Building Wealth

For the first 30 or so years of working, saving and investing, you’ll be first in the mode of getting out of the hole (paying down debt), and then building your net worth (that’s wealth accumulation.). But don’t forget, wealth accumulation isn’t the ultimate goal. Decumulation is! (a separate category here at the Hub).

Paying taxes on capital gains could be the best decision you make this year

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When it comes to capital gains taxes, sometimes it pays investors to give Ottawa its due (Shutterstock)

Marc Bellefeuille, Manulife Wealth

Special to the Financial Independence Hub

In times of market volatility, anything can happen from one quarter to the next. Market participants witnessed a wipeout in the financial markets in Q4 of 2018. The S&P 500 saw its fortunes accumulated throughout the year evaporate from September to November and American stocks suffered the worst declines ever recorded on a December 24thtrading day. Other markets around the world followed suit.

Fast forwarding to Q1 of 2019, the bounce-back for equity markets has been nothing short of impressive. So what can investors take away from the last six months? Certainly, many investors may have questioned those who advise them at the end of 2018, only to be rewarded for having stayed the course in recent months. But what lessons can we learn from recent events, and how should we adjust to protect our precious nest eggs in the years to come?

In the famous paper by Brison, Hood and Beebower, “Determinants of Portfolio Performance,” the authors suggest that a whopping 93.6% of portfolio return volatility is explained by the asset allocation of the investment portfolio1. Nobel prize-winning economist Harry Markowitz called diversification “the only free lunch in finance.”

Yet, more often than not, I see portfolios of bright and capable people concentrated in a few specific positions. The culprit? Capital gains tax. Investors feel at ease by the value they see on their quarterly statements and often feel like they are playing with house money so they can justify letting their portfolios drift into a state of concentration of their winners. The idea of paying the taxman keeps them from rationally re-balancing their portfolios which, ironically, can expose them to large shocks during market corrections.

The average market drop in a recessionary bear market is 30.4%.2These kinds of drops often take place without warning – and certainly without mercy – and can drag every sector down with them. These declines can often be more severe to high net-worth investors due to under-diversification of their investments.3

Most high net-worth investors know they should follow a diversified portfolio strategy. However, knowing is only half the battle. Many, when asked, could not explain their strategy for selling positions within their investment portfolios. When pressed, many investors believe that, for any position that declined by more than 10%, they would advocate to hit the sell button and stop the loss. But when a position was up 10% or more the button was harder to push: the greater the gain the harder it gets to take the profits. Investors tend to be loss averse but when they are, in their minds, playing with house money the rules go out the window and many sit on large gains without re-balancing back to their strategic asset allocation.4

Better off taking profits and rebalancing

One of the impediments to profit taking is the tax bill. Let’s do the math. Assume a successful investor put half a million into the shares of one of the big five Canadian banks in the fall of 2008 and the stock doubled. Were they to sell those shares, as a resident of Ontario, the tax bill would be approximately $133,800: assuming the top marginal tax bracket. Continue Reading…

Retired Money: Work Optional and the FIRE movement

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My latest MoneySense Retired Money column looks at the so-called FIRE movement: (an acronym for Financial Independence/Retire Early), as well as a new book by a FIRE blogger titled Work Optional. You can find the full column by clicking on the highlighted headline here: How “Work Optional” can fit into your Retirement Plan.

You’ll see that regular Hub blogger Doug Dahmer — founder of the Retirement Navigator planning software — has been using the phrase Work Optional for at least five years, even though the new book of that name was just published in January 2019. It’s a useful phrase that describes the kind of thing Mike Dark and I refer to as Victory Lap Retirement in our jointly authored book of the same name.

There are many ways to describe this phase, but generally it refers to a period after full-time employment. FIRE proponents often declare that they “retired” in their 30s or 40s but of course most of them do not spend the next half century doing absolutely nothing. They really create encore careers based on self-employment, and often build businesses based on book-publishing, blogging and public speaking, wherein they reveal “how they did it.”

Victory Lap and Findependence

To some extent this very website does a similar thing, focused as it is on Financial Independence, or my contraction of it, Findependence. Continue Reading…

10 keys to picking the best Canadian income trusts and REITs

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Canadian income trusts have always involved far more risk than most investors realize. This is why we’ve recommended so few of them in the past.

