Friday, April 10, 2009

why 5 is greater than 7

looking back at those two portfolios. they are modest, six-figure portolios that could represent an inheritance, a personal pension, a life-time of savings or just one part of a larger portfolio. but for argument's sake, let's say your old, retired and have paid off everything, your home, kids, medical bills. your healthy, active, retired and free. well, it's possible that $15000-$18000 would be enough to pay all your bills and even have some extra to reinvest every year (consider the left over cash in this case to be spent on grand kids or vacations etc. if you were married and your spouse had worked and saved, you would likely be even more than able to pay the bills, have something left over and avoid spending any of your principal.
So, why not go with the portfolio that offers more money.
that is the line of reasoning people have been fed for the past 30 years. and given the current prices it's hard to argue against that logic. placed in historical context, the difference in the two portfolios becomes clear.

the 'stock' portfolio has the following advantage:
-currently, the cash return is higher
-the taxes are greatly reduced
-the possiblity exists for the share price and dividend to increase
-almost half the principal is fully protected in government savings bonds

the 'bond' portfolio has the following advantage:
- the return is still high enough to pay the average cost of living for an individual who owns their own home in canada for a year
- the cash return is guaranteed*, ahead of preferred shareholders and common shareholders
- the principal is guaranteed* to be returned at the specified dates
- choosing longer maturities with each return, will result in the real growth of cash return
*remember, real guarantees are not absolute and homework must still be done to have confidence in an investment grade bond not defaulting

on face-value, the danger of interest rates falling too low seems to put the bond portfolio at a disadvantage. while it is true interest rates are very low, this information should be considered in the context of our current economy, which is experiencing deflation. meaning gas is cheaper than last year, food is cheaper, electronics, cars, and homes are cheaper. it really is possible to pay all the bills with that amount of money- provided you are in good health and/or have effective medical coverage (not expensive in canada).

Regardless, these are current prices and yields and all those stocks represent buying opportunities right now.

But what if it wasn't right now. What if it was a year ago, with those prices and yields.. and suddenly the market tanks. It loses 35% of it's value. the revenue streams of several of your stocks have been hit hard and will continue to have trouble until the economy bounces back to growth (which everyone thinks is a long way off). what happens when the face value of the stocks dips 35%, the dividends become too expensive for many of the companies that relied on a growing economy. earnings and dividends could be cut in half.

where does this leave the two portfolios?

Disadvantage of the 'stock' portfolio:
- face-value of your investment is at risk to go all the way to zero
- common shares are the first to have their dividend reduced or stopped all-together
-interest from canada bonds is not enough to pay cost of living without dividends.
-long-term bonds are much must susceptible to inflation and interest rate risk

disadvantage of the 'bond' portfolio:
- lower returns means less income
- higher tax rate
- some interest rate risk and hyperinflation risk

the risk for the bond portfolio if the economy is in recession and the stock market crashes, is that interest rates go down and inflation rises. in this type of environment it is next to impossible to earn a return that will pay the bills.

the risk for the stock portfolio is that half your investment could get literally wiped out. in this situation 35% of the value of your stocks was evaporated. meaning now you only have $235000 of your $300 000 and the dividend has been cut in half overall. you would be left with the same inability to pay your bills with your return and you would have lost 65000 into thin air.
i apologize if the math is wrong, i'm just trying to illustrate a point about what happens when you experience significant losses.

which is a worse worst case scenario? which is a better best case scenario? what does that mean about the correct way to invest money?
you probably know my feelings on the those issues, but i'll elaborate in my next posting.
anybody reading this?

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