuses

Windfall: (n.) An unexpected legacy, or other gain.

We use our weekly or monthly paycheques to pay for our day-to-day lifestyle and we live within our means based on that income.  We have a set amount that we save and invest every month - an amount that comes out of our monthly cash-flow.  This is the discipline part of our money plan... However, every spring there is a chance we get a tax refund, I sometimes get a bonus from work, and at some point we may get an inheritance but we dont know when or if that will ever occur.  We don't know how much (if at all) any of these windfalls are going to be, so we never consider them when planning our monthly or yearly budgets.  We essentially treat them as found money.




Have you ever had a one of these sizeable windfalls that you weren't expecting come in?... a significant amount of cash that isn't part of your regular paycheque, and you were faced with the question "what should you do with it?"   Should you use that money to renovate your kitchen?  Buy a new car?  How about a motorcycle? Some people take their bonus and go on big vacations or pay off large credit card debts that they've racked up.  I even know people who spend like crazy at Christmas and then plan on having their tax refund in the spring pay for the credit card bill... Yikes.  But I digress... Assuming you're not breaking my credit card rule, what should you do with such found money?  Should you use it for a one-time consumer purchase or should you put that money towards something that would make you life easier every day to infinity... such as to pay down debt or invest in assets that will continue to send you a cheque for the rest of your life every year?  Ahhh now thats starting to sound like me.

Whenever we have one of these windfalls we apply it to our investment strategy so that we continue to benefit from the windfall for the rest of our lives, through predictable cashflow... usually dividends.  Its sort of like a a shot of adrenaline to our portfolio's cashflow and can make a significant difference over time.  We ALWAYS use bonuses, tax refunds and any other "found money" to further our progress towards financial independence.

Lets assume a quick example of a $10000 windfall from something.... say a bonus at work because your company had a banner year.  Invest that money in a company such as Bell Canada (BCE), who pay a quarterly dividend equal to about 5.3% annually at today's stock price.  That dividend will now pump an additional $530 into your annual cash-flow this year and next year and likely every year after that so long as people keep buying their phone, cable and internet services through Bell.  Another way to look at it is that that $44 ($530 divided by 12 months) of your monthly budget is now paid for each month from your Bell investment.  Its interesting that the one definition of windfall is an unexpected legacy, because that is what you're setting up when you invest this way... it is  legacy cashflow that is potentially for the rest of your life.  What you do with that $44 each month is up to you.  You can re-invest it, or spend it on something else like paying for your internet through Bell.  See what I did there? Investing windfalls is certainly not as sexy as buying a motorcycle, but reaching financial independence has some pretty good perks as well.


By: TwitterButtons.com

Friday, September 14, 2012

Rule #16 Plan on Financial Independence without CPP

(Note: FYI, this post is mostly relevant in Canada as it talks about the Canada Pension Plan. I am not familiar with other government run pension plans in other countries but I would bet many of the points I raise here are similar.)

I generally don't trust that the government will do what is in my best interest.  I am usually skeptical of any incentive that they offer us as citizens and taxpayers, and I usually challenge whether whatever they are "offering" is truly good for me and my family or not.  I value my freedom and don't take kindly to being coerced or forced into doing things I don't like or want.  An example of this is the Canada Pension Plan.



The Canada Pension Plan takes 4.95% of your first $42000 of earned income and sends it to a government office to manage your money for you.  Thats about $2000 a year.  If I am an employee, I am required to pay into it annually. I am not permitted to opt out of it.  To us, this a bad deal.  The other kick in the teeth is that your employer has to match your contribution... so there is about $4000 per year being funnelled into the CPP each year per employee making over $42K.  But Ryan, why wouldn't you want a government managed pension?  The government has decided to look after you, isn't that a good thing?  No, it isn't.  Not for us.  I would rather manage that money myself.

The maximum amount that CPP pays you if you were to retire in 2012 in before-tax dollars is $986.67 monthly. Not much, eh?  You have to be aged 65 and have worked 40 or more of those years, while maxing out the contributions, in order to qualify for the max pension.  If you didn't make the max contribution, your amount goes down. If you take your benefits early at age 60, your amount goes down.  If you didn't work 40 years or more, for whatever reason, your amount goes down.  Now me, I went to Graduate School so I didn't start working 'til I was 28.  I've also taken two Leave of Absences to be with our boys when they were born.... So fat chance I'm going to get the full $987.  My wife always planned to take some time off and raise our kids so odds of her making that maxed amount is also nil.

There are some other reasons why I am not a fan of the CPP.  If you are single and you die before you are old enough to collect a pension - age 60 I believe for a reduced amount for example - no residual value is left to your estate or your heirs.  If you die the day after your first pension cheque, your surviving spouse may, from what I understand, get up to 60% of it, but if you have no spouse or they have already died, poof your pension is gone.  Again, there is no residual value to pass on to your heirs.  Its essentially an insurance plan that the government forces you to pay into... and not a very good one at that.  You will have paid into if for all those years and gotten very little or none of it back if you expire early.  I can think of a better way to use my own $2000 per year AND have some residual value left over.  Remember Mr Gunter?

