There is a lot of woe out on the land. Folks with Canadian equity mutual funds lost 34.6 per cent in 2008. Canadian small to mid cap stock funds dropped 40.6 per cent. Natural resources funds lost 44.8 per cent. And financial services funds loaded up with banks and insurance companies lost 45.9 per cent. Only bond funds, up 2.9 per cent for the year, were safe. How to make up stock losses? There are several ways:
WA IT IT OUT
Stocks have gotten over every shock short of alien invasion and will eventually recover from the ongoing credit crisis. How long will this take? It could be five or 10 years.
DOUBLE UP YOUR BETS
This is an old gambling idea called a Martingale. Invented in the 18th century, it superficially seems to work: If you lose $1, then bet $2. If you lose the $2, bet $4. Eventually you will win and recover everything. But the concept has flaws. One, you may run out of money or patience before you recover. Two, making successive bets a few minutes apart at a roulette table is easy. The time intervals for betting stocks are unclear, though they are critically important. Three, the gain in the process is only one unit. So if you have lost $1+$2+4+$8+$16 for a total of $31 and you win on the $32 bet for a $64 return, you have only the $32 final bet (your capital) and $32 profit. $32 minus $31 lost is a $1 gain. The system is a waste of time.
RESET YOUR RISKS
This plan allows positive action and may boost income while you wait for your portfolio to recover. Here is how it works: Take cash from your off-farm accounts and buy senior investment grade bonds. This means senior deposit notes of chartered banks, senior bonds of regulated utilities, mutual funds that have lot of investment grade corporate bonds, or exchange-traded funds that have a hefty load of corporate bonds. An investment advisor can lead you through the minefields of quirky bonds and murky funds. Buying these assets is not a five-minute job at the breakfast table.
Senior bank bonds pay four to eight per cent to maturity. Junior bank debt could be in trouble if the banks lose a lot more money. And it could happen. But nobody really thinks that the banks will default on their senior debt. It would wreck the country. Check out senior deposit notes, which are something like GICs but traded actively — which you cannot do with GICs. Senior bonds of regulated utilities pay about five to seven per cent to maturity. Assume that the whole pot of senior debt pays seven per cent and work through this little example with me.
If you hold a seven per cent bond portfolio for five years, you get your 35 per cent income plus compounding but minus income tax if the bonds are in non-registered portfolios. You do have some risks:
If interest rates rise a lot before the five years are up, you could have some losses, for new bonds with higher coupons will force down the prices of old bonds with relatively low interest rates. So make sure that the bonds have terms in a three to five year range. That way you won’t find your bond recovery turned into a bond disaster.
Make sure the bonds you select are really good corporate credits. That way, when business conditions start improving, the rising credit quality of the bonds will offset any price deterioration caused by rising interest rates. Rising interest rates make yesterday’s five per cent bond look crummy next to new bonds with eight per cent coupons. You want credit safety in a senior bond, but enough sensitivity to help the bond gain value as the recession ends.
As you wait for recovery, you get bond interest income which may exceed dividend yield. You also have the security of holding senior debt, which is a lot safer than stock. And you have an asset that will continue to be countercyclical to some degree, holding value fairly well even when stocks drop.
A FEW WORDS OF CAUTION
A solo investor can’t pick bonds as easily as stocks. Stocks have a central board that displays their prices. At any moment in time in the trading day, there is only one price for a share of the Royal Bank and every share of Royal Bank common stocks in the same as every other.
Bonds are traded over the counter at whatever prices sellers and buyers agree on. There are many boards, many prices, some dealers have inventory, some don’t, and two bond issues from the Royal Bank or any other issuer can be very different. You need guidance to help pick bonds. You have to read the conditions, called covenants, on the bonds, and you need some help in finding the bonds you want to buy. For this task you need a fully licensed investment dealer.
Alternatively, you can leave the hard work of bond analysis to a bond mutual fund manager or to an exchange-traded fund (ETF) that holds bonds. You need to do some research to find funds or ETFs with a 40 per cent or better weighting of investment quality corporate debt. You can find menus of bond funds at www.globefund.comand at other financial web sites run by Morningstar and other services. Once you have the fund in sight, drill down to find exposure to corporate bonds. Review the fund’s performance in the past in crises in 1991 and 1998.
To all of these suggestions, one may object that bonds are in a bubble and could fall. That’s true for short-dated government bonds that have been priced up so high that they yield approximately nothing. It is also possible that a really terrible economic collapse could drive even big utilities into bankruptcy. This is the theory of left and right wing survivalists who are sure that the only good currency in the future will be gold and canned soup.
I try to take a balanced view between the idea of sticking with financial assets and riding them to recovery and the belief that all money is about to become worthless. Reduce your risks, raise your income and, provided that the world does not come to an end, your portfolio should have a better chance of recovery.
Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life After Work, was published at the beginning of January by Viking Canada.