Investing: ‘What ifs’ and ‘maybes’ lose out to long-term planning

Back in August 2011, I posted Don’t Panic.

I took a look at investor psychology in the face of negative sentiment on the markets. In It was the best of times (for dividend investors), I outlined how well dividend-payers did over the last few years. The markets have done very well for the dividend-centric.

So what’s an investor to do, now?

Interesting U.S. market stats

Bob Pisani, of CNBC, points out some interesting information regrading U.S. markets:

Most notable among the trends was a near-record pace of fund flows last week into equity funds.

Stock mutuals saw $19 billion come in, the highest since 2008 and the fourth-biggest in the 12-year history of tracking the data, according to Bank of America Merrill Lynch.

The latest American Association of Individual Investors survey registered a 46.4 percent bullish reading during the same period, well above historical averages, while those expecting the market to be lower in six months fell to 26.9 percent.

Finally, the CBOE Volatility Index, or VIX, a popular measure of market fear, is at a subdued sub-14. A declining VIX usually means rising stock prices.

(Read More: Why VIX’s Recent Plunge May Be Bad for Stocks)

About the only areas showing caution were safe-haven money market funds, which saw assets grow to $2.72 trillion on an influx from institutions, and commodities, which had outflows of $570 million.

The most popular reason among traders for all the optimism is basic relief that the U.S. made it through the “fiscal cliff” scare relatively unscathed.

If that’s the case, the looming debt-ceiling battle and a likely lackluster earnings period could offer perilous counterweights.

So, what’s an investor to do?

The reality is, if you know who you are as an investor, and more importantly, where you want to be, none of this should rattle you. But it should make you think. Trading the media is something some do, and some do it very successfully, but most don’t. And that’s why investors must plan.

When planning for a year, plant corn. When planning for a decade, plant trees. When planning for life, train and educate people.

— Chinese proverb

Warren Buffett plans. Why not you? After all, planning is a form of self-reflection and self-education.

The metric of the past and planning for the future

It may be wise for investors to reassess their investing plans, to decide if their plan is capable of meeting their goals and then have the courage to sail on the course they’ve charted. If past is prologue, then the last couple of years have rewarded the longer-term planners for wading through the ‘what ifs’ and ‘maybes’ and sticking to the fundamentals.

The market hasn’t had a 10 per cent correction in a while in the U.S. While we all watch, we have to wonder at the market’s resilience while remembering why we hold assets that act as ‘insurance’ against revaluations. Any correction should be incorporated into your plan and taken advantage of. But a 2 or 3 per cent drop from an all-time high is hardly a correction. Having some cash on hand when markets have hit recent highs is rarely a bad idea.

The market hasn’t seen a traditional correction in almost three years. Majority sentiment would have seemed against this phenomenon three years ago. We will have a correction at some point. No one can be sure of the degree of the next correction. But does this alter your planning?

Planning empowers you in the face of ‘peril’

It’s best if you incorporate the possibility of a correction into your plan. Because, at some point, the stock markets will correct.

In a world gone into overdrive, where the short-term seems like the long-term to some, authentic long-term planning may be the most valuable commodity.

The markets are like anything else with respect to planning. And the markets are one of the best barometers of human psychology. ‘Perilous counterweights’ need to be part of your planning.

We’ve all heard that in the long-term risk gets reduced by time-in-the-market. In the meantime, knowing your tolerance for risk is crucial. What we can learn from the period from August 2011 to now is that risk happens in so-called ‘safe’ investments, too.

The broad markets have outperformed cash. At some point, markets will correct. Maybe that process has started. Markets correct. This is part of what makes a bull market healthy. And corrections are the reason why we should use proper asset allocation in our portfolios.

One thing is sure. It was better to be in-the-market than it was to be in cash in the time period we looked at above.

No one owns the patent on the future. No one ever knows the exact nature of the next correction. It’ll be interesting to see what the next six months holds …

A plan we can live with is part of what keeps people happy as investors over the long-term. So that we can sleep and dream of sheep.

