Farm income has been lower than expected and family issues have arisen over how to manage the farm business. Jack and Molly approached Don and Erik Forbes of Forbes Wealth Management Ltd. in Carberry, Man., to develop plans.

The facts are straightforward. Ten years ago, they expanded the farm by purchasing 1,000 acres adjacent to their existing property. They also created a farm succession plan, asking Max, then 29, to come back from a city job to farm full time.

At that time, 2008, Jack and Molly incorporated the farm, transferring their farm machinery and inventory into the corporation for $1 million worth of new-issued preferred shares. Max bought $100 of the only common shares. The parents retained the personally owned farm land.

Typically, Max would have gains from the corporation’s profits through his common shares. However, the 3,000-acre operation has not been profitable for many years. The corporation’s retained earnings account is zero.

The financial failure of the farm has caused friction. Max wants to change the way the farm is run. Jack and Molly want no changes. The family needs a workout plan, Don Forbes says. Three are three ways to go: Plan One: Sale of Max’s common shares; Plan Two: Preferred share conversion; Plan Three: relocation for Max and Chloe.

Plan One recognizes that Max is the owner of all common shares of the farm corporation. Common shares have voting rights while preferred shares usually do not. Max might be able to find a buyer for his common shares. If he can, the first $835,716 of capital gains on the common shares would have an offsetting federal tax credit. Manitoba tax and the Alternative Minimum Tax would apply, but the AMT is actually a carry forward of federal tax prepaid. It is a tax credit, in other words, usable over the next 10 years. Any gain over the $835,716 level will be taxed at a preferential rate of about 22 per cent rather than the 40 per cent to 50 per cent rate on the proposed table dividend income, Forbes says.

The downside of this plan is that a third party is not likely to invest $1 million in a company which does not make money. Moreover, for non-arm’s length transactions, the Canada Revenue Agency has an additional requirement that the full price must be paid in the year of the transaction. If it is not, the capital tax exemption will be denied.

Plan Two conceives of a preferred share conversion and a payout. There is a potential offer of $1 million for the preferred shares of the farming corporation. This is not the best deal for Max, but it may be the only way for him to receive value for his work since 2008.

Preferred share redemption would be fully taxable in Max’s hands. He would still be at risk because his payout depends on the farm becoming profitable. His equity would be locked in at a fixed value with a zero-interest rate and would at best be paid out over the next 20 years.

The Brown’s accountant has pointed out that the farming corporation’s articles of incorporation provide the board of directors with the right to convert the existing preferred shares into common shares on a one-to-one ratio. Max would be outvoted two to one by his parents if they, the majority of the board, go ahead with the conversion. Max’s commons are now worth just $100 and, were he to convert on a one to one basis, he would have only 100 of the total 1,000, 100 common shares.

The parents’ rationale for this possibility was that Max was only to participate in profits, not in any increase in land values. Given that the company’s profits are zero, Max’s equity value would be zero.

Max assumed that the increase in total company value after repayment of the parents’ $1 million preferred shares was his. He signed the articles of incorporation, but neither read nor understood what some of the clauses meant.

In Plan Three, Max and Chloe would move away. They would put $25,000 into Chloe’s RRSP. Max has that and more. Their RRSPs have a combined present value of about $50,000. Eventually, they could use the Home Buyers Plan to take a maximum of $25,000 from each plan, repaying the loan over the next 15 years. They could use the $50,000 as a down payment for a home in the $300,000 range, Erik Forbes suggests.

In future, Max and Chloe should maximize their RRSP entitlements to defer tax liability on employment income. If Max and Chloe achieve accelerated savings for 20 years with savings of 20 per cent to 25 per cent of gross income for two decades, they can achieve the goal of a secure retirement.

The moral of the story is that one should set up a written contract, which could be an employment contract, partnership agreement or a shareholder agreement requiring unanimous agreement. The agreement should cover such events as a partner’s death, disability, divorce, changes in valuation formulas or voluntary termination, Don Forbes explains.

“This is a sad case, for it involves children having little choice but to leave the family farm,” Erik Forbes says. “But at least there is a way out and a plan for them to build a strong financial future.”

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In the U.S., the strength of the economic recovery — enhanced, some say, by President Trump’s tax cuts — has accelerated the rise in interest rates. The Federal Reserve Board is expected to raise its critical short rate three times in 2018 — some observers say four. A fourth raise would put the critical overnight rate — the rate banks pay to borrow reserves from the central bank — at about 2.875 per cent, more than twice the present 1.375 per cent overnight rate. In Canada, one more raise from the present 1.25 per cent to 2.0 per cent by the end of 2019 is expected, says Royce Mendes, director and senior economist at the capital markets division of CIBC in Toronto.

The combination of recovery in the U.S., a potential trade war with Canada over steel and aluminum, geopolitical jitters triggered by threats of nuclear war with North Korea, and the unknown durability of the incumbent president and his policies have pushed U.S. and Canadian yield curves into a swamp of risk. Where the risk lies depends on whether you are borrowing or investing.

Borrowers and investors

From a Canadian homebuyer’s point of view, current mortgage rates range from 2.69 per cent for a one-year term with a floating rate, to 3.04 per cent for a five-year fixed term, to 3.84 per cent for a 10-year fixed term.

Canadian borrowers tend to seek security. Thus five-year closed mortgages at 3.04 per cent tend to be more popular than the floating rate five-year mortgage currently at 2.21 per cent. Clearly, buying peace of mind is worthwhile to some borrowers.

