The Ultimate Investment Challenge

In the world of investing, there are numerous options and places to put your money, some riskier than others

Feb 1, 2007  

by Ray Turchansky

An investor can buy individual bonds, either government (federal or provincial) or corporate, and either short-term or long-term. A general rule is to “ladder” your bonds, buying some for short, medium and long terms. The Money Letter investment newsletter recommends government bonds for secure but limited returns, and corporate bonds for riskier but potentially greater returns. If buying individual bonds seems too onerous, you can also buy bond funds, namely a mutual fund that includes a variety of bonds chosen by a fund manager. While this gives you some diversification and expertise in choosing bonds, the fund fees often reduce returns significantly. If inflation is a concern, you might want a real return bond fund, which guarantees a return greater than inflation.

7. Know when to fold ‘em

Investors spend the majority of their time plotting what stocks to buy and when, but the truth is more money is lost holding onto stocks and not knowing when to sell. Many investors who bought Nortel Networks at $40 or $80 a share watched their stock soar to $123, and then rode it all the way back down to 69 cents.

Investors tend to hang on too long, becoming emotionally attached to their investments. They sweat over their selection, stand buy them during rough times, and are reluctant to let go when they are hopeless. “Making portfolio selections is not always about being right,” says Adrian Mastracci, financial adviser with Vancouver-based KCM Wealth Management. “It is important to admit that one was wrong about the initial investment analysis, and equally important to do something about it.”

Ask yourself why you bought the stock in the first place, and whether those reasons have changed irreversibly, or whether conditions that caused the downfall could improve so significantly that a rebound is possible.

One way of removing the emotion from selling an investment is to place a mental or physical “stop loss” order on it. Adopt a rule of thumb to sell any stock that has lost 20%, unless there is compelling reason to keep it. (By the same token, many investors set an upside goal — either a target price or a time period — to sell a rising stock and take their profits.)

Also, realize how great the rebound must be just to get back to even, let alone make money. If an investment loses 50%, it has to gain 100% just to break even; and if the investment tanks 60%, it has to gain 150% just to get you back where you started. “Now those are miracle turnarounds. The bad news is that I can’t recall many of them,” says Mastracci. Successful investing isn’t about being right all the time, just more times than you’re wrong.

8. The mortgage question

The classic dilemma facing millions of Canadians when they receive their income tax refund each spring is whether to invest the money or use it to pay down the mortgage.The answer may depend on your tax factor, and here’s how you figure it out.

An Albertan making $25,000 has a marginal (federal and provincial) tax rate of 25.25%. You divide 100 by 74.75 (100 minus 25.25) and that gives you a tax factor of 1.34. That means you must earn $1.34 before taxes to have one dollar left after taxes.

Say your mortgage rate is 6.5% a year. That would mean you would need an investment making an annual return of at least 1.34 times 6.5, namely 8.71%, to be better off investing your money than putting it down on your mortgage.

Similarly, an Albertan making $75,000 has a marginal tax rate of 36%, and therefore a tax factor of 1.56. Given the same mortgage rate of 6.5%, you would need an investment making you 10.2% a year to be better off investing than paying down your mortgage.

You can also use your tax factor to check for inflation. A person making $25,000 has a tax factor of 1.34 and if inflation in Alberta is running at 4.7% (twice the national average), you need an investment return of 6.3% annually just to cover your taxes and inflation. For a person making $75,000 with a 1.56 tax factor, you need to earn 7.3% from an investment to overcome taxes and inflation.

Sadly, if you’re purchasing a guaranteed income certificate (GIC) that pays you 3% a year, you’re losing money if you take taxation and inflation into consideration.

9. Investing inside and outside of RRSPs

There was a time when investing inside a registered retirement savings account was a no-brainer – you got a tax deduction for the investment up front, all growth was tax-deferred, and you only paid tax when you withdrew the money, usually when you retired and dropped to a lower tax bracket.

But beginning in 2000, the federal government lowered the portion of capital gains earned in non-registered (investment) accounts that you pay tax on from 75% to 67%, then 50%. This poses two difficult questions for investors. Should you take no tax deduction up front in an investment account, but then pay tax on 50% of the capital gains profit at your marginal tax rate? Or should you take the tax break up front but then pay tax on 100% of the original investment plus all profit at your marginal tax rate?

There is growing sentiment that investors should put their first $100,000 into an RRSP and at least some of any further amount into investment accounts. This gives you the flexibility to pay less tax on money withdrawn from an investment account when you’re in a period of high income, or to withdraw money from an RRSP when you have little other income, or before you start collecting pensions.

Another thing to consider is how various investments are taxed. In an investment account you are taxed on 100% of the interest you earn, 50% of your capital gains, and generally somewhere in between on dividends, depending on your marginal tax rate.

The rule of thumb is to hold investments that produce capital gains and dividends, in most cases due to enhanced dividend tax credits, inside an investment account. Hold investments that produce interest like bonds and GICs inside your RRSP.

10. The income trust shuffle

An income trust is a structure whereby a corporation avoids paying tax on profits by putting them into a trust that disperses them to unitholders as distributions. The distributions include mostly interest, plus some return of the unitholder’s investment, that is, a return on capital.

If you buy a stock for $10 and it goes up to $12 and you receive a $1 dividend, you make a profit of $3 ($2 when you sell your share and $1 when you receive your dividend). If you buy an income trust unit for $10 and it rises in value to $12 and it pays a $1 distribution, you make a profit of $3 ($2 when you sell your unit and $1 when you receive your distribution.)

Trusts have been embraced by companies because they avoid taxes, and by investors because they usually provide a healthy income stream plus an increase in unit value.

To increase the attraction of dividends, the federal and most provincial governments announced increases in the dividend tax credit. Fearing more lost taxes from Telus and BCE’s planned trust conversion, last October the federal government announced its plan to tax new trusts in 2007 and existing trusts starting in 2011. That caused trusts to immediately lose $30 billion in market capitalization, as the S&P/TSX Capped Income Trust Index fell 16.2%.

However, after the sell-off, CIBC World Markets over-weighted its investment in income trusts, and said in its 2007 Canadian Portfolio Outlook that the trust market “continues to offer good value.” Its advice: “With average yields above 9%, the sector will continue to hold appeal, particularly for income-oriented investors. Ottawa’s recent clarification of expansion rules for trusts gives some room for growth over the next four years, particularly for oil and gas royalty trusts.”

If the new rules have scared you away from trusts and you’re still looking for good yields, move into common shares paying large dividends, such as bank stocks, or the oft-forgotten, old standby, preferred shares.

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