Everyone saves during their working years with the intention of building a nest egg for their retirement. The goal is to use the capital effectively and generate a reliable source of income to support their day-to-day living expenditures, travel expenses, and other miscellaneous expenses.
So, the key question is – What can investors invest in today to achieve that objective?
In today’s low interest rate environment, retirees are faced with a dilemma. They would like to invest in bonds because of the benefit of capital preservation. On the opposite side, bonds no longer pay an attractive return like the 1980s. In 1981, the interest rate was approximately 18%. Today, the 10-Year US Treasury Bond is at 2.86%. Therefore, someone who can generate $18,000 per year from investing $100,000 in 1981 can only generate $2,860 in today’s environment.
There is another factor that investors need to consider. The negative correlation between interest rate and bond prices. As the interest rate increases, the bond price declines. The bond market has enjoyed a 30-Year bull market with the interest rate declining over time. We are currently in an all-time low interest rate market. Therefore, as we have seen in the past year, interest rates are increasing. The result is bond prices have declined and had negative impact to the portfolio.
Physical property is a good source of income for retirees. I believe that it is important to have real estate in a portfolio for diversification purpose and hedging against inflation. However, one should not only have this asset class in their portfolio. Although it provides a good source of revenue, it is not free of financial risks. They are illiquid and sensitive to interest rate movements.
In general, it requires time to sell a property. It may take one week, one month, or several months. Until the property is sold, the investor does not receive the sale proceeds. Therefore, depending on how quickly the individual requires cash, it could lead to problems.
The increase in interest rates will lead to more difficulty for people to get qualified for mortgages. In turn, it will lead to more difficulty in purchasing properties and may cause a decrease in demand for properties. The effect is it could potentially lead to a decline in property values.
As mentioned in my previous article, there are risks associated with investing in stocks. However, not all stocks are the same. Some are defensive, while others are more sensitive to economic cycles. Similarly, some are great at providing consistent dividend payments, while others do not pay at all.
The stocks that provide a steady stream of dividend payments (3% to 6% per year) tend to incur relatively low fluctuations. Although they are not principal guaranteed, the probability of loss of capital remain relatively low. In addition, they are liquid so investors can obtain cash from the sale within several business days. Since they are liquid, they provide the flexibility for investors to adjust from one dividend paying equity to another (for example, from financials to consumer staples). This is dependent on the market and economic conditions. As a result, investors have the opportunity to continue receiving income regardless of what is happening in the market.
It is very important to note that the “Rule of Thumbs” on the internet do not apply in today’s environment because they are based on historical data and situations. For example, the theory that states when an individual becomes older, he/she should have more allocated into bonds and be more conservative. This is true in theory. It is also true that they should be more conservative. However, in reality, the individual may actually incur more capital losses and lower income generation by allocating more into bonds in today’s time. Is that actually being more conservative?
I would like to remind everyone that March 1st is the last day to contribute into your RRSP. I hope you had a chance to get your contribution in on time!
Joseph Tang is an Investment Advisor at BMO Nesbitt Burns and holds the Chartered Financial Analyst (CFA) Designation. He has been working in the financial industry for over a decade. His passion is to provide comprehensive wealth management strategies and build customized investment portfolios for his clients. He firmly believes in fundamental investing and in active management of assets by adapting to constant changing economic conditions. Furthermore, proper diversification in asset classes, industries, and countries is vital to achieve sustainable wealth for his clients in the future. Joseph Tang can be reached through his email address: [email protected]
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