But the cost on a 30-year mortgage is substantial. For a $500,000 loan, the 2.21 per cent rate costs $1,901 per month; the 3.04 per cent mortgage costs $2,118 per month. Leaving out variations in amortization (the cheaper mortgage pays off the loan balance faster), the difference in rates amounts to a $78,120 difference in total mortgage outlay. For more information on the cost of peace of mind, visit www.ratehub.ca/best-mortgage-rates.

For investors who want to lock in returns, the differences between borrowing and lending are striking. The annual yield to maturity on a Government of Canada 10-year bond, 2.17 per cent, just 16 basis points less than the 2.33 per cent average annual yield to maturity on a 30-year Government of Canada bond. In other words, for a 20-year $10,000 bond, the annual premium one gets for locking up money for 20 more years over a 10-year bond is just $16. That’s chump change.

Corporate bonds have more risk than government bonds. Canada’s corporate bond market does not yet reflect the potential effects of trade wars, the chance of a U.S.-caused economic slowdown or sheer uncertainty.

“Bonds do not reflect event risk, but those are mostly one-off events, such as problems with North Korea,” explains Chris Kresic, partner and head of fixed income at Jarislowsky Fraser Ltd. in Toronto. “Corporate bond prices are higher and yields lower than they would be if geopolitical and other risks were priced in. Growth and inflation are more important drivers of return.”

The question for the fixed income investor, who will get back only the amount of money in a bond if it’s held to maturity plus interest, is whether promised returns are appropriate for the political risk rocking the stock market.

Fixed income markets for bonds and GICs are pricing in inflation but not geopolitical risk. On down days, global stock markets are offering bargains. There is no default risk in the federal bonds of Canada and the U.S., but paying the list price for bonds when you can buy them at nice discounts of a fraction of one per cent of yield is just unnecessary. Talk to a financial advisor if this stuff is not part of your toolkit.

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Investing in early stage ideas is problematic. The high-risk path is strewn with failure. However, if you spread your financial commitments widely and keep costs down, your upside will be greater than your downside. This is no way to get rich quick, but it will keep you from becoming suddenly poor.

Risk can turn from theory to disaster very fast. Atari and Commodore 64 were primitive computers, if anyone remembers. LEOs were low earth orbit satellites that cost hundreds of millions and then were made obsolete by cell phone towers. Airlines rose and collapsed. Remember Eastern Airlines, Pan American World Airways, TWA, Swissair, Sabena, and our own Canadian Pacific and Wardair? It is not just the idea, but the survivability of companies that turns concepts into long term gains.

How do you know what to do when rules seem to change so quickly? The integrated North American car assembly industry may be shattered by the American president. Quebec may keep or lose its protected dairy industry depending on what happens in trade negotiations. How can a person without a crystal ball make rational decisions? I don’t think you can.

Look back a century to 1918. Germany was financially shattered by the First World War, ditto Austria. Both lost their monarchs, then were united in one empire, the Third Reich, by a movement led by a failed artist who had a gift for making rousing speeches. That the most robust monarchies on the continent would flop was unpredictable — before they did. That Germany would be reindustrialized by the American Marshall plan was unimaginable and actually against the advice of the Secretary of the U.S. Treasury who, in 1944, had urged that Germany be left in defeat and ruin never to rise again.

In 1960, IBM owned the world of mainframe computing. In 1990 it was a big player still. Today, who cares? IBM was the world 30 years ago, now it is just one of many companies in computer services.

And think of the flops of the last 20 years: dot.coms with no business plans, Nortel Networks with unbelievable and often disingenuous accounts, Enron — an outright fraud. How can a sane person invest in this stew of lies and hopes?

The analysts

When you examine the record of analysts paid for their crystal ball work, you come away scratching your head. The CXO Advisory Group, a Massachusetts-based think tank, rates gurus. Here is what they found:

• The average guru has a forecasting accuracy of about 47 per cent.
• The distribution of forecasting accuracy by the gurus looks very much like what you would expect from random outcomes. That makes it very difficult to tell if there is any skill present.
• The highest accuracy score was 68 per cent; the lowest was 22 per cent.

The gurus may be smart and have degrees from MIT and Harvard. But most work for investment banks who pay their salaries and sell the stocks they rate. Gurus who want to keep their fat paycheques do not tell the world that their firms’ clients are money losing enterprises with overpaid managers.

I think you can do better with a combination of skepticism and a refusal to pay more than about 20 times annual earnings for anything, plus an insistence of a dividend rate of 2.5 per cent or more and, as well, refusal to buy when the dividend yield goes to seven per cent or higher — a sure sign the market thinks the dividend will be cut. Be a skeptic and reject others’ advice even if they have fabulous titles and brilliant resumes.

In the dot.com era from 1998 to 2000, some stock market analysts urged investors to pour money into companies that had no profits, no sales, sometimes no business plan, but did have a period in their name. This advice produced astonishing runups in price and then equally astonishing flops when folks realized they were buying wind without sails.

Today, we have imaginary money being priced to the heavens by people who don’t know what characteristics money should have. Imaginary money that behaves like a rocket on the way up and then flops like a bad North Korean missile test is not money. It is not even a good commodity. But novelty and lack of understanding propel Bitcoin and about 800 other cryptocurrencies to the heavens.

As for cannabis, it may work. It is, after all, an agricultural commodity with a known and vigorous market. Valuation of the product with consumers having vast choices of this or that bud is going to be a challenge, as is the precise legality of the stuff in various jurisdictions.

So we come back to the problem of finding solid investments.

In the end, there is no substitute for doing your own research, being a cynic, never paying too much for somebody else’s business, and keeping plenty of cash on hand so that, if things turn bad, you won’t be forced to sell at fires sale prices. Caution cuts risk. If there is one lesson for off-farm investing, it is just that. Be early and be at risk. Be late and lose.

