54. How to reduce points of failure in your portfolio
How to reduce points of failure in your portfolio
There are a number of ways that an investor can get in their own way and fail to reach their goals. Today, we discuss how to reduce these single points of failure to increase your chance of investment success.
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TOPICS IN THIS EPISODE
1. Too much in any one country, sector or individual holding
2. Not enough upside potential
3. Speculation
4. Insurance
5. Spending habits
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Transcript:
Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld. Today, we are talking about how to keep your financial life in order when things go wrong, by reducing single points of failure in your investment portfolio. Jordan, we're creeping up on the end of summer here. Did you have a good summer?
Jordan Arndt: Yes. Great summer, it's always sad though. You know, mid-August starts to creep in, the nights are a little cooler, days are a little shorter, but that's okay. Get maybe a pumpkin spice latte on and something, it's nice.
Evan Neufeld: Depending on when you're listening to this, you might have the pumpkin spice present.
Jordan Arndt: Mid-season already.
Evan Neufeld: Oh my goodness. Something to look forward to. Thank you so much for joining us today. If you're new to the podcast, please follow along with us. Hit that follow button and every couple of weeks we'll send you an episode just like this, where we help people invest smarter, reduce taxes and create a retirement paycheck. But one of them is investing smarter, which is what we're going to talk about today. Let me backtrack a second here, have you seen some of those crazy photos from this James web telescope?
Jordan Arndt: I did. Those are impressive.
Evan Neufeld: Pretty crazy. I'm no astronomer, not astrologer. I'm neither actually. But anyways, this thing's pretty cool. So for those of you who haven't listened, this isn't the science podcast, but James web telescope has taken some pictures of galaxies and nebulas and all these things that I’ve only heard of before. I don't really know exactly what they're, but these images are pretty crazy. And there's lots of wild technology in there, but I was listening to a podcast that was describing how this thing got built. And they were saying that with this telescope, there's lots of moving parts, which is surprising to me for a telescope, but there's lots of moving parts with it. It has 344 single points of failure. Let's unpack that. So a single point of failure means that, if any one of these things fail, the whole thing is completely shot. It just doesn't work. That's mind boggling, how much engineering has to go into this? Jordan, you have an engineering background in a former life. Are you familiar with single points of failure?
Jordan Arndt: Absolutely, yes. You want to avoid those as much as possible?
Evan Neufeld: How many of those do you have on a bridge? Probably zero. Hopefully none. So 344, that kind of peaked an idea in my head and thought well in the investing world here are there single points of failure that you can have in your portfolio. And I thought yeah, there's lots. So today we're going to talk about some of those and some other ones that aren't necessarily related to investment portfolio either, just ways that you can prevent yourself from getting into significant trouble. Before we dive into all the different options, maybe let's clarify failure here, Jordan, does failure mean like losing every dollar that you have.
Jordan Arndt: Yeah, it could, I hope at the extreme extent. But no failure, I think could be more broad, you know, not reaching your goals at all, or as quickly as maybe you might be able to. Putting you in a situation where perhaps choices have led to greater declines in your portfolio that could have been avoided otherwise, by hopefully following some of these tips. So failure can be quite broad here from the extreme of complete loss, but even just much more moderate failure, maybe just not quite maximizing the success that is possible.
Evan Neufeld: So let's talk about some of those. The biggest one that jumped off the page for me is individual stock holdings. Nothing inherently wrong with them, but the issue with owning individual stocks is when you own very, very, very few of them and the unfortunate reality is that companies go bankrupt all the time. Like I'm not trying to scare anybody here, but it happens. It's not necessarily the TD banks and Microsoft’s of the world, but big companies do fall from grace over time as well. So if you own an individual stock, let's use the crazy example of Enron. For those of you are familiar with that. It’s a big company that there was a massive accounting fraud with it. It was a huge company. That was in I think 2001 when it happened. Many of the people that worked there, they received significant stock based compensation and so their retirements were almost comprised of entirely Enron stock. And when that company went bankrupt, poof, they got nothing. Single point of failure. Now that's obviously the extreme example. That's in every, you know, finance textbook around these days, but you know, more benign things like that could lead to significant declines in your in your portfolio. How do we avoid this one? Diversified portfolio. So you don't own just an individual stock, even if it's a good company, things happen.
