This is the third article in a 3 part series on income investments by Frank Weiler.
I find that investors sometimes have the tendency to own too much of one type of investment. If they buy a preferred share for example, whether that initial investment does well or not will impact their “comfort level” and in turn their willingness to buy more preferred shares. If an investor owns all the same types of investments they are at risk of having adverse market conditions affect all those investments in a similar way. They could all go down in tandem since they are so similar. I think the risk of owning concentrated positions is worth discussing.
The “d” word
The word diversification gets thrown around a lot in the investment world. Basically it means owning a lot of different type’s investments to reduce risk. The reasoning behind this is that not all these investments will react in the same way to adverse market conditions. Diversification is often measured by correlation. Correlation refers to how one investment tends to behave versus another investment or market index. One asset class like gold might tend to rise when bank stocks fall for example. When investments tend to move together we say they are positively correlated, and when they tend to move in opposite directions we say they are negatively correlated. The trouble is that the way things correlate can change over time. Nevertheless, having different asset classes increases the chance of having negatively correlated investments and reduces risk.
In my previous article: “Income paying investments in Canada”, I pointed out the many income generating investments available in Canada. In this article I would like to provide some thoughts on how an income generating portfolio can be constructed and maintained. Keep in mind that this is a snapshot of knowledge. For further information please refer to my acclaimed book: Insync Income, The must Read Guide to Investing for Income in Canada.
Two types of income producing investments
When investing for income I recommend dividing the income investment landscape into two groups:
Category 1: Investments that have a maturity date where there is a return of your original principal investment. For example:
- Convertible Debentures
- Preferred Shares (non-perpetual)
- GICs and money market instruments
Category 2: Investments that do not have a maturity date where there is an intent to return your original principal investment. Some examples include:
- Real Estate Investment Trusts (REITS)
- Preferred Shares (Perpetual)
- Resource Trusts and their successors
- Business trusts and their successors
Both groups are income producing but are quite different in the way they trade in the market, and react to economic changes. A category 1 investment provides the opportunity to hold the investment till the maturity date, which is a huge difference from owning something “perpetual” where the only way out is to sell in the open market at the best price possible.
Which category is better?
There is no better or worse all of the time. It really depends on economic factors. Two of the primary economic considerations I look at are the forecast for future interest rates and the spread between guaranteed and non-guaranteed investments. Generally, in riskier environments you would want to own more category 1 investments, and in less risky environments you would see additional category 2 investments added to the portfolio.
The next step is digging deeper
Once an initial asset mix is nailed down it is time to look at different options (see above) within those categories. When choosing investments in either category, you need to decide whether you want to be more or less defensive. Here are some tips for choosing asset classes:
· Look for opportunities in sectors that are out of favour
· Use credit ratings to help in the decision-making process
· Compare the yield of a sector to its historical norm
· Is there anything favourable or unfavourable in the outlook?
· Look at trading ranges; is an asset class or industry group trading at lofty levels?
Once decisions are made on the general make up of the portfolio, it is time to really drill down and look at individual security selections. Often an income investor will look at the current yield of an investment as the main consideration. This can be dangerous since a high yield is sometimes a warning sign of a potential dividend cut. You need to drill down and do some serious research.
In my book I have introduced an entirely new security analysis tool called the Weiler Dividend Anchor Score. The DA score provides a way to initially compare income producing investments by scoring them based on their yield and how volatile they have been versus the market. The DA Score was recently featured in a Globe & Mail article by Rob Carrick called “Anchor your Dividend Expectations”.
Maintaining the portfolio
Maintaining the portfolio is a matter of adjusting the proportion of category 1 and 2 investments, and the general level of defensiveness as the economic climate changes. These corrections and adjustments can produce a portfolio in tune with the current and upcoming economic environment which is what I call an Insync Income Portfolio.
Contest to win Frank’s Book
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Frank Weiler, author of InSync Income, The Must Read Guide to Investing for Income in Canada. He describes himself first as an investor advocate. A former investment advisor with some of Canada’s leading wealth management firms, including RBC Dominion Securities and CIBC Wood Gundy. Frank draws from a dozen years of experience in the financial industry, including years of research, and a lifetime of unfettered curiosity to produce The Income Investor’s Advocate.
Check out Frank’s Blog: The Income Investor’s Advocate where he writes posts to try to help investors understand more about financial topics that he feels are important.