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The CAPE index smooths out the wobbles in average price of the biggest 500 companies in the U.S. Getting rid of some short-term noise adds clarity, but the underlying issue is that stocks are very expensive and getting more so.

Today, the S&P 500 index is 47 per cent over its February 2016 low. It has risen dramatically even though the great leveler of the stock market, interest paid on government bonds, has risen dramatically. As of early January, the 10-year Government of Canada bond yielded 2.20 per cent per year, more than double the prevailing rate just six months ago. U.S. Treasury 10-year bonds yield 2.54 per cent, also double rates earlier in 2017.

Bond interest is hugely influential for share prices because it sets the cost of borrowing money to buy stocks. So far, government bond interest rates, though rising, are low on an historical scale.

Why are stocks rising?

Why are stocks are thriving in spite of warnings signs from the bond market? Top candidate: there is so much money sloshing around as a result of the massive bond purchases by central banks used to reflate banks’ after 2009 and, of late, extensive stock buyback moves by big issuers like Apple Inc., that old-fashioned measures like price/earnings ratios are being disregarded in favour of momentum investing. That means people are not buying companies so much as they are betting on the trend. It’s very dangerous kind of speculation.

So if you like pot stocks at 1,500 times estimated 2020 earnings, goes the logic, you should like them even more at 3,000 times estimated earnings. This is flawed logic, for it should be the other way round. But this is a market for the very nimble and the gullible.

If this concept, that suckers rule, needs validation, consider the fortunes of such pot stocks as Canopy Growth Corp, symbol WEED on the TSX. It was selling for $8.40 per share on July 24 and, as I write this, it is trading at $41.17, which is about a 500 per cent lift in five months. WEED has no earnings, no dividends, its legal status is not quite settled, there are many competitors and devotees can grow their own. Recreational marijuana may replace tobacco and even booze, for all I know, but the word is “may” and I would not throw good money into this abyss.

The cryptocurrency craze

Even more outrageous are Bitcoin prices, which have been going for something like $17,000 dollars each, up from about zero a few years ago. Bitcoin is a synthetic commodity enthusiasts generate via a qualification process on their own high-powered computers. The quantity of Bitcoin in circulation is limited, but there are numerous competitors in the digital currency biz.

Bitcoin is scarce and transactions are untraceable. But if you want to convert Bitcoin to real currency, there are paperwork costs and exchange fees of several percent. Competing with scarce Bitcoin are 800 — that’s eight hundred — other digital currencies such as Ethereum, Ripple and Litecoin. Kodak recently announced it would go into the digital currency business too. As of early January, the value of Bitcoin outstanding was reportedly US$284 billion with another US$122 billion in competing cryptocurrencies.

Friends, in spite of the cryptocurrency frenzy, it will not last. Four hundred years ago in the Netherlands, tulip mania convinced sober people to sell their houses and borrow against all their worldly assets to buy tulip bulbs. In 1637 one speculator offered five acres of land for a Semper Augustus bulb. The market crashed shortly thereafter when folks realized that tulips make more of themselves and that they would not long be scarce. Ditto Bitcoin, except that digital money is not as pretty as a flower. Moreover, with values of coins zooming and plunging by 20 per cent on some days, your odds of winning or even your ability to stick out the volatility are probably not as good as in Russian roulette where, with a six gun and one bullet in the chamber, you have a five-out-of-six chance of walking away unharmed.

A look at the basics

Let’s assume digital currencies crash in flames due to oversupply and the fundamental fact that they are synthetic money backed by nothing more than electricity. Let’s therefore look at basics:

1. Government bond prices will soften as long as interest rates rise. Rise they will, due to central bank moves and because the Trump budget creates huge deficits that have to be financed by Treasury bond sales. To get more money, the Treasury cuts prices and yields (interest rates dividend by prices) inevitably rise.
2. Corporate bond yield will rise even more. Top quality corporate bond prices will fall even more. Junk bond prices will fall from their recent highs. Bonds are a pit for now.
3. Stocks with solid dividends that tend to rise over time can do very well in this rising interest rates environment, even banks with a lot of debt that has to be financed with more bond borrowing. Banks make more money when interest rates rise, as the spread between what they pay on savings and lending rates widens.
4. Real estate prices will be under pressure, for almost everybody borrows to buy property.

There are few enduring truths in stocks and bonds beyond the guarantee that prices bob up and down. However, if you buy solid value — strong companies with growing income and rising dividends, valuable products and well-defined markets — things should work out in the long run. Invest, diversify and let the bandwagon of foolishness rumble on with you not aboard.

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The company issuing the annuity would prefer a sooner death, to cut short the payments of the simplest life annuities with no guaranteed minimum number of payments. Annuities are a mirror image of life insurance, in which the insurance company would like the person insured to live as long as possible, delaying payment of benefits.

Annuities have a curious history. They existed in the Middle Ages but they were often annuities in kind, for example, the right to hold land for the life of the beneficiary. In a financial setting, tontines — asset pools with income paid to surviving members — were sold by governments to raise revenue. Investors paid a sum to the government for the right to receive income and, at the death of an investor, his or her share would be reallocated among the surviving investors. Tontines led to much mischief, as you can imagine, for it paid to be a survivor. Tontines are not available in Canada for good reason.

In Canada, there are a handful of annuity varieties. None have incentives to do in other members of the pool. Each annuity is sold individually — what others do or how they fare has no bearing on what the annuity pays.

Annuities in Canada are just investment devices. You pay a lot of money for what, at present interest rates underlying the annuity, will be a trickle of income, For most people retiring with a fixed sum of capital, the annuity provides a rock solid guarantee of income backed by the insurance industry bailout fund called Assuris that will pay annuitants even if the insurance company becomes insolvent. It happened with Confederation Life when it became insolvent in 1994, but no annuitant lost money.