Jordan Arndt: Right. It's just putting all your eggs in, in literally one basket.
Evan Neufeld: Right. So diversification is as it was said, is the only free lunch in investing. It's boring, but boy does it work? Let's keep going here. So owning one individual stock. That's a single point of failure. Another one could be owning just the stocks of one country.
Jordan Arndt: That's a good example. You know, we were talking here Japan, 1989. It hasn't recovered to those highs in over 30 years or didn't recover to those highs in over 30 years.
Evan Neufeld: Just very recently. I think that it kind of got back to that high
Jordan Arndt: That's a long time. So if you only own Japan and you know, let's go worst case scenario in 1989, that's a long time to, to earn your earn any sort of meaningful return from there. Now again, that's maybe a bit of an extreme example, but I think the point remains that it's a potential single point of failure in your portfolio.
Evan Neufeld: And you know, even large countries like the United States, they've had long periods of time of negative or flat returns. You know, depends on when you buy and if you're consistently dollar cost averaging into the market into a diversified portfolio, it limits these risks, of course, but one country can be a problem there too. Another thing along with the country side of things is investing in Canadian stocks or American stocks or European, it has nothing to do with the flag or a political leader or anything like that. It's just, there's different sectors that are present in those countries that make those countries more or less attractive as an investment. Some of them have much better historical risk and return trade-offs than others. So you want to be careful with how you invest globally as well, but investing in any one specific country exclusively just opens yourself up to more risk than is necessary. So along with that, a lot of people here and in other countries fall, maybe not victim, but they end up having what's called a home bias in their portfolio.
Jordan Arndt: Yeah that's a good point. You know, home bias, just being that, if we're here in Canada, we consume Canadian media, we see Canadian companies. We may be more inclined to invest in the public Canadian markets and companies there. Just something to be careful of though, if you let's say you live here in Canada, well your job is tied to the Canadian economy, value of some of your other assets, like your house will be tied to the Canadian economy. And then if your portfolio's invested in solely Canadian companies as well, it's just another potential point of failure.
Evan Neufeld: Sometimes things move in one directional at the same time, that way.
Jordan Arndt: Your portfolio is dropping, while house price is dropping while maybe losing your job.
Evan Neufeld: We see that here in the prairies from time to time because our economy here, Alberta, maybe not Manitoba as much, but we have a lot of resource based economies provincially. And so when resources do really well, people end up moving here to get those jobs that are paying higher. And so that bumps up the housing market. And so housing, I think of Edmonton, Calgary, Saskatoon, they move pretty well in tandem with resource prices in both directions. Right? So when oil and gas drops, you know, housing doesn't look as fantastic there. So it's a bit of a compounding problem in the wrong way. Don't invest only in one country. yes, yes. Diversifying into more than one country just eliminates some of that risk of compounding the wrong way.
Let's jump it into sectors, only one sector. So during 2020, which is a completely wacky time to be investing, but tech was the only thing that made a lot of sense back in 2000 same thing. But everything only works until it doesn't so you know, tech in the late nineties and early 2000’s there were some pretty scary declines that happened there. Perhaps it wasn't completely wise to be fully invested there, but when things go up, FOMO kicks in.
Jordan Arndt: You hear about your friends, earning outsized, outrageous returns.
Evan Neufeld: Yes. My neighbor said this, my friend said that, I heard on the radio this. Once you've heard about it, the money's probably already been made and so really committing to any one sector can be problematic for one's portfolio. Any rules of thumb for sector concentration that you would recommend.
Jordan Arndt: Yeah. One might be, you know, avoid maybe like 25%, look at 25% as a max for one sector. So if you're going to invest in resources or commodities or something like that, make sure it's under 25%. Even tech, consumer discretion, any sort of sector that you can think of try and keep it under, under that 25%.
Evan Neufeld: Depending on where you're investing. That might be a little bit harder. So here in Canada, we just have so few meaningful sectors in publicly traded markets.
Jordan Arndt: So good thing we talked about more than one country.
Evan Neufeld: Yes, exactly. But even tech now, just the nature of investing in tech these days, is way different than it was in the 2000’s. Cloud computing wasn't a thing in the 2000’s, but neither were iPhones, right? All of these things are considered tech but they're completely different parts of the market. And you know, 2000 was anything with “.com” in the name was a billion dollar company. It's like, well, that's kind of stupid now in hindsight, but now there's really well diversified companies within there. So all that to say, 20 to 25% in any one sector. Once you see your portfolio kind of trending in that direction, maybe rebalance into some other stuff. There's probably some deals to be had if your portfolio was trending in that direction.