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Part Two — Get the balance right

Can we simplify asset allocation?

Yes, we can.

Watch out for rebalancing fever

It’s possible to get rebalancing fever. Be careful. Like all manias, there are dangers. If you start rebalancing your portfolio every time there’s a slight move, you may find you have no more time for anything else – not to mention creating potential tax liabilities.

In “Let’s think about assets” I also discussed rebalancing. A five per cent portfolio drift is a good measure of when you need to act. The time frame for a five per cent change in your stock or bond allocation depends on markets and economic conditions, investor sentiment and the ever-changing universe of moving parts and multiple players in a global economy. It’s a fluid investing universe.

Automatic for the people

The key with asset allocation is to make it automatic. The sun will rise. The sun will set. Investors rebalance their portfolios.

Eliminating emotion from your rebalancing philosophy makes it more effective. When you rid yourself of the “noise”, you can gain focus, discipline and the ability to implement.

Check your portfolio at least once a year. If you do, you should be able to catch when your portfolio needs rebalancing. When your allocation has strayed enough, rebalance. During times of great volatility, like this past August, have a peek to see if your allocation has moved enough.

Do your emotions get the best of you? Stick to looking at the percentages of your different allocations rather than the dollar values of investments. Market corrections and severe volatility have a way of making investors, especially novice investors, weak in the knees.

Discipline

There is one overarching rule to rebalancing:

•             Stick with your plan

Once you have decided on a plan of action, abandoning your strategy makes it useless. So why do so many investors flee their plans when the going gets tough? Because they’re allowing emotion to eat into their strategy. Often, the cause is assessing yourself as a more aggressive investor than you really are.

Everyone is superhuman when there’s no kryptonite around.

What’s an investor to do?

Use market corrections to re-evaluate your risk tolerance. Corrections are opportunities. Not only do they show who you really are as an investor, but they reveal inevitable bargains.

Remember, assessing yourself openly and honestly as an investor is very important. After all, this is a conversation with yourself (and your advisor, if you use one).

In the end, every investor has to take a certain amount of responsibility for their investment decisions. We should expect good counsel, transparency and best practices, but we are the best evaluators of ourselves – especially during market volatility. The financial crisis and the resulting market drop clearly demonstrated that many investors couldn’t take the heat. That’s okay.

Know thyself. Then move forward from there.

When it all comes down to it, remember, if you’ve been sitting in GICs for the last few years, you have missed out. (See “Bonds: Why you should love the unloved investment”)

Invest in You Inc.

The thing some investors miss when they rebalance their portfolios is that rebalancing really is taking stock of you. When the media becomes shrill and volatility is very high, this is a strong signal to look in the investment mirror and ask:

•             Who am I?

•             What’s going on?

•             Where are the opportunities?

All we are is all we are

No one ever knows exactly what the markets are going to do. Rarely are great opportunities uncovered by knee-jerk reactions to our most basic fears. We are who we are. But we can all step back from ourselves, think, and reflect:

Fear is a great motivator, but so is stepping outside of fear and looking out at opportunity. Opportunity is like a good neighbour. Often, the potential for good fortune knocks at the door in an unusual form. It’s up to us to recognize it.

Meanwhile, there may be shrill voices on the street and much gnashing of teeth.

Part One is here.

Find out more: Asset Allocation can be easy as A, B, C

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Get the balance right

Can we simplify asset allocation?

Yes, we can.

While there may be more to asset allocation than just stocks and bonds, stocks and bonds are the best starting points for most investors. Anyone can become an investor through mutual funds or ETFs.

What have most investors heard about stocks?

• Stocks usually outperform bonds over long periods of time

Ok, now, in this hypothetical, let’s imagine that stocks take longer than average for that outperformance to take place. What can we do to bolster our portfolios?

If we find ourselves in a period where equities take longer to outperform than average, we can arrive at two conclusions:

• Fixed income positions (bonds) are even more important

• Rebalancing is even more important

Why?