Canadian annuities are based on government bonds. At present, government bonds pay little so annuities have low payouts. Were government bond interest rates higher, annuities would have more appealing incomes. Annuities almost never cover inflation. Such coverage would reduce what they pay to a trickle. However, if one buys a ladder of annuities, say one every few years, inflation is automatically indexed.

The practicalities

Once you are in and getting paid, backing out of an annuity is difficult or impossible. Because annuities function under life insurance law, the payments have limited protection from lawsuits, though not tax claims by the Canada Revenue Agency. In sum, annuities are very useful for providing a known income for the life of the person receiving the money. They are a lousy way to build up savings late in life and usually a lousy way to receive savings in late life.

There are almost as many annuity structures and payment possibilities are there are pebbles on a beach. They vary by age of annuitant(s) at start of payments, guarantees of payment, jurisdiction, gender, immediate or deferred start, tax structure, and number of lives until end of payments.

Here are some examples from current annuity rates based on $100,000 starting capital. These are representative quotes. In actuality, there is a range of prices among insurance companies:

• Male, age 60, simple life annuity, no guarantee: receives $473 per month.
• Male age 70, simple life annuity, no guarantee:receives $633 per month.
• Female, age 60, simple life annuity, no guarantee: receives 432 per month.
• Female, age 70, simple life annuity, no guarantee: receives $559 per month.

If we add up the payments by year, for male at 60, the payoff is $5,676 per year, for a woman $5,184 per year. Displayed as interest, it’s 4.73 per cent and 4.32 per cent at 60, which is more than a savings account or GIC pays these days. But the annuity is illiquid, irreversible, and, with our example of no guarantee period, results in confiscation of capital at death. These are crap shoot odds and, personally, I would not take them.

If you add a guarantee period of 20 years, the payoffs drop to $434 and $493, respectively, for men and $413 and $475, respectively for women.

If the survival factor is reduced or eliminated for the guarantee period, the annuity pays less. These are term certain annuities. Thus a term certain for either gender at age 60 for 20 years pays $521 per month or $125,040 over the term of the annuity. That’s $6,252 per year or 6.25 per cent in crude interest disregarding potential compounding of payouts and the eroding capital base. It’s not bad, but when the 20 years are up, all the capital is gone and the payments stop.

The discouraging returns and retention of initial capital is less onerous when you consider that part of the return of the annuity is capital. That makes the crummy returns a lot more attractive.

Consider an annuity for $100,000 up front purchase price paid by a 70-year old man. He would receive $6,880 of income each year of which $1,000 would be taxable income. This tax advantage can be compounded by buying a ladder of straight life annuities. The payout increases with each year you get older and the relative tax advantage over straight interest grows as well. Annuities are for those who don’t want their capital back but who do want bulletproof guarantees of income.

Annuity calculations are designed to expend all capital at some defined time. The Department of Finance incorporates the annuity idea into Registered Retirement Income Fund tables. They have increasing payouts and are thus not pure mathematical annuities. For RRIFs established before the end of 1992, they start with payments of four per cent at 65 and 20 per cent at 96 and thereafter. Pure insurance annuities have constant payoffs, although in other countries, annuities can be structured to carry investment risk and therefore to pay more or less than the mathematically determined rate.

The upside of annuities is that they leave no risk for the annuitant other than inflation. That can be covered by buying a ladder of annuities with payouts rising alongside interest paid on the government bonds that power them. As to security, even during the Great Depression, not one insurance annuity failed. But there is a hidden cost in annuities: commissions. They are embedded in the rates, hard to figure out, and, alongside the lack of ability get your money back after the annuity starts, they are negatives.

Bottom line: annuities can be a solution for the elderly, for the infirm and even as a way to put a floor under a retirement income, leaving the annuitant to take on stock market risk without the danger of running out of money and winding up poor. If the annuity idea appeals to you, check with a financial planner and price a few annuities with independent insurance agents. The homework will be worth it.

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Normally, the curve rises gently from one day to 30 years, reflecting inflation expectations. If the yield-to-time relationship drops, it means several things: one, that there will be less inflation ahead. Moderate inflation is associated with economic growth. So no curve rise or even a drop means less growth or no growth and stagnation or recession to come. What’s more, after a fairly sustained rise since the end of the mortgage meltdown crisis of 2008-09 and the correction at the start of 2016, it’s time stock markets, many at all-time highs, take a break and reset. A collapsing curve of government bond yields would precede that event.

American investment bank Morgan Stanley recently told its clients that the U.S. Treasury yield curve would go flat in the third quarter of 2018 with the 10-year Treasury bond hitting a record low of two per cent.

Flattening to inversion

There is evidence that the process of flattening going to inversion is underway. Stock prices are high because interest rates are low. People take risk on stocks rather than holding safe government bonds because bond payouts are so crummy. A yield curve inversion would, however, tell people to take cover, sell stocks, and accept even lower bond returns. That would, in effect, be insurance against worse to come. Federal government bonds may be a poor way to earn income, but they never default.

A yield curve kink indicates two things: From the investor’s point of view, it’s evidence of people buying shelter through lower bond yields and accepting the cost in terms of lower returns. From the point of view of companies that sell bonds to raise money, it shows precaution for they borrow less and thus offer lower interest rates.

Where government bond yields go, corporate bond yields follow. It is worth noting that yield curve inversion, that is, the point where the curve stops going up and starts to head down, has predicted every North American recession in the last half century.

