Planning for Better Investment Results (Part 2)

Part 2 of this blog article looks at how an investor might develop a financial plan that is consistent with their risk profile. It also discusses the importance of documenting how progress will be monitored. Here is a link to the first part of the article.

The Five Planning Steps (continued)

Develop Your Financial Plan

When an investor is developing a financial plan, there are a number of asset classes available to construct their portfolio. The main ones are:

Equities (or stocks), which provide the highest return over the long term;
Fixed income, such as bonds and GIC’s, provide a known income if they are held to maturity;
Cash equivalents, which includes money held in a high-interest savings account, Treasury bills, and other marketable securities with maturities of less than one year; and
Alternative assets, such as real estate, commodities, precious metals and cryptocurrency.

Since the asset allocation choices you make will play the largest role in determining your investment return, it is important that you take great care in making this choice. The relative weights for equities and fixed income should reflect your investing time horizon. If your time horizon is 30 years or more and you can tolerate stock price volatility (i.e. average stock price drawdowns of 50% or more), then it makes sense to have a fairly high equity weighting. On the other hand, any money that you will need within the next 5 years should be placed in a secure investment like Treasury bills or GIC’s.

Some aggressive investors go as far as to have all their investments in equities. In this case, a significant portion of their portfolio is usually allocated to conservative stocks, like utilities or pipelines, that provide bond-like income with some growth over time. Many investors believe that they can absorb a 50% decline in stock prices, but find out that they can’t when it actually happens. This is one of the main reasons why investors sell stocks near the end of a stock market decline, which is the exact time when they should be buying more.

Investors have traditionally reduced the volatility of their portfolios by holding fixed income. For example, a 75/25 portfolio of stocks/bonds would typically suffer a drawdown of less than 37.5% during a 50% correction in the stock market. The bond positions normally increase in value during market corrections due to investors fleeing to safety (on a short term basis) and central bankers reducing interest rates to stimulate the economy. I am not sure to what extent this will happen in a low interest rate environment like we have today.

Investors that have a very high weighting in fixed income investments take a significant inflation risk over the long term. Their portfolio may grow in value, but their buying power could actually decrease over time.

Some investors prefer to keep a portion of their investments in cash equivalents due to the relatively low returns on investment-grade bonds. This money would typically be employed to buy stocks during a stock market correction, but could equally well be deployed to buy bonds if their yields become relatively attractive. Investors should also strive to maintain an emergency cash fund that can be quickly accessed in case of unanticipated expenses. Lastly, retired investors should have liquid cash equivalent investments available for living expenses so that they don’t have to liquidate equities after a big market correction.

The final asset class is alternative assets, such as real estate trusts, commodities, precious metals and cryptocurrency. I have grouped these assets together to simplify matters.

Real estate assets like office buildings, retail malls and apartment buildings generate fairly consistent revenue streams that increase with the inflation rate. Real estate investment trusts (REITs) are corporate structures that enable companies to distribute these revenue streams to investors in a tax efficient manner. I am somewhat cautious on REITs at the present time due to the elevated price of real estate assets in Canada.

Commodities, as well as the resource companies that produce commodities, tend to do very well late in the business cycle and during inflationary times. Crude oil, natural gas, coal and uranium are important energy commodities. Copper, steel, aluminum, lead and zinc are major industrial metals. Major agricultural commodities include fertilizer, wheat, corn, sugar cane, tobacco and timber. Commodities, as well as commodity companies, tend to be very cyclical in nature as their prices are basically determined by supply and demand dynamics. An investor has to know when to buy a commodity stock and be diligent in taking profits after the underlying commodities surge in price.

Lastly, precious metals (PM) such as gold and silver tend to do well when investors lose confidence in the economy. I look at them as an insurance policy in case everything else fails. Cryptocurrencies may be seen as competing alternative currencies to gold, albeit with only a very short track record compared to gold. An investor has to be diligent in rebalancing their portfolio after the price of their PM or cryptocurrency assets increase.

The alternative asset class is often neglected due to the high cyclicality of commodity prices, which tends to make them a poor investment over the long term. However, they do provide diversification to a portfolio, as well as significant protection against black swan events. As Benjamin Franklin said, “an ounce of prevention is worth a pound of cure.”