Because, although a 100 per cent portfolio of stocks should statistically outperform over the long-term, most investors are more human than they are instruments of logic. People are emotional.  Since they’re emotional, what is theoretically true about investing may not hold true in real life.

Volatility takes its toll. Big market drops herald big investor reactions. When bad news reaches a fever pitch about stock markets, many investors start to feel ill. Investors start abandoning strategy and discipline.

After all, there’s Europe, a potential recession, inflated house prices in Canada, and a blue sky that’s sure to fall. (Never mind that equities haven’t been this cheap in quite a while.)

The only things that have really changed are the names of the crises. Not to belittle the difficulties we face economically – these are challenging times – but we’ve always faced difficulties economically. With market corrections, and, with prudent planning, difficulties become opportunities.

Seeing the opportunity in today’s markets may be better than running around screaming the sky is falling.

If your portfolio has a good allocation to fixed income products – if you have a mix you’re comfortable with – and you have a disciplined rebalancing strategy, you should benefit. There are times when stocks and bonds move up or down at the same time, but usually, stocks and bonds move in opposite directions.

If your allocation is 65 per cent equity (stocks) and 35 per cent fixed income (bonds), then when your allocation drifts, let’s say to 70 per cent equity and 30 per cent fixed income, it’s time to rebalance.

What do you need to do? Sell some stocks and buy some bonds. Sell the asset class that has outperformed, and buy the asset class that has underperformed.

Sell high. Buy low.

Everyone knows that, right? But it takes great discipline to do. You have to automate the process.

Some investors worry that they’ll impede portfolio performance by selling stocks when they seem to be doing nothing but going up. True. This happens. Your allocation may change early in a bull market. But many investors struggle seeing future benefit in the face of the madness of crowds. The “noise” affects their focus and their resolve. It can make investors buy at the wrong time or sell at the wrong time. In down markets, too many investors only see current losses or declines.

What might be the best rebalancing schedule theoretically, may not work for the average investor struggling to cope with “noise” during a market correction, especially, if it’s a severe correction like 2008-2009.

While the financial crisis may have caused some grey hair, it was one of the best times in recent memory to test out your portfolio. Recent weeks also put some pressure on investor nerves while squeezing portfolio integrity.

It’s times like 2008 – 2009 that make people happy to own bonds. Bonds performed very well as stocks declined.  Stocks usually outperform bonds over the long-term, but bonds add some insurance to your portfolio.

As the market began the steepest part of its recent decline, we can see that bonds once again outperformed as investors positioned themselves for safety. The steady income from bonds and the hedge they provide against market drops often make them fund manager favourites.

Why should the average investor be any different?

Bonds providing a hedge during recent market correction

Part Two is here.

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Don’t panic

In the face of the typhoon (market correction), bend like bamboo

What is it about market corrections? Wise, rational people can become wide-eyed pessimists and conduits of fear in the face of steep market drops. Can you remember a time when you sold investments during a market correction and it turned out to be a wise move?

Investors ruled by a forest fire of emotions, fanned by the media looking to report the latest, most sensational story, rarely make wise decisions. Often, when the market is hitting new record after new record, they’re buying. But when the market turns the other way, and suddenly high quality companies are on sale and can be bought at excellent discounts, emotion-ridden investors are running for the hills or putting their heads in the sand.

Here are some facts that you’d do well to pay attention to. The study tells the sad tale of how investors, suffering from a bad dose of “Oh, no! The world’s going to end!”, make some classic mistakes while investing. In fact, what may be the most important aspect of your investment plan, after asset allocation, is dealing with the forces of rampant negativity that rear their ugly heads every time there’s a market correction.

Glued to the media, wide-eyed and beset with your worst fears for the economic future? It’s time to go for a walk. Fund managers wait for corrections to go out bargain hunting. Wouldn’t you be happy if the suit or new pair of shoes you wanted to buy were now on sale? Because that’s exactly what’s going on now: high quality, dividend-paying companies are on sale.

