Monthly Archives: September 2017

Asset allocation for a Canadian 10 years into the past

Hanging out with friends. Inas and Daniel

If you have been reading my blog for awhile, you will know that my favorite asset allocation for Canadians is ⅓ Canadian stock, ⅓ US stocks, and ⅓ International stocks.

Let’s say that you met me 10 years ago (October 2007) and you asked me how to invest your money. And let’s say that I gave you the same advice that I give out today. Would you have been a happy investor? Let’s find out.

If you invested on October 2007, you were in for a wild ride. The national and international markets where about to tumble due to the financial crisis of 2008. You would have been looking at your portfolio and calling me a complete idiot, cursing yourself for ever talking to me.

I often say that if you are going to invest in the stock market, you have to have a 10 years outlook and that at the end, if you are well diversified, you should come out fine. That prediction turned out to correct.

The financial products which I use to do my investing are as follows:

  • Canada: The XIU. This represents the 60 biggest Canadian Companies
  • US: VTI. This represents the whole US. Market
  • International: XIN. This represents big size companies from all over the world.

As you can see in the graphs, on 2008 everything dropped. The Toronto and US market lost about 50% of their value while the international index lost about 40% of its value. At this time, many retail investors without a financial adviser would have bailed out.

Let’s say you endured the pain. Where would you be today?

  • Your International exposure would still be negative by 14.7%
  • Your Canadian exposure would be positive by a mere 5.04%
  • But your US exposure would be positive by 67%

Your average of these three investments would be 19.15%.

Divided by 10 years, this will give you about 1.9% per year.

These are not great returns, considering the amount of risk involved. The amount of pain related to seeing your investment dropping by over 50%.

There is a problem with my calculations. I don’t know how to add the dividends earned during these past 10 years. Let’s say that on average you earned 1.5% in dividends. Now your total return per year is 2.4%. This is less bad, but It’s still very poor return. Consider the psychological stress, I would have preferred to lose out to inflation and have my money in cash.

What are the alternatives?

During the same period, bonds have gone down the the less that 1% territory. You might as well keep your money under the mattress.

And real estate, also had a big drop in the States. Since then it has recuperated as well, but let’s be honest, real estate is not a real passive investment. I invest in real estate and believe me, it gives me plenty of headaches.

In conclusion, in spite of a 50% in the stock market. Stocks are still the best place to put your passive money. However, the faith that I once had on the stock market, it has been badly bruised. I feel that 2.4% is not enough compensation for putting my money in harm’s way. I am still investing in the stock market, but I feel a lot less enthusiastic and optimistic than when I first started writing this article.

Currency diversification for Canadians

Here is a 10 year graph of the same investment, the S&P 500, being held in Canadian dollars and being held in US dollars.

Because of the cost of hedging, the investments in Canadian dollars under performs the investment in US dollar by a whooping 15.60%, that’s a lot of moolah.

Long ago I suggested that the ideal portfolio for a Canadian would be composed of ⅓ Canadian index stocks, ⅓ US index stocks, and ⅓ international Index stocks.

Now the question is: In which currency should you hold  those investments which are not in Canadian dollars?

Filming “A closer Look” with my friend Elijah.

The way I have decided to do it is by investing my ⅓ of US index in US dollars.

I would have considered investing the ⅓ of international in foreign currency but it is just too complicated. I would have to deal with Euros, Yens, Yuans, and all the other currencies of the emerging market. My portfolio in not big enough to burden myself with all those details.

On the other hand, my US investment is ⅓ of my portfolio, that is quite substantial. So the question is valid. Should I invest my US portion in Canadian dollars or in US dollars.

Many of you may be unaware that there is such an option.

When we buy the most popular US index, the S&P 500, we have the option to buy it with US dollars or  in Canadian dollars. The S&P in Canadian dollars is protected against the currency fluctuation of the Canadian dollar vs. the US dollar. But that protection comes at a price. It is like paying for home insurance, it’s not for free. This hedging cost is about 0.15% of your US assets. Not a lot, but it’s just another erosion of your capital.

If you are investing for a short term period, you should not be investing in the stock market.

If you are investing for a long term goal, then you are further diversifying your portfolio not only by investing in the US market but also investing in the US dollar.

As Canadians, we have to be aware that our currency fluctuates a lot with the price of oil. We think that Canada is an advanced economy, but we are nothing more than a big gas station for the rest of the world. If oil prices go up, our currency goes up, If oil prices go down our currency goes down. Our currency is in fact too volatile and the US dollar is the more stable currency; their economy is more diverse.

Looking it from that point of view it makes sense to have some of our money in US.

In regards to cost, how does it compare.

When I keep my US investment in Canadian dollar I have to pay the hedging cost every year, this hedging erodes my returns over time.

When I keep my US investment in US Dollar, since I earn in Canadian dollar, I have to pay the conversion cost from Canadian to US and then when I retire, from US to Canadian.

In the long run, I feel that keeping my US investments in US dollars is less expensive and I feel more diversified.

