Winnipeg Free Press - PRINT EDITION

The ups and downs of being in equities

There are rewards, but also some risks

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We talked last week about why you might want to invest in the ownership of companies by purchasing shares on the public markets. The benefits include collecting cash dividends and growing the investment over time through appreciation of the share prices. We also reviewed the favourable tax treatment of dividends and capital gains.

Today's column will talk about different methods of investing in shares, other than direct ownership. But I want to start out with a true life story that will illustrate the risks and rewards of equity investing.

I know a couple -- we'll call them Bob and Carol -- who did well saving and investing and then retired at age 60, in 2006. Carol began her pension as a monthly income, which provides about one-third of their regular needs. Bob had no pension, but his RRSP and non-registered investments were worth almost exactly $1 million and he started drawing regular income from each of those. So far, nothing too unusual.

Here's where it gets a little more interesting.

Bob decided to maintain his investment policy of 100 per cent equity investments -- all stocks -- and not make any changes due to retirement. His logic was that the 12 Canadian blue chip stocks he owned were paying dividends of more than four per cent on average, and he was confident they would keep paying. Over time, he believed the companies would keep increasing their dividends, which all had done in the six years he'd owned the stocks.

The dividends provided all of the income they needed, so they were not depending on capital gains. As Bob put it, "The stocks are like apartment buildings with good tenants. I don't care if the real estate market goes up or down, as long as I can keep collecting and increasing my rents, to beat inflation."

OK, makes sense... but then came 2008.

You remember 2008? Global financial crisis, falling stock markets, even bankrupt financial institutions... it's all coming back to you now?

Bob's portfolio value dropped in half. Ouch. I spoke to him then and, although shaken, he decided to stick to his approach. The dividends kept coming, so why change?

It's a happy ending, of course. Bob's stock values are back above the 2006 levels, and almost every company he owns is now paying a higher dividend. Their income is therefore up, keeping pace with rising costs.

Now, I don't recommend this approach, and it's not the one we use with our clients. (We are more balanced, allowing for tactical adjustments to take advantage of market cycles, and less stress for clients.) Anyone taking Bob and Carol's approach also needs to have cash reserves and other safety measures in place.

However, this extreme -- but real-life -- example shows how equity investing can pay off, in spite of the so-called bad markets.

Mutual funds and ETFs

Many people have portfolios that are too small to practically use individual stocks, or they would rather have a professional manager pick the shares in their portfolio. When you invest in a mutual fund, you become part of a pool of investors set up by that fund company, to use such a manager to choose the investments.

The fund collects the dividends and the proceeds of sales when the manager chooses to sell the stocks. (Note that different mutual funds invest in different asset classes. Today, we are talking about funds that invest only in shares.)

In a mutual fund trust, you own units of the fund, and the net taxable income is allocated to the unitholders each year.

In a mutual fund corporation (often called "capital class"), you own shares of a corporation, which has more tax flexibility to defer tax. Both of these are "open-ended funds" where the pool agrees to buy back your units at the end of any trading day, at the net asset value per unit or per share.

When you invest in an ETF (exchange traded fund), you are buying shares of the ETF from other sellers during the trading day, just like any other share. The difference is that the only assets of the company are a basket of shares, usually replicating a recognized index of shares. Management fees for passive (index tracking) ETFs are generally much lower than for the active approach of most mutual funds.

No matter your approach, remember an equity investment means becoming an owner of companies, with the rewards and risks of ownership. The rewards can be great, and the cost is volatility. In the next few weeks, we will talk about how to take advantage of that volatility, and why so many people are rotten at market timing.

David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).

Republished from the Winnipeg Free Press print edition March 30, 2012 B18

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