Let's talk about speculation. This one's fun. We could have a whole podcast on this one, I'm sure. You know, every stock has a version of speculation baked into it because when you buy a stock, you hope that it will increase over time. And so call that speculation, it's just hope, there's a little bit of that baked into it all the time. However, there are certain types of investments, I will name them here, that I'm personally not as much of a fan of, crypto and commodities specifically, if anyone's a huge fan of those, feel free to send me an email. But these types of investments are based on the idea that the only way that it makes money is if someone buys it from you for more than you bought it for.
They're not necessarily income producing assets in and of themselves. Let's contrast that with say real estate. If you have a rental property and you have someone living in there, they pay rent every month. That's an income producing asset. If you own a company that pays dividends, that's an income producing asset.
Jordan Arndt: I was going to say, go check out the dividend investing podcast.
Evan Neufeld: Yeah, exactly. Whereas, you know, I'm not as well versed in the crypto world. I know there's some other things in there, but just, let's just simplify it here. You own some Bitcoin. The only way it makes money is if someone buys it from you for more than you paid for it, same thing with gold or silver, the only way that it makes money is if someone buys it for more than you, it's called the greater fool theory that there's someone else that's going to be dumber than you eventually and end up holding the bag on it. Boy, maybe you can have some of that in your portfolio. I try to limit that as much as possible, but you know, the more you have in there, the more you're dealing with a faith based asset, which I'd rather have income you know, profit based assets. I don't want to spend too much time on there, but speculation. This one is a little bit more nuanced and Jordan, do you want to talk about how having enough upside in your portfolio or not having enough upside in your portfolio might be a point of failure.
Jordan Arndt: Yeah. And I guess this probably comes back to understanding your asset allocation and what you're invested in. So not having enough upside potential would just mean you're, you're invested to conservative based on your timeline to meet your goals, whatever, those goals are. If you have a long enough runway being too conservative is, is just going to lead to a portfolio that doesn't grow or have the opportunity to grow into what you want it to be, need it to be. This one is nuance because there's, you know, we can probably strongly say like, don't own one stock in your entire portfolio. But we can't say everyone should have whatever amount of upside equity stocks in their portfolio, and it's going to depend on each individual investor for what's appropriate. But I think what we could say is understand how you are invested and what your asset allocation is. So whether you have a pension plan or a group RRSP or something where you, maybe you made a decision at one point, or maybe you just check something, because you are filling out the onboarding paperwork or whatever it is. And maybe you don't even know, maybe you work with an advisor and you're just a little bit unsure of how you're invested. It's just worth knowing, I guess, how you are invested from an asset allocation, you know, bonds versus stocks versus cash to understand what is the potential of your portfolio to meet your goals and make sure that you are on track and have the opportunity to get there.
Evan Neufeld: Right? A lot of the content that you'll see online for, maybe I hang out in a different part of the internet than our listeners, but you see a lot of DIY advice saying, oh, just buy the S and P 500, everybody just do this and you'll make 12% a year. It's like, okay but investing is a little bit more nuanced than that and not everybody has the risk tolerance, capacity and risk attitude to just own something like the S and P fund or the TSX, or even like, globally diversified equity, only portfolio. Being a conservative investor is okay. This isn't conservative shaming by any means. It's just know thy self and know thy portfolio. So if you want to be a conservative investor, do you know how much you need to be saving based on your expected rate of return to actually meet your goals? So being a conservative investor is okay. As long as you understand what the upside potential of your portfolio is, and you have the discipline and capacity to make it up with your savings rate, right? So if your investments aren't going to grow by as much, you can just save more out of your pocket. That's fine. But you have to know that. And how can you know that?
Jordan Arndt: Have strategies, have plans and make sure you understand them.
