The big picture: Categorizing income paying investments

Posted on April 26th, 2012.

When investors start getting closer to retirement their appetite for risk will often decline. Makes sense that investors with long time horizons would generally feel safer that they can withstand the volatility that the stock market often provides, and that those with shorter time horizons would want to reduce risk. I believe that this tendency to reduce risk is prudent.

When we discuss reducing risk it is often assumed that we are discussing moving away from more volatile stock market based investments into more conservative fixed income investments – selling stocks to buy bonds and GICs and such. A portfolio that is all in equities might very well do just that to help reduce risk. Although I would agree that many portfolios would likely change their makeup in this way, it is important to note that there are really types of income producing investments, those with maturity dates and those without maturity dates. Understanding how risk can be managed by owning different proportions of each under different economic environments is helpful to say the least.

In my acclaimed book: InSync Income, The Must Read Guide to Investing for Income in Canada, I introduce a new way to initially categorize income paying investments. The way that I do this is by dividing them into two simple categories:

Category 1: Investments that have a maturity date where the original principal investment is meant to be returned.

Category 2: Investments that do not have a maturity date where the original principal investment is meant to be returned.

Category 1 investments Include:

  • Bonds
  • Convertible Debentures
  • Preferred Shares (non-perpetual)
  • GICs and money market instruments

Category 2 investments include:

  • Real Estate Investment Trusts (REITS)
  • Preferred Shares (Perpetual)
  • Resource Trusts and their successors
  • Business trusts and their successors

The reason I categorize these investments in this way is that although both groups are income producing, they are quite different in the way they trade in the market, and react to economic changes. A category 1 investment provides the opportunity to hold the investment till the maturity date-a huge difference from owning something “perpetual” where the only way out is to sell in the open market at the best price possible.

Unless an investor is very risk averse, an income producing portfolio will generally be made up of a combination of the two categories. In my book I provide examples of what proportion of category 1 and category 2 investments might make sense in different types of economic environments. A portfolio with more category 1 investments being considered more conservative since those in that category have maturity dates and such. Chapter 2: The Solution, An InSync Income Portfolio is recommended reading for anyone in retirement or anywhere near retirement.

Once a mix of category 1 and category 2 investments is determined, then it is time to look closer at which types of investments make sense at that time. In category 1, using bonds as an example, the proportion of government guaranteed versus corporate bonds would be decided. In category 2, the prospects for oil and gas investments versus real estate investments would be weighed. These are examples and there are of course many things to consider in each category.

The idea is to adjust your portfolio so that it is insync with the current and upcoming economic environment. If successful you would be more defensive when there is reason to be concerned about risk and less defensive when there is opportunity.

Investing has a lot to do with risk management. Some investors manage risk by buying only very safe investments like GICs and government guaranteed bonds, these investments have very low rates of return at this time. My book is meant to educate investors about risk management among many other things.

It is always prudent to seek out the advice of an appropriate financial professional prior to making any changes to and existing, or implementing any new financial strategy. Invest with advice for best results.

Frank Weiler

The Income Investor’s Advocate

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