Investors need to do themselves a favour:

• Develop a thicker skin
• Stop dwelling on the investment media during corrections
• Stop chasing investment returns
• Ask yourself: since everybody’s talking about gold bullion (or whatever the flavour of the month is) right now, do I really want to buy it?
• Get a sound investment plan
• Stick to your plan
• Buy or sell investments when your asset allocation veers away from your planned allocation, and do it regularly
• Remind yourself that great, stable companies are not going to disappear

Further considerations that you should bear in mind:

• Remind yourself that Warren Buffett (and other smart money managers) are looking for bargains rather than making rash, panic-fuelled decisions
• Aren’t all the companies you wanted to buy when they were more expensive, cheaper now?
• The economy’s gone through corrections dozens of times before – this won’t be the last time (e.g., Latin American bonds, the Asian Crisis, the Tech bubble, 9/11, [Remember when people were talking about the Canadian peso?], the financial crisis, etc.)
• If you’re buying in the midst of this correction, or any, remember, you don’t need to throw all your money in at one time – you can also buy gradually, giving you a cushion and better prices should the market go down further
• There’s a place in your portfolio for bonds – do you have any?
• Revisit your plan yearly

If you’re still spooked after a hard, meditative look at your investments, maybe your asset allocation is too aggressive. Should you reduce your equity holdings somewhat? Reducing stock holdings amidst any correction is tricky. You’re probably going to be selling at the worst of possible times – maybe you should revisit your asset allocation model when things calm down a bit? (Have I mentioned stick with your plan and re-evaluate your plan regularly?)

The time for strategic thinking is before a correction and during one. When it seems that investment losses are falling out of the sky, too many investors forget their planning. Many have heard Warren Buffett’s “Be greedy when others are fearful” philosophy – slowing down and taking a breath during the bad news feeding frenzy will help give you some perspective on where you’ve been, where you’re at now and where you want to be.

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Part Two — Bonds: Why you should love the unloved investment

Count bonds. Forget about sheep.

5-year chart comparing Canadian government bonds and the S&P/TSX 60

In the two years before the financial crisis, government bonds underperformed. Stock markets were hitting all-time highs and few investors were interested in bonds. However, as the risk premium for stocks was rising and stock indices in Canada and the U.S. were hitting highs, shrewd investors were reallocating their portfolios to include more bonds.

Bonds were unloved, but they were cheap, and when stock markets came down in a hurry, bonds acted like the buffers they are: they rose while stocks were coming down in portfolios.

The case for bonds in a portfolio as a permanent asset seems pretty solid. Let’s take a look at the last six months.

6-month chart comparing Canadian government bonds and the S&P TSX 60

Over the last six months, stocks have finally gone into a correction. Stocks have been incredibly buoyant since the bottom of the 2009 crisis and have performed very well. But corrections are a normal part of the investing landscape. Corrections are healthy since they clean out the speculative element in the market periodically. Investors, on the other hand, especially average investors, aren’t huge fans of volatility.

Looking at the chart over the last six months, we can see that government bonds turned up as the markets headed down. Bonds are doing what they do, once again: smoothing out returns by acting like insurance in your portfolio.

Equities hit home runs, but bonds keep you from crashing into the catcher’s mitt and getting called out at the plate.

Equities should outperform bonds in the next few years because bonds have made out well recently, but good diversification together with prudent asset allocation suggest the average investor should have some bonds in the asset mix. Recent news has shown us how commodities and stock markets can change direction in a hurry.

The debt situations in Europe and the U.S. illustrate the importance of having Canadian bonds in a diversified portfolio. Canadian bonds are in a good place when it comes to quality these days.  Just when many were saying Canadian bond returns had peaked and there was no future investing in them, boom, sovereign debt issues exploded in the media – again. Both recent history and the last few days are excellent reminders of why bonds have a place in the average investor’s portfolio.