The inversion may be coming, but it will take at least some months. The main player is the Federal Reserve Board. For flattening or inversion to happen, the Fed has to push up short-term rates above present 10-year rates at least. That would mean that the three-month U.S. Treasury yield, now about 1.25 per cent, and Canada’s as well at one per cent would have to rise to two per cent. That’s not in immediate sight, but it could happen next year. If T-bond buyers prefer to go long and lock in money ahead of the dropping long rates that are part and parcel of a recession in combination with rising short rates, the kink would happen.

How sure a thing is the inversion? No one knows what the American administration may do. Uncertainty is itself a reason to buy Treasury debt, especially long debt to lock up money safely until the fog clears.

“The Fed has been wanting to raise rates for a couple of years and if it does, its overnight rate would rise from today’s effective rate of about 1.4 per cent by 1.6 per cent to three per cent. That would take at least a few meetings of the Fed’s rate-setting Open Market Committee,” says Edward Jong, vice president and head of fixed income at TriDelta Investment Counsel Inc. in Toronto. “We think that the Fed would be smart enough not to cause an inversion. Moreover, rising inflation is not yet a concern.”

What to do? Investment decisions based on political forecasts are dicey. Precaution suggests lightening up on stocks because markets are high. The potential of a yield curve inversion adds to the incentive to move to 10-year Canada or U.S. bonds for a recession that may yet happen. A yield curve kink is part of most recessions, but the timing remains uncertain. But the post-2008 to 2009 boom, which withered in 2015 and then restarted in early 2016, is almost a decade old. A stock market reset heralded by a kink in the government bond yield curve would just be part of the process.

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The lure of gold is what all investing is about. The “gold” in farming is tangible. You grow something or raise something, sell the crop, the herd, the milk, the eggs… and you get into the pickup and ride off to town.

Off-farm, it’s different. The vast majority of off-farm investments are intangible — shares of stocks that do not even come with certificates anymore, bonds that are also certificate-free, gold units held on your investment banker’s ledgers and participation in real estate investments documented by yet more account statements. Where is the reality?

• More ‘Guarding Wealth’ with Andrew Allentuck: Index investing versus buying mutual funds

It lies in the future. The great investor Warren Buffett, chief of Berkshire Hathaway and master of much of the bond and stock universe, has said that a stock is worth as much as but no more than all the money it will ever make. Estimating that number is no mean trick. But we can try.

If a stock, say a telecommunications company like BCE Inc. which has earnings, then it has a ratio of price to earnings per share. For BCE, it’s 18.75. It should pay a dividend. BCE’s is 4.75 per cent. This is good. This means that if the earnings are stable and do not increase, you will get your money back in about 19 years during which time you make a nice living from dividends. This should work provided that BCE does not go the way of the bad — Nortel Networks (accounting from outer space, bankruptcy) — or the really ugly — YBM Magnex (Russian mobsters controlled this TSX-listed maker of actual magnets and bicycles). The hazards are everywhere. For safety, you need to go for the most solid stocks, the least risky bonds, and the most solid real estate deals you can find. Tangible is good, solid earnings make it better, and well-supported dividends provide insurance that even if the company goes into a slump, patience will save your financial life.

Today, you can buy the hottest things on the planet. They include many stocks high on concept, e.g., the marijuana company Canopy Growth Corp., shares of which are up about 300 per cent in the last 18 months based on no earnings, no dividends, a product that remains illegal in some jurisdictions and potential for regulation that may turn it into, who knows, something like dried milk solids priced by marketing boards. Canopy could also be like a distilling stock in the U.S. at the end of Prohibition in 1933.

You can also buy Amazon.com with no dividend, a ratio of price to earnings of 280 (yes, not a mistake, that is two hundred eighty), no dividend, and a chance to be part of a business that appears to be eating the retail world. Amazon was priced at a modest US$300 per share in 2014 and now it’s about US$1,100 per share. It has 341,000 employees, stock price volatility 1.5 that of the market as a whole and is a must-have stock for every major American equity mutual fund. However, with no dividend support, it is a pure play on the future. If earnings — and there are genuine earnings — stumble, the stock price could drop by 280 times the shortfall in expected or delivered results. This stock has a future but it is one with a lot of risk.

And what about bonds?

A bond is a promise that, if you lend some outfit money, it will pay you back and add interest at whatever was agreed to when the bond was sold. With U.S. Treasury bonds or Government of Canada bonds, the promise will be kept. The issuers will print money if they have to. With Canadian provincial bonds, there is no ability to print. But the provinces can tax. Worry about something else. With corporate bonds, you should worry.

Once upon a time, there were AAA corporate bonds, lots of them. Today, there are just two U.S. companies which have an AAA rating. They are Johnson & Johnson, maker of health care products, and Microsoft Inc., the centre of the digital universe. AAA means that nobody can imagine that it will not pay its bonds. If you go down to straight A, the future is bright. B+ is OK, B- gets people worried, C-level bonds are close to default and D bonds are in default. If you buy corporate bonds below B+, you are brave or patient or maybe a great investor sure that Kodak will turn around (it didn’t) or that Enron was no fraud (it was).

When considering a bond, always look at financial reports such as the annual statements of corporate bond issues. Make sure that the bond issue is not less than $25 million in Canada, US$100 million south of the border. Any less and the bond issue will not be easy to trade. It may not have its prices reported on bond price boards (analogous to stock tickers and online data) and may not be easily saleable without big cuts in your offering price. Further to that, if you can explain the bond’s story in a sentence, it is probably OK. If the story is paragraphs about sales forecasts and air rights for new shopping malls and explanations of how company X will soon be a hit in Indonesia, forget it. The longer the story, the crummier the bond.

Sometimes things go badly

What all this is leading up to is that for the off-farm investor prepared to throw money at things as intangible as the prospects of stock shares or bond coupon payments, cash flow is vital, distributable profits are essential and dividends sufficient to put dinner on the table are life boats when things go badly.