My Target Allocations and Thoughts

My current target allocations are: 55% equities, 20% fixed income, 10% cash and 15% alternative assets. I currently maintain 5% weights in both energy and precious metals. I will add a REIT or two at some point in the future. I also have a defined-benefit pension, so my overall asset allocation is quite conservative. I plan to diversify my commodity stock holdings beyond energy if inflation proves to be an enduring issue. For disclosure purposes,, the stocks on my watchlist have not traded down to their target buy prices since late-2020 so my current cash position is higher than 10%

The main takeaway is that your asset allocation decision will play an important role in determining the price volatility and return of your investment portfolio. Investors that are unable to handle high price volatility sabotage their investment returns by selling equities at the most inopportune times. In summary, investing is very personal and everyone has to achieve the right asset allocation balance for their personal situation and risk tolerance. Unexpected economic events happen way more frequently than investors think, so make sure your portfolio is prepared for any eventuality.

Monitor Your Financial Plan

An investor must monitor their investment plan on a regular basis to ensure that they remain on track to achieve their investment objectives. I review my financial plan and target asset allocations on an annual basis, but only make changes infrequently. The last change to my financial plan occurred as I approached retirement age and committed to a higher-quality, more diversified portfolio that I expect will produce a growing income stream during my retirement years. I review progress made each year towards achieving my financial goals.

Every quarter, I check to see how my asset allocation has deviated from my target asset allocation. I do this because I use my dividend income to restore my target asset allocation. Moreover, any stock purchases are consistent with moving towards restoring my sector allocation. The asset and stock sector allocations serve to direct new money towards assets and sectors that have not done as well, which is a cost-effective way to restore portfolio balance without selling any investments.

As stocks are the foundation of my portfolio, I review the quarterly reports produced by each company that I own. I focus on the revenue, earnings, free cash flow and dividend trends. My main objective is to confirm that each company will continue to pay and grow their dividend in the future. I watch company debt very closely. DEBT is a four letter word for conservative investors. I tend not to pay excessive attention to the stock price, which is subject to the vagaries of the market in the short term. However, I am always looking to take advantage of price volatility as an opportunity to increase the size of my stock holdings.

The first metric that I pay attention to is the dividend yield relative to the average dividend yield over the past 5-10 years. A high-quality stock that is trading at a higher than normal dividend yield may represent a buying opportunity. (Please not that lower quality stocks that trade at a higher than normal dividend yield are more likely to be value traps.)

The second metric is the dividend growth rate trend over the past 10 years. Stocks that increase their dividend at the inflation rate or higher provide a growing cash flow that maintains your buying power. Of course, the investor must check to make sure that the dividend payout ratio is not increasing in an unsustainable manner. Management tells me more about the overall health of their company through the annual dividend increase than almost anything they say.

Astute readers will recognize that the sum of the dividend yield and the dividend growth rate is the Chowder Number. I will have more to say about the Chowder Number in my next post. Of course, stock prices are always subject to the current perception of the investment community, which leads to P/E ratio expansion or contraction relative to the company’s average P/E ratio. Buying a stock when it is trading at an above average dividend yield often implies that there is the potential for P/E ratio expansion. Likewise, buying a stock at a lower than average dividend yield will often produce disappointing results until the company grows its earnings to match the price you paid for the stock.

There are several other metrics that are important to understand when you are looking to monitor a company or purchase it’s stock. This gets into the essence of what makes a great company. I will leave these discussions for a future post.

Focus on your Increasing Income Stream

Every month, I verify that all anticipated interest, distribution and dividend income has been received. Many investors maintain a graph of monthly investment income. This is an excellent way to track progress if your long term goal is to generate a specific income stream. Investors that focus on portfolio value tend to get overly excited when their stocks go up in price and become despondent when stock markets decline. This can lead to irrational investment decisions rather than maintaining focus on their investment process.

Closing Thoughts

This post documents the framework I have developed to build my investment portfolio. It keeps me focused on my long term objective and enables me to sleep well at night. When the market is going up, I enjoy watching my companies grow their revenue, earnings and dividends. On the other hand, my focus shifts towards identifying attractive investment opportunities when the market is correcting, which distracts me from the fear of “losing” money. After all, wise investments made in a correcting market lead to a higher income stream and larger capital gains in the longer term.

Further Information Sources

Investors who would like to read up more about Investment Policy Statements can explore the following links:

Three Questions to Consider

Do you have a realistic financial plan in place?

Is your financial plan consistent with your risk tolerance?

What steps do you consistently do to monitor your financial plan?

I look forward to hearing your thoughts on any of these questions in the comments section.