Canadian government bonds may not work in a get-rich-quick scheme, yet when it comes to your portfolio, it pays to think. Think of bonds as insurance. Think of bonds before you go to sleep. In times of volatility, count bonds and forget about the sheep.

Part One is here.

Update: Foreign investors are also loving the unloved investment in Canada.

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Bad news, gold and dividends: When it’s pouring through the roof – what’s pouring into your portfolio?

In “Gold Riot”, I wrote about gold , discussing how it might be overvalued. My post was a little early.

We recently saw a couple of interesting days in the gold market while silver corrected heavily. It’s rarely a good time to take a position in a commodity after an enormous run up. After all, when investments get sold off, there are some powerful players out there, and they can cause some big price movements. For example, Goldman Sachs.

Some investors are now taking positions at better prices, still, the behaviour of gold and other metals has melted some hearts. Newbie investors heavy on silver must have had some palpitations during the spectacular volatility.

With everyone talking about gold, and with it seemingly pouring bad economic news at the moment, how do dividend stocks fit into the picture?

My focus is more on average investors than speculators, and the average investor generally has less of a stomach for volatility. Many investors aren’t even aware there’s quite a difference between gold stocks and gold bullion and how they both perform. There’s a lot more volatility in gold stocks, and gold stocks’ performance is based on the outlook of the underlying companies. (For more on this, see the above link “Gold Riot”.)

While silver was making the headlines for all the wrong reasons, dividend-paying stocks have outperformed. “Get paid to wait” is the mantra of investors in dividend-payers. During difficult periods of volatility, those dividends are smoothing out some of the volatility in price movements. When comparing the iShares Dow Jones Canadian Select Dividend Index to gold as a commodity, gold still did pretty well if you bought early, however, many bought very late — rarely a good thing. It would have been better to wait for a correction.

iShares Dow Jones Canadian Select Dividend Index Fund, S&P TSX Global Gold Index and XIU (nearly a proxy for the S&P TSX 60)

Many investors don’t have the time or don’t want to spend the time glued to the markets. While nothing is ever guaranteed with any investment, dividend-paying stocks will give you a little more comfort. The highs may not be as high, but the lows are also not quite as low.

When news is uniformly bad, remember that stream of dividend payments pouring into your portfolio. The managements’ of dividend-paying companies believe enough in their businesses to share some of the wealth with you.

So how did these asset classes make out? Dividend-paying stocks returned more than 10 per cent while gold stocks were down 15 per cent over the last year. Gold stocks have disconnected from bullion for now as regards performance. It happens.

Bullion had a good return at about 18 per cent but with a lot more volatility than dividend-payers. Gold stocks are potentially even more volatile. My target audience is more the average investor, so I won’t over complicate this — gold bullion has had a lot of its recent increase because of bad economic news — this is a bit of a simplification. More is involved in the price of gold, but does the average investor need complication? What is important is that if the news outlook changes, so might the performance of gold.

Remember, if you own a broad-based Canadian equity fund, it probably has somewhere between 15 – 20 per cent of its holdings in gold or other mining stocks. How much gold do you want?

Better yet, how much gold does a proper weighting allow for? If you’re not a speculator, keep your gold holdings manageable at 5 – 10 per cent of your total portfolio. A good fund manager has a lot of intelligence when making decisions on gold stocks. Do you? If you’ve decided to hold a significant weighting in gold stocks or bullion, you have become a speculator. Do you have time to watch your holdings with the eye of a fund manager or a speculator? Probably not.

An investor holds shares in a business and shares in business ownership. The average investor would do better thinking like a business owner rather than a speculator.

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Goliath gets a dose of realism: Does the average investor understand how Nasdaq’s re-evaluation of Apple’s weighting could affect markets?

Nasdaq had to reshuffle. It hadn’t touched weightings since 1998. Nasdaq decided it’s not in investors’ interests to have one holding representing over 20 per cent of the index. And it’s right, such an over-weighting doesn’t represent an investors’  best interests.