And they do. Consider poor General Electric. Trading at US$20 give or take, the price is about where it was in 1997. Holders have been kept alive and hopeful by the 4.77 per cent dividend but, as warning notes on many reporting services say, it may not last. Here is the word from Thomson Reuters: “General Electric Co’.s dividend may not be sustainable; the company has paid out more to shareholders over the past 12 months than it has earned.” It was a 20th century winner. But perhaps no more.

GE has endured through the Great Depression, numerous crashes and corrections. It was one of the original stocks in the Dow Jones Industrial Average in 1893. Its present return on equity is 9.6 per cent compared to Honeywell International Inc.’s 26 per cent RoE. The analysts hate it. Jet engines, electric power turbines and toasters are so old economy that almost nobody wants to hear anymore. Curiously, Amazon’s return on equity is also nine per cent, but GE has old technology and Amazon has new stuff embedded in its gigantic distribution system. It is the future. GE is the past.

Ultimately, off-farm investments are a commitment to assets you cannot touch and whose management you must trust. The more distilled the asset is from its base, the harder it is to find solid value. But to invest only in what you can see from your porch window is also risky. Your farm, its equipment, the crops, the animals and the land are tangible. The balance of assets in a diversified portfolio is intangible. Management is vigilance.

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Index investing

The choices of index funds are vast. There are about 20,000 exchange-traded fund (ETF) index followers, including those that shadow the Dow Jones Industrial Average, the Standard & Poor’s 500, the Wilshire 5000 (a broad U.S. index which covers almost all small and large cap stocks traded in the U.S.), numerous European and Asian indices and the biggest wrapper of all, the MSCI World Index. You can buy index ETFs that mimic European pharmaceutical company shares or small cap companies in India. There are about as many ETFs as all the shares listed in the whole world. The problem is to make sense of them.

It’s about making money, so let’s look at some returns. For example, the iShares S&P/TSX 60 Index ETF, trading symbol XIU, has a management expense ratio of 0.18 per cent and a 7.07 per cent average annual return since inception in September, 1999, slightly less than the benchmark index itself. The reason for the lower return is the fees paid, but that is small — the cost of owning the ETF is far less than the average annual mutual fund fee of about 2.6 per cent. The XIU fund, like the TSX 60 index, is made up of 40 per cent financial stocks and 21 per cent energy stocks, which is a fair description of Canada’s stock market.

Buying shares that represent the whole market can be perilous to your wealth. Consider Nortel Networks shares that were priced at $124.50 in July, 2000. At that time, they made up 35 per cent of the value of the Toronto Stock Exchange. Then Nortel collapsed, dragging down the TSX 60. The value of all stocks on the TSE fell from about 1,200 in mid-2,000 to 6,500 in October, 2002. The Nortel collapse was part of the slide, as was the broad failure of the dot com boom. The point of this vignette is that index investing doesn’t work if you pick the wrong index.

The concept of index investing is diversification, which is a good thing. The downfall of index investing is when an index is not diversified. The Finnish index was overweighted with shares of cellphone maker Nokia. As the respected tech publication Wired noted on October 4, 2013, “by 2013, Nokia accounted for 70 per cent of Helsinki’s stock exchange market capital, 43 per cent of all Finnish corporate R&D, 21 per cent of total exports and 14 per cent of corporate tax revenues. That dominance of a stock exchange was and still is unprecedented. The Finnish stock index could not have been said to have been diversified by any stretch of the imagination. The same problem exists in the weight of brewer AmBev on the Brussels exchange, the weight of bank Santander and telco Telefonica on the Madrid board, and banks on the Paris bourse. In short, diversification among industries is not always achieved by indexing.

Let’s take another example, this time the widest index ETF of all. That’s the Morgan Stanley Capital International (MSCI for short) World Index ETF. As of October, 2017, it’s 58.9 per cent U.S. stocks by value. It is not so much a world index as a U.S. index with a scattering of other national markets.

Cap-weighted indexes are based on capitalization — the number of shares outstanding times the share price of each stock. The unfortunate characteristic of these indexes is that the stocks with the biggest capitalization get the biggest weight in the index. If you buy one of these cap-weighted indices, you are buying the winners. The higher the share price and the more shares outstanding, the bigger the capitalization. That is the opposite of what most investors want: a chance to buy low.

If you want less risk than the benchmark index, seek out a low volatility ETF. If you want more growth and don’t mind the extra rollercoastering, go for a growth index. .

There is another issue with index fund investing. Index funds, which by definition are fully invested, hold no cash. So when markets are on the way up, index funds will tend to beat managed mutual funds which tend to hold cash in order to buy stocks or bonds when they seem good deals and to provide funds for redemptions. On the way down, index funds with no cash cushion, will tend to fall more than managed funds with their cash cushions.

Moderation of index moves is a potential virtue of cash-cushioned mutual funds, but how well that works in relation to pure index investing is murky.

The problem is to compare indexes, which are public and lay bare their entire numerical history, with mutual funds, which can conceal their history. This issue is called survivor bias.

If a mutual fund has a dreadful record, its management company can merge it into one of its successful funds. The surviving fund, which has absorbed the loser, now has more money under management, which makes it look good, and the record of the loser is buried.

Then there is the problem of continuity. The same funds are not always the best performers. If you set aside the funds in the top fourth of performance, the first quartile in fund speak, five years later only half the original lot is still in the first quartile. Another five years on and now half of the first fourth are leading in the first quartile. Another five years and half of that lot remain in the first quartile. Fund profitability is random, not based on skill.