Income trusts are a type of investment trust that holds income-producing assets. Their units trade on stock exchanges, but they flow much of their income through to unit holders as “distributions.”

On January 1, 2011, Ottawa imposed a tax on distributions of income trusts. The new tax put income trusts on an equal tax footing with regular corporations.

Virtually all Canadian income trusts then converted into conventional corporations. But some are still out there: mostly real estate investment trusts (REITs).

Investing in trusts — and in particular oil and gas trusts — was risky, as the businesses that underpinned them needed steady cash flow. But that could stagnate during economic downturns. At the same time, we believed that investors should have looked for trusts with low capital expenditures and mature businesses.

More about Canadian Income Trust taxes

Canada offers special tax treatment for Canadian income trusts. When they flow their income through to their unitholders, they don’t pay much if any corporate tax. Investors pay tax on most of the distributions as ordinary income (although some distributions qualify as a tax-free return of capital).

Ottawa feels the income-trust business structure is appropriate for real estate investment trusts, or REITs, so it has exempted REITs from the income-trust tax.

Real estate investment trusts resemble Canadian income trusts, but with a key difference: REITs invest in income-producing real estate, such as office buildings, shopping centres and hotels. (We cover a number of carefully selected income trusts and real estate investment trusts in our Canadian Wealth Advisor newsletter.)

Regardless of whether or not they have converted, the basic tests we use to ferret out good investments and reject bad ones still apply, not only to Canadian income trusts, but to other types of investments, as well.

Keep “Investment Inputs” in mind when judging income trusts, or any investment

In evaluating investments, many investors focus on what we’d call “investment outputs,” such as earnings, dividends, cash flow, return on equity, sales growth and so on. These are all important, of course, but you shouldn’t focus on them to the exclusion of what you might call “investment inputs.”

Investment inputs are harder to work with than investment outputs, since it takes a judgment call to determine their risk or value. To give you a better idea of what we mean, here are 10 keys to picking the best Canadian income trusts and real estate investment trusts. We look each before recommending any income trust: Continue Reading…

Should you invest in pot stocks? How do you invest in the cannabis sector?

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The importance of diversification

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By Noah Solomon

Special to the Financial Independence Hub

Harry Markowitz, recipient of both the 1990 Nobel Memorial Prize in Economic Sciences and the 1989 John von Neumann Theory Prize, referred to diversification as “the only free lunch in finance.”

As most investors are aware, diversification is an essential element of any well-constructed portfolio. Diversification across different markets and individual securities can lower volatility, mitigate losses in declining markets and produce higher risk-adjusted returns over the long-term.

Easier said than done: the temptation to chase returns

Of course, during times when one asset class or country outperforms for an extended period, this can lead to feelings of regret. Looking in their rear-view mirrors, investors often wish that they had been less diversified and had an overweight position in the outperforming asset class. This regret can result in FOMO (fear of missing out), whereby investors pour capital into those areas of the markets which have been outperforming.

The U.S. stands alone

Since the post-financial crisis market bottom of March 2009, the U.S. stock market has dwarfed those of other markets in terms of performance. U.S. stocks have produced almost double the return of emerging markets stocks, which have been the second-best performer.

Country Annualized Return Cumulative Return
U.S. 15.1% 381%
Emerging Markets 7.5% 199%
Europe 6.9% 189%
U.K. 6.1% 176%
Japan 5.7% 170%
Canada 4.9% 157%

 

Sources: MSCI, Factset Research Systems

Unsurprisingly, the outperformance of U.S. stocks, reflected in the table below, indicates that the U.S. market currently stands as the most richly valued market as measured by its cyclically-adjusted Price/Earnings Ratio (CAPE).

Country Cyclically Adjusted P/E (CAPE)
U.S. 32.1
Japan 27.2
Canada 22.0
Europe 19.4
U.K. 16.9
Emerging Markets 16.4

 

Source: www.starcapital.de

Punished for doing the right thing

The spectacular outperformance of the U.S. stock market means that portfolios that have been heavily concentrated in U.S. stocks have generated considerably higher returns than their more diversified counterparts. In other words, investors who have sacrificed diversification in favour of being overweight U.S. stocks have been handsomely rewarded. Continue Reading…