Saturday, November 17, 2018

Era of Balanced Portfolios – 60/40 is coming back

The old adage 60/40, meaning 60% invested in stocks and 40% in fixed income has been abandoned by most investors in recent years. That trend may reverse soon.  After years of excessive low interest rates, those rates are now on the road to ‘normalization’ – especially in North America. The interest cycle has turned, and we may be heading for years of higher interest and inflation rates.

The boom-bust cycles of high tech may stabilize. Too many are aware that growth companies follow momentum and often do not tracked traditional value-investing. But dividends often deliver 60% of the profits made on a stock investment. And… those equity gains are often a lot more volatile than steadier dividend income.

In the age of low interest rates, RRSPs were a very unfavorable investment vehicle, but this may change when it is regarding tax deferral of taxes on interest and contributions.  Especially if a large contribution space leads to an immediate tax saving during a high-income year a lower tax rate during a future year of low income. Over the coming years, for retirees who no longer enjoy employment income or for small business owners control their self-employment income our strategies regarding tax sheltering and fixed income may change substantially.

If you borrow money during deflationary times your principal, in terms of purchasing power, may increase while during high inflation years you don’t only reduce principal as part of your loan payments such as with a mortgage but also the principal may lose significant purchase power due to said inflation. In the meantime, your asset value will appreciate with inflation and then some. Also, your rental income on real estate is basically inflation protected while your loan service costs decline.  Thus the new market conditions of rising interest rates create new opportunities and strategies.

Now is the time to plan your future investment strategies and gradually implement them.  One scenario at the end of this 9 to 10-year long bull market is to wait for the final euphoria stage of the U.S. stock market; build an opening position in commodities (if not already done so) for the coming commodity bull market – yes even here in Canada. Then during the ‘euphoria’ take stock market profits and park the proceeds in gold; GICs; money market funds and plain cash.  You also may buy bonds near the euphoria peak and benefit from capital appreciation during falling interest rates in the subsequent crash.  This latter strategy is quite speculative.
Although it may take a long time for stocks to recover from such a crash. So many retirees and speculators will have lost their shirt and will shy away from re-entering the stock market, during the recovery following the crash. During these recovery years, dividend earning stocks bought quite cheaply may then be even more profitable than simple interest income.
Maybe such a final period of stock market euphoria may not arrive but still if you gradually park more and more cash in laddered GICs and other fixed income you may do quite well over the coming years. However, in that case avoid bonds as they will lose value with continued rising interest rates.  Either way, even with a good economy, stocks fare typically less well when interest rates rise. That rise may be very gradually but still, your principal will decrease over time.
Overall, with rising interest stock investing becomes riskier and putting more assets in fixed income (including real estate) is probably more profitable. Yes, in the coming years, I foresee a major shift in investment style. More corporations will likely borrow rather than issuing more stock as dividends may become more expensive to raise corporate working capital than simple debt that will be inflated away.  Corporations don’t care how they obtain the working capital they need for their operations or for expansions. They just look for the cheaper form of financing. Over the coming years debt financing is cheaper than issuing dividend paying equity – guess what the corporate suites will do? 
When in previous years I barely invested in fixed income, especially while becoming of a more ripened age, I expect a significant increase in my fixed income investments. I think 60/40 is back for the next decade or two.

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