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Safety in numbers
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THE KNOWLEDGE BANK
David West is a veteran financial adviser, journalist, and teacher. He covers the waterfront on the nuts and bolts of investing in mutual funds and ETFs.



By David West  | Thursday, February 09, 2012


 
TFSA STRATEGY

Safety. Every investor wants an element of safety in their portfolio. But ask an investor to define “safety” and that’s where the difficulty begins.

One of my friends, who has owned his own retail business for years but has never seriously invested in the stock market, recently came into a fair chunk of money, and is considering whether to set up an investment account. “Is it safe?” he asked me.

When I asked him what he meant by “safe,” he referenced Bernie Madoff, Martha Stewart, Sam Waksal, and Weizhen Tang, the self-proclaimed “Chinese Warren Buffett” from Vancouver. Seriously, he thinks the market isn’t safe because a few bad actors like that get a lot of press.

For others, safety means not being able to lose any money. For others, it’s yet another thing. So, for lack of a universal definition, let me take my own stab at defining safety.

To me, safety is the certainty of achieving an expected return, and it comes in degrees. The ultimate in safety might be in the form of a federal government Treasury bill. Here’s why: You know the price you’re going to pay for it, you know in advance the price it’s going to mature at, you know the time frame, you know the income to be received in the interim (none), and there is virtually no default risk.

As an example, if you buy a 91-day T-bill at 98 that will mature at 100, you anticipate that your return will be 8.19% annualized. Your actual return is exactly the same as your expected return. Thus, there is no risk.

By way of contrast, let’s now look at a federal government bond. If you buy a 4% five-year Government of Canada bond at par, hold it to maturity, and it matures at par, meanwhile paying its interest semi-annually (and we’ll assume no risk of default), you expect a return of 4% annually. Coming out, your actual return will be very close to 4%, the only variation being at what rate you were able to reinvest the semi-annual interest payments. Your actual return is therefore very close to your expected return, so there is very little risk. Or, said another way, a lot of safety.

What about a common share? You’ll know your buy price, and perhaps your expected holding time horizon, but you can’t be sure of the selling price. If the stock pays a dividend, that dividend could change, as could the reinvestment rate of those cash dividends. Bottom line, your actual return could be vastly different from your expected return, so by definition stocks are not as “safe” as bonds or T-bills.
 
Cash: the ultimate in safety

But enough of the academic talk. If you as an investor want safety, you can find it in a high-interest savings account, a GIC, a term deposit, a certificate of deposit or a Treasury bill. The gross return won’t be high, but it’s more about what you keep than what you make.

For that reason, I advocate that you hold only cash, in any of the above forms, in a tax-free savings account (TFSA). In my opinion, TFSAs are wasted if they’re used to hold stocks, bonds, or mutual funds instead of cash. And that includes money market funds: Why would you give up half of your return to a mutual fund distributor in the form of an MER when it’s so simple to buy a T-bill yourself?

My friend the business owner already has his TFSA topped up to the limit, and he has a lot more money still to invest. He still wants more safety, so now what? Now he needs to build a portfolio, allocating his capital among three asset classes at a minimum: cash (i.e., his TFSA); fixed-income securities; and solid, blue-chip equities. The safety comes from not having too much allocated to any one of the three buckets, and the fact that the three buckets have low correlations with each other.

Real safety in portfolio design

In other words, the safety comes from diversification as well as from choosing large-cap, blue-chip, dividend-paying stocks. If you have a lot of money to invest and you want safety, there is no better way to go than a well-designed portfolio.

One fund that exemplifies the large-cap blue-chip approach is the Bissett Canadian Equity Fund A, Fund codes TML 302(BE) and TML 202(FE), managed for Franklin Templeton Investments Corp. by Gary Aitken since 2002.

This fund carries an MER of 2.52%, but earns that fee. In the year ending May 31, 2011, the fund returned 23.8%, putting it in the first quartile, and 5.1% per year compounded for the past five years, also first quartile. This fund currently ranks 25 out of 408 peer funds.

David West, CFA, FCSI, has more than 25 years’ experience in the financial services industry as an adviser, trainer, writer and commentator. He is a columnist for The MoneyLetter and Canadian Business Online among others, and is a regular contributor to the Fund Library.

Notes and Disclaimers

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

 
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