To this problem, fund manager and math whiz Ted Aronson, adds that it can take between 16 and 75 years to provide that a manager’s returns are the result of skill to a confidence level of just 75 per cent. The 95 per cent level of certainty can take up to a millennium. Jason Zweig, a very respected financial writer concludes that picking investment funds based only on their past performance is, we’ll quote here, “one of the stupidest things an investor can do.”

What can you do?

If index funds are biased on the way up and overloaded with winners while managed mutual funds can be winners one day and clunks the next, what to do? I’d suggest following three rules:

Rule 1: Diversify inexpensively. Index investing is imperfect, but index ETFs do provide diversification at very low cost. Low management fees are a cushion against losses in more expensive funds. U.S. broad market index ETFs replicate the S&P500 and the Dow Jones Industrial Average and many other indices. You can also find equally-weighted index ETFs that reduce a stock like Apple Inc. from about 11.5 per cent of the NASDAQ 100 Core Index to 1/100th of the total value of the index. Even if Apple, which is 58 per cent of the index in raw form, were to evaporate, the direct loss to the index would be at most one per cent. This is because the equally-weighted index gives each one of the 100 stocks in the NASDAQ equal weight.

Rule 2: Use ETFs when trading costs are very high. It is tough to buy small lots of bonds inexpensively. Banks and other dealers sell them as principals and want profits, not as agents just charging commissions. In a bond index fund, you get pricing every moment of the trading day, you can sell any time you like, you can slice off any amount you like, and trading costs are low.

Rule 3: If you choose to buy individual stocks, get an edge by focusing on industries you understand. Farmers have an edge when buying Deere & Co., for example. Bank on your knowledge when you have an inside track.

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First, there are returns. In order to rescue the world financial system from towering debt, much of it derivatives (financial instruments that take their price from other financial instruments) in such things as U.S. mortgages that turned out to be valueless, the world’s biggest central banks bought bonds. That made bond prices rise and the yield on bonds, which is the coupon interest rate divided by the bond’s price, tumble. Bonds issued by the European Central Bank and the Bank of Japan actually turned in negative yields. So did German bonds. U.S. Treasury bonds due in 90 days or less produced negative yields for a couple of long weekends in 2008 and at Easter, 2009 when the fear of global collapse was so great that large banks and investment funds paid more than the redemption price to buy the bonds. Buyers paid to store money for fear that the banks they might put it in would not be around at opening time Tuesday morning. Bargain basement interest rates allowed banks to borrow through term deposits at some of the lowest rates in history.

• More ‘Guarding Wealth’: Investing: Taking risks in the new economy

The world’s biggest central banks rescued fallen commercial banks such as New York’s giant Citigroup by allowing them to borrow money at rates as low as a fraction of one per cent. Investors, turned off by ridiculously low interest rates, bought junk bonds that had payouts in the customary mid-single digit range or even more. That is still going on, for the vast majority of the world’s 200 or so nations cannot issue investment grade debt.

In August this year, Greece, which had a good deal of its public debt written off in 2012, was able to sell US$3.5 billion of fresh bonds. Argentina recently sold a U.S.dollar-denominated bond due in 100 years. Argentina defaulted six times in the 20th century. It has just settled its latest defaults going back to the 1980s after decades in U.S. courts. Presumably, investors think, the country has turned the page and is now trustworthy.

The idea that old defaulters won’t do it again has gained traction. Ivory Coast, for example, issued a bond in 2010 to pay for older bonds the interest on which it could not pay (a “refinancing” in polite language) and then defaulted on the 2010 issue in 2011. More recently, the Democratic Republic of the Congo, which has a lot of minerals as well as one of the world’s last officially communist regimes, sold bonds. The prospects for payment of interest and principal vary from questionable to dim, but these bonds are a hit. Why? There are two explanations.

This is reason two. Bond index funds have to buy the stuff. As recently as two decades ago, bond investors would burrow into voluminous research reports on the credit worthiness of any new bond to hit the market. For- eign bonds had to be AAA at the top or maybe no worse than a middling B to get sold. Bonds rated C, which is the letter grade of junk, did not get sold.

Global bond funds

Today, global bond funds structured to replicate their markets follow every twist and turn of their underlying assets such as global emerging market debt, long or short U.S. domestic junk, or Asian speculative grade indus- trial bonds. Congo government junk has ready buyers and default no longer matters. All that counts is the global bond exchange traded fund’s mandate and the fact that the fund has gushers of cash coming in. The money has to be invested, for ETFs almost never hold cash.

Oddly enough, the odds favour the global junk bond ETFs. Research shows that bottom-of- the-barrel stock and bond markets go through a renaissance and that those at the bottom fix themselves and then return to respectability. Buying the worst performing national markets one year and then waiting a year, then selling, turns out to be much more profitable than buying winners.

The turnarounds work when the laggard, even bankrupt governments, loaded up with unpayable debt, drained by paying huge subsidies to allow their citizens to buy food or gasoline, then devastated by high inflation, go cap in hand to the International Monetary Fund. It’s a bank of last resort for failing nations. The IMF loans them money, imposes strict conditions, forces cuts in subsidies, knocks down inflation, and the formerly bankrupt countries return to respectability. Lately Argentina, which created a tax amnesty to allow its wealthy citizens to bring back U.S. dollars without penalty, and Egypt, which is trying to bring down food price inflation running at 40 per cent per year, have seen their sovereign bonds rise in price, yields come down, and fresh bonds they have issued eagerly bought by investors. Note that in the bond market communist governments, dictators and even national despair as in Greece where people have lost government pensions are just details. Bondholders usually rule.

Bond exchange traded funds have replaced the eyeshade-wearing credit analysts who used to be kept out of sight in backrooms. Today, emerging market nations can be sure of a sale. Their offering rates of seven per cent or even more in what is now called the “frontier market” compensate for some risk.