At what point should you start adding bonds to your portfolio

Preparing for winter

I advocate not to have bonds in a portfolio, but the conventional wisdom is to have a portfolio of stocks and bonds.

Let’s clarify a few points:

  1. Stock are not more risky than bond in any 10-20 years time period, they are just more volatile.
  2. Stocks produce a higher return than bonds.

If stocks are not more risky than bonds and if they give higher return than bonds, why should anyone own bonds? Because they reduce volatility, because with smaller ups and downs an investor is better able to withstand the changes of the market.

Let’s assume a portfolio of 50-50 stocks and bonds. Let’s assume that the expected return of stocks is 8% and the the expected return of bonds is 2%. The expected return of your portfolio is 5%.

What I suggest is to put 100% of your portfolio in stocks. then draw a line that goes up at the rate of 5% per year. This means that if you start your portfolio with $100,000, by the end of the year you should have $105,000.

Here is an example the Toronto Stock Exchange vs. a 6% growth line.


In this example, I overlap the real returns with the 6% growth line. If the returns are in excess of the 6% line, they are not to be considered are part of your assets, they are meant to be considered as insurance money, or protection against a downturn. Just like you don’t consider the money that you pay in insurance as part of your assets.

If the returns are less than the 6% line, then you just have to be patient and have faith that eventually the returns will catch up.

All that being said, you think  you should own some bonds. At what stage should you add bonds to your portfolio?

Most financial advisers suggest adding bonds as percentage of your assets as you grow older. They will say that if you are 60 years old, you should have (for example sake) 60% of your portfolio in bonds, and the older you get, the biggest the percentage of bonds you should have.

But let’s be realistic. If you only have $100,000 at age 60, you don’t have much money to protect and therefore, you should be more concerned with growing your portfolio than protecting it. On the other hand, if you have $5,000,000. You don’t care about making more money, you care about protecting your assets and you could easily be 100% in bonds.

Actual amount of money matter more than percentages.

So here is the question again: At what stage should you add bonds to your portfolio?

Answer: When you have reached your capital objective.

Let’s say that you believe that to retire you want to have $500,000 in your bank account. After years of hard work you have reached the amount of $500,000. Then, the next step should be to start protecting your asset.

Let’s say that your portfolio of $500,000 grew 8% in one year. That would be $40,000. You would sell about $40,000 worth of stocks and buy some bonds. And do that for every year thereafter until you reach a level of dampen volatility which will make you feel good at night.

Disclaimer: Of course, this is my way of thinking which fits my risk profile. I am not saying you should do the same or that you should follow my example. You may have different risk tolerance or time frame.

The way that I think about it is that first you want to make your money and then you want to protect it. As you grow your assets you should keep in mind that there is an strategy to make your money, and there is another strategy to conserve your money. You don’t want to be too conservative if you have very little to protect and you don’t want to take risks if you don’t have to.

There is no solution for income inequality

There are two seasons in Canada: Winter and July.

Social inequality is nothing new, it has existed since the beginning of civilization. Some people like to focus on building wealth and some people focus in other activities other than building wealth.

Here is a short excerpt for Plutarch in the year 594: “the disparity of fortune between the rich and the poor had reached its height, so that the city seemed to be in a dangerous condition, and no other means for freeing it from disturbances… seemed possible but despotic power.”

No only has income inequality existed for thousands of years, but it has existed in all the geographical areas of the globe. In short, income inequality is just one more trait of humankind.

And why wouldn’t it exist? Business people who like to accumulate capital practice their craft with the same tenacity that a pianist practice his scales, or a painter practice his techniques. If a musician gets better with each practice session, shouldn’t a capital accumulator get better with each business deal? Imagine that we tell a guitarist who practice 8 hours per day, that he has to give half of his skills to someone who only practice 30 minutes per week. It doesn’t make sense, but we don’t think twice to tax a business person more that 50% of his income to re-distribute his wealth.

We live in North America, a land full of opportunities and choices.

You present two college students with two career options. One career pays $80K per year and the other pays $35K per year. One student picks the career which is better paid and the other picks the career which is less well paid. These are choices these students took out of their own free will. One student is going to earn more than the other one. Why should we penalize him/her by taking some of his earnings away?

Two consumers are presented with two smart phones, an iPhone and an Android. One cost almost $1,000 and the other one cost about $100. Both of the phone do phone calls, text, Facebook and YouTube just the same. One buys the iPhone and the other buys the Android and invest the savings. For sure, after 10 years, the one who invested the money will be better off. Why should that person be penalized.

There are two apartment renters, each one renting a two-bedroom apartment. One uses the extra bedroom as an office/storage room. The other one uses the extra room to rent it to a friend. One is going to accumulate more money that the other one every month. Why should we penalize his money making decision?

Income inequality will never go away. We should not penalize a person for making a decision which will benefit him/her financially. Instead, we should educate people to become more savvy consumer, better informed investors. We should teach people about the magic of compound interest, about  investments, about how to become better consumers and don’t waste money on brands.

Once we do a better job educating people about the investments opportunity presented at their feet every day, then we will have a better chance of reducing income inequality.