When I look at the CPP, I see it as a retirement savings vehicle for people who are not savers.... and to some extent another example of the government encouraging people not to take responsibility for their own well-being.... Or, as in our case, the government not letting people take care of themselves.

When we started planning our finances years ago, we looked at the above CPP conditions and said to ourselves "These are way too restrictive!" For one, we won't be working 40+ years.  If one or both of us want to take a few years off here or there, that small amount gets smaller and smaller.  Then we said "Do we really want to work continuously 'til we are 65" The answer to this was a resounding "No."  Its not to say that we won't work 'til 65... or even beyond... It was that we would be required to work that long because the government would be holding this carrot over us to make us continue to work.  "Screw That!"  So our plan is to make sure that we can look after our monthly liabilities without relying on the government managed CPP. We plan to stop working when we want, if we want.... not because we were forced to work until a certain age. When making up our master plan, CPP doesn't even factor into it.

So our solution is that we plan our finances as if there will be nothing in CPP for us when we get there. If there is anything for us in CPP we would take any benefits into a system that we were forced to pay into, regardless or how poorly it fits for us.  Based on our plans we expect to be just loose change.


Thursday, September 13, 2012

Rule #15 Don't try to "Beat the Market"

Do you know the only thing that gives me pleasure? 
It's to see my dividends coming in. -John D. Rockerfeller

Have you ever heard anyone talk about beating the stock market?  Its what hotshot investors talk about at cocktail parties.  What they mean is that if the stock market has an annual return of 10% in one year, they have had a better return than that 10%.  Very impressive indeed!  They will try to achieve this by building and adjusting a stock portfolio, mutual fund portfolio, or with index funds.  Beating the market is all well and good if the market goes up, but what if the market goes down? If the market has a loss of 5% the next year and the investor only lost 3%, then they have also beaten the market because they have done better than the market has done that year.... but people don't tend to brag about losing money "Yeah! I only lost 3% this year!".  The market (and by market I mean Dow Jones Index, S&P 500 index, or TSX index etc...) has historically returned 8-12% returns annually but those numbers are smoothed out over decades of data, so you certainly couldn't count on a 10% return every single year... as has been the case the last decade.  One thing about measuring returns in the market this way is you only realize these returns when you sell the investment... and that brings on the issue of timing, and few people have mastered that.

I don't really care if I beat the market or not.  Beating the market is not my objective.  I am not in competition with the market, My objective is to build a portfolio that will eventually result in me being financially independent.  Who cares if you beat the market if the market has lousy or negative returns?  If the market loses 25% in a year, I feel no pride in only losing 20% that year.  And if the market were to make 25% in one year, its ridiculous for me to worry that I only returned 22% instead.  I feel this "beat the market" mentality is a waste and makes people take their eyes off the prize, or chase capital returns instead of stable cashflow.  People shop around for stocks or sectors hoping to get a winning year or to follow advisors or mutual funds because they have a few good yearly returns.  That just seems dumb to me.  I prefer a system that provides stable and somewhat more predictable results.

We have our own metrics.  We don't compete with the market, and we sure as hell dont try to beat it.  Our goal is to grow our cash-flow on existing assets by 8% a year... We get this by reinvesting the 3-5%-ish dividends that we get in cash-flow and then plan on a 4+% increase in dividends annually.  We generally don't pay much attention to stock prices once we own the stock because they tend to fluctuate due to world and political events rather than be based on actual company financial metrics.  Tracking growth of cashflow is pretty easy to understand and we don't have to follow the stock prices or compare with how the market is doing.  In fact, since we are reinvesting dividends to buy more stocks for cash-flow, we don't mind when the market takes a dive because it means we can pick up good stocks with even higher yields than before.



Every year for the last 10 years, our cashflow from existing assets has increased.  Every year! And Every year it has gone up above the rate of inflation.  The lowest growth rate was about 5% in 2009 and the highest has been about 15%.  Thats a pretty good record if you ask me.  This year is turning out to be a good one, we expect about a 10% increase in total this year if we keep going the way we're going.  Three quarters of our dividend producing stocks have increased their dividends this year and the rest probably will within the next 3-6 months, and we just keep rolling those dividends back into the portfolio buying more cash-flow-producing stocks, furthering the compounding.  This increase also does not include any new monies that we put to work in this strategy.  Include the new monies, and our conservative leveraging strategy and we're increasing our cashflow above our 8% per year target relatively easily.  Do I care how this all compares to what the stock market performance is doing these days?  No, I don't.