What will happen if markets turn and investors want out? If investors in these global junk bond funds want to sell their ETF units, the funds will have no choice but to sell their bonds holdings. In a global selloff there will be no one to buy those dicey bonds. Their prices will plum- met. There will be no one to mop up the blood on the floor, for actually getting paid by the underlying bonds is going to be a dim prospect — as it always was.

It has not happened yet. As long as U.S. Treasury 10-year bonds pay around 2.2 per cent, about half the historic five per cent rate, global sovereign junk paying seven per cent or more is going to have a solid market. If interest rates in the U.S., Canada and Europe, Japan and the U.K. start to rise smartly, money may start leaving global junk. That could be the trigger.

Bonds are supposed to be life preservers when stocks fail. In my view, junk bonds issued by governments on shaky foundations and held not by choice, but just by mandate requiring funds to hold them, are a financial juggling act that is doomed to fail. These bonds are the dot coms of the bond market. Those who feast on this banquet of bad bonds will eventually lament that they bet that the improbable would succeed.

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The future is not quite so bright. Inflation, the driver and indicator of such things as national gross domestic product figures, is low in the big industrial countries where it matters. Canada’s Consumer Price Index is up 1.9 per cent on an annualized basis as of April 30.

Low inflation is not a bad thing. It makes debts easier to pay in devalued dollars, in effect giving borrowers credit to buy and borrow more. With low single digit inflation rates, borrowing is cheap and repayment relatively painless.

Not surprisingly, Canada is tapped out. Lousy retail sales and shrinking margins show it.

Canadian household debt at the end of 2016 was a worrisome 167.3 per cent of income, according to Reuters. That means we owe $167.30 for every $100 of pre-tax income — that means we own about two bucks for every dollar left over after income taxes. Consumer spending drives much of the economy; it’s become weak according, to many Bank of Canada warnings.

• Read more: Signs of future risk in the stock market
• Read more: Keeping your financial portfolio stable

Perhaps because bonds pay so little and perhaps because there is so much cash sloshing around after nine years of recovery from the crash of 2008, our stock market is doing moderately well.

The solutions

What’s an off-farm investor to do? The short answer is be very cautious about the market in general. These days, tempted by exceptional results from Alphabet (formerly Google), Amazon.com Inc., and Apple Inc., investors are chasing tech industry returns. The latest exchange traded fund to hit the market is the PowerShares QQQ Trust Series 1 ETF, a fund which tracks the NASDAQ 100 index that is heavy with Amazon and Netflix and other megatechs.

Within days of the fund’s launch at the end of May, investors poured in US$1.78 billion, a strong indication that they think the tech boom will continue, regardless of U.S. tax policy or trade relations. In this topsy turvy world, tech stocks, formerly regarded as high risk (remember the dot coms 17 year ago?) are now seen as safe compared to resources whose prices gyrate with the world economy and manufacturers whose fate is tied to tariffs.

In Canada, the counterpart to the American tech boom is centered on the pending legalization of marijuana. There are fortunes being made as companies transition from penny stocks to mid-caps, but it’s a perilous path to invest in the legalization of recreational drugs. The market is wavering.

Shares in Canopy Growth Corp., a leading player in this emerging agricultural sector, recently traded at $6.80, down from $13 in February. Another marijuana stock, Aurora Cannabis Inc., was down from about $3 in November 2016 to $2 in early June. Cannabis Wheaton Income Corp., shares of which sold for pennies a few months ago, rose to $1.50 in May and settled at $0.98 in June. Cannabis Wheaton may do very nicely, or not, but it is at least as risky as the dot coms, which never had to face a problem of legality or environmental regulation that could seek to protect moose from being intoxicated if they graze on fields of dope. A new world of regulation lies ahead.

The cannabis companies have to compete in a market in which people can (legally or otherwise) grow their own product. There will be a mass of new regulatory hurdles, such as pesticide residues and chemical components, far beyond the elimination of criminal penalties for use or possession. Legal marijuana may be the future, but caution is essential. Pricing these companies’ shares is a witches’ brew of valuation, information on market share, and clarity of legality.

Investors who want to improve the ratio of probable gain to probable loss should stick with companies whose stocks offer dependable dividends based on strong earnings. The dividends are paid in good times and bad, helping with the psychological problem of wanting to sell a stock bleeding red ink. The instinct to flee danger is often stronger than confidence in the probability that good stocks will rise again.

Among the stalwarts of dividend payers are chartered banks. Their earnings and dividends grow with the ever-expanding money supply. Then there are non-bank financial companies such as Power Corporation and Power Financial Corporation. They have dependable and rising dividends and deeply entrenched lines of business in insurance and other financial services. As sources of non-bank dividends, they are worth a look, even though their trends are uninspiring. What makes up for their moribund stock price is the five per cent dividend each offers. Even if dividends don’t rise, this will give you a 100 per cent gain in 14 years if held in an RRSP.

In the end, stock investing is a spectrum of risk that moves from buying sure things, like dividends from major chartered banks, to buying dreams and schemes from novelties in the dope biz. You cannot make 100 per cent overnight in a chartered bank stock, but you could do it or at least could have done it with microcap marijuana companies headed for listing on the TSX. But the risk of loss is far higher in these fields of fancy than in dreary but relatively safe old industries.

Off-farm investing is supposed to spread risk and produce alternative income. Investing in any agricultural commodity whether banal like turnips or exotic like marijuana is not really diversifying. Farming is a high-risk business. Diversification should mean that money earned on the farm is safe and profitable somewhere else. In the choice between bravery in the unknown and patience with the proven, I’ll stick with the old reliables that are legal, profitable, and ooze cash.

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