Evan Neufeld: Yeah, exactly. So we help people build financial plans. If you don't have one or even a bit of an idea of one, feel free to reach out. Contact info's always in the show notes or talk to your existing advisor. There's some calculators online, even the government has one that you can kind of estimate how much you'll need to be saving based on about a standard rate of return. I recommend that people have a customized financial plan for them because it planners like ourselves, help people understand these things. I'll stop there but making sure that you have enough upside to match your savings rate capacity, if you don't, that might be a single point of failure in your portfolio. Last one on the investing side here, oftentimes when I've seen people that have pension plans, they have often invested in RRSPs alongside there. Again, depending on your situation, that might be a smart move to do. However, when retirement comes around and you have guaranteed income sources, that means that you have a pretty set tax bracket that you're going to fall into for the rest of your life. So when you have a portfolio that's only RRSPs. When you need to make money, what happens?
Jordan Arndt: Everything coming out is taxed.
Evan Neufeld: Everything you have to pay tax on every dollar and that stings. It's fine, that's the nature of the beast and I hope that you knew that when you signed up for the RRSP, but you know, the portfolio starts to dwindle a little bit faster than you might have thought because of the additional tax that you might have to pay with that. So including a TFSA as part of your retirement income strategy is a nice way to limit some taxable implications of different types of spending throughout retirement. It just creates flexibility, you know, paying taxes isn't bad or anything like that. By planning ahead, you might be able to avoid some additional taxes that you wouldn't necessarily have had to pay, especially for people that have a defined benefit pension plan.
Jordan Arndt: This probably isn't the single point of failure, blow up your entire portfolio type failure. But this is not the most optimal way of structuring things.
Evan Neufeld: It’s not optimal paying more tax than you maybe should. Again, not a single point of failure. You're not going to blow yourself up by having too much much invested. Okay. What are some other things in your financial life then might be single points of failure? I think about insurance, or lack thereof, I should say.
Jordan Arndt: We insure our house. You know, if our house floods or worst case burns down, we don't want to be on the hook for hundreds of thousands of dollars there that we’re left still owing on the mortgage. You can think about your financial life as well. So disability insurance, protecting your income should you become disabled. Life insurance, you know, worst case protecting your loved ones so they can cover off some debt and replace some income. On the flip side, too much insurance can be expensive and it's a bit of art to figure out what you should be insured for, but definitely not having any insurance is one of those things that should the unfortunate event happen? There's a huge opportunity for risk. No, there's just a huge risk there for you and your family and those that are left behind.
Evan Neufeld: Let's hopefully add some reassurance here for many people who have benefits through work. Lots of you will have disability insurance already. Take a look through your benefits package to make sure you understand how that works.
Jordan Arndt: That comes back to what we were talking about earlier is know thy self, know thy work plan and know thy work benefits. That's right. You know, again, you might have got that when you started and you breezed through the booklet and it's now been five years. It's a good thing to make sure that you have. Everyone's plans are different. So there's no one size fits all or anything like that.
Evan Neufeld: LTD is the acronym that you might be looking for there that stands for long term disability. If you have questions about that, talk to your HR person at work, there might be some life insurance in there as well.
Jordan Arndt: Yeah, often it's not a whole lot, maybe one time salary or, or two times or something like that. But again, something to look into.
Evan Neufeld: Some of these things like life insurance in particular, you want to be careful about relying too much on your workplace plan. It's almost never more than two times your salary and your mortgage is likely more than that alone. Let alone replacing your income for a while and you might switch jobs. Bingo, go. There we go. Say, if you ever leave your job, you don't own that insurance policy. In some cases you could buy it out, but in that case, it's probably more expensive than what you could have bought on your own. Anyways.
Jordan Arndt: So just consider insurance as part of your larger financial picture and understand that there is a single point of risk there.
Evan Neufeld: Yeah and for self-employed people, disability insurance is something that you want to look at. For life insurance, there are very, very affordable ways to ensure yourself through things like term insurance. It doesn't have to be expensive at all. Anyways, just make sure that that's covered off there. Now on the spending side of things, there's a variety of ways that you could have single points of failure. One thing that I've seen pop up all the time here, and anyone listening is probably familiar with this is that there's a subscription for everything.
Jordan Arndt: It's definitely the business model of the decade.
Evan Neufeld: Yeah, a lot of ways it can be great for sure. But if you buy anything online, there's a variety of companies now that'll say, buy this with four payments instead of all at once. That's not a subscription, but it's stretching everything out monthly. By doing things like that, you can really get comfortable with overspending beyond your income. And if you have things on a subscription basis, which I would almost include leasing a car is almost like a car subscription in a way. You never really own anything, but yet you're always having to pay for it. So when you own something, I've heard of some companies doing furniture subscriptions. Kind of a cool idea, but even after you've paid for something, you have to keep accounting for it in your monthly budget that really starts to become troublesome. And then eventually if you don't pay for these things anymore, the car disappears, the coach disappears. Like now what. You know be careful with subscriptions, especially when it comes to physical goods. This isn't like magazines and gym memberships, but just be careful of what you're stretching out from payments. Along with that, buying more house than you can really afford.
Jordan Arndt: It'll be interesting to see how this takes shape now with rates, that they've raised fairly substantially given the most, recent frame of mind. But you know, when rates were so low, it was pretty easy to extend your mortgage a little bit. Maybe extend how much house you're buying, getting in something that you can't really afford. You know, maybe we're seeing it now is as your rate perhaps has gone up, if it's variable or you're thinking about your renewal time, buying more house than you can really afford, can put you in a bit of a pinch for sure.
Evan Neufeld: My problem with house affordability is that there's been this stress test that's been put on people when they apply for a mortgage. And it says, okay, well at this income and your other debt obligations, you know, going up to, a much higher interest rate than is current, it appears that you could still keep making your payments. What that doesn't account for is your spending habits, right? So Even if you don't have any other debt, but you're spending every dollar anyways. If your mortgage then increases, say you're on a variable mortgage and your payment goes up because you're spending every other marginal dollar. No, you can't afford it anymore. There is no slack anymore In your budget. So buying more house than you can really afford, know thy self and know thy budget. You know, if you have to sacrifice your kid's diapers and putting food on the table, my goodness, no, you can’t afford it. But then start taking a look at that budget and maybe scale back, some eating out, going on the lavish vacations or things like that. Anyways, buying a house is a quick way to go broke, and that's very common for Canadians being house rich and asset poor. Just be careful. Sometimes it's tough to avoid, but just be careful.
Jordan Arndt: So what do we do about this? You know, there's lots of single points of failure here. Are there any ways, or what are your recommendations for how we avoid this as much as possible?
Evan Neufeld: Well, when it comes to the portfolio, seemingly all of those problems can largely be solved or at least addressed by diversification. Diversification is your friend. It's not a guarantee. It's not by any means, but it reduces certain types of risks within your portfolio. So globally diversified, even asset class diversified. So Jordan, you have a hundred percent equities, maybe add 10% into fixed income, something like that. You know, there's a lot of ways that you can add little bits of cushion in your portfolio, but again, you have to know yourself, what you're comfortable with, what you understand. And if you don't, talk to your advisor, do some research, things like that. Beyond that, insurance is your friend. Be careful about doubling down on things that you think might work. I've seen so much anecdotal evidence. You know, when you own a little bit of say energy stocks recently, let's go all into energy. And it's like, okay, well now oils now, 80 bucks a barrel or whatever it is, everything works until it doesn't right. Careful about doubling down. Think about it on the other side of things. Investing is inherently an optimist's exercise, right? You have to think positively about the future or else you'd never do it. You just sit on your cash. So it's very easy to just look at the upside only. Flip every choice and decision on its head and evaluate whether your investment decisions are leading to single points of failure. So it's like, well this stock is looking really good. I'm going to buy some more of that. And it's like, oh my goodness. Now it's 75% of your portfolio. What happens if this thing blows up? Well, you blow up along with it. Right? Rebalancing is a really nice way to address some of these things that might happen outside of your control. So even if you just own a set portfolio, things that work will throw things a skew over time and so rebalancing is really important. That's why I recommend to do that on a fixed schedule, no one ever lost money by taking profits. That doesn't mean you have to do it every day. Don't be afraid to take some money off the table, buy something that looks foolish because different sectors, different countries, ebb and flow over time. Rebalance, buy diversified portfolios, invest globally. Anything else? That seems to be it.
Jordan Arndt: Try and avoid those single points of failure.
Evan Neufeld: Awesome. Thanks so much for joining us today if you haven't already followed along. Thanks for all the ratings. We've got lots of ratings, that helps other people find the podcast. If you rate and leave a comment on apple podcast, that's great. We really appreciate all of those who follow along and you'll see us in a couple of weeks.
Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and Registered Investment Fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.