It’s been said before, and it’ll be said again, one company’s over-weighting in an index counters the principles of proper asset diversification. Think Nortel and what happened when it was hugely dominant in the Canadian stock market. When Nortel got crushed in the tech bubble so did Canadian investors — many  watched their portfolios bomb.

Investors have definitely benefited from Apple’s meteoric rise over the last few years, however, at some point, rational thinking has to prevail. Do you really want the extra risk associated with an enormous weighting?

How many investors buying the Nasdaq know how overweight Apple is? In slashing Apple’s weighting about 8 per cent down from 20 per cent, Nasdaq’s doing the responsible thing.

Apple has been getting an enormously disproportionate share of the market due to its dominance of the Nasdaq. Apple’s been profitable but so have other companies.  In comparison, Microsoft, posting profitable quarter after profitable quarter, hasn’t been getting its due. And it pays a dividend!

Perception often rules over reality in the markets. But reality often comes back with a smack.

In the short-term, there will definitely be re-weightings of Nasdaq stocks in portfolios the world over. These re-weightings should benefit Microsoft, Cisco, Oracle and Intel. Apple stock should experience some interim pressure as managers adjust their portfolios over the next month.

What the future holds is as yet unwritten, yet Nasdaq’s re-weighting of the benchmark will be a wise long-term move for the index.

While the Nasdaq is nowhere near the valuations of the tech bubble, Apple has done almost nothing but go up since the financial crisis. However, during the volatility of the crisis, it got hammered.

Portfolio managers are measured against the indices that are their benchmarks. A benchmark should never be overweight one stock. It forces managers who want to compete with the index to buy more of the very stock they should be cautious about.

Here’s a graph and story of what happened to the Nasdaq after the tech bubble, when mania overcame rational, strategic thinking.

Smiling through your dividends

Seeds that grow

(Please see update on U.S. dividend stocks at end of article.)

I recently blogged about why dividend-paying stocks deserve their place in your portfolio. If you enjoy high speculation, these may not be the stocks for you. You may get more of a kick out of the potential plunges that could affect your portfolio, however, since the financial crisis, the stomach for significant ups and downs doesn’t appear to be as high for the average investor.

If you’re looking to have a portfolio with:

• More protection against corrections

• Solid earnings that are shared with investors

and

• A history of outperformance during difficult economic periods

then dividend-payers are for you.

But let’s see if we can walk the talk regarding these investments. A quick look at the performance of dividend-payers over the last six months:

• The Dow Jones Canada Select Dividend Index is up over 15 per cent

• Over the same period of time, the DEX Universe Bond Index is down about 1 per cent

While there’s definitely a place for bonds in your portfolio, it’s hard to argue against the numbers above.

Dividend-payers have been kicking butt.

Interested in what dividend-payers can do for you portfolio?

Looking for a historical understanding of dividends in tough times?

Then go through the rabbit hole.

Follow up:

How about U.S. dividend-payers?

RESPs for the educated mind

The kids are all right

Strategy. Strategy. Strategy.

You have watched your child grow and develop. You can’t believe it, but your little bundle of joy has grown up, has her own opinions and philosophies and is now ready to embark on one of her greatest adventures. Higher education. Goodbye high school. Hello post-secondary education.

Remember your own first year in university or college? Everything looked so big … How could you possibly get from one end of the campus to the other in five minutes? The excitement … The feeling of learning and collaborating … And now, it’s your own child ready to swing the door open to a whole world of possibilities. Immensely proud, you have some small, nagging worries about your child getting a great education and a smooth path into the future.

You have planned for this, though. Long ago, you established a Registered Education Savings Plan (RESP). And now, that long-term thinking is about to pay off. You might think your financial planning and strategy for you child’s education is done …

Think again.

Did you know that the way money is withdrawn from an RESP is enormously important? Strategizing doesn’t end now – it evolves.

Just like that little baby that grew into a teenager ready to take on the world.

• Limit withdrawals – Remember the government … The government limits the withdrawal of RESP income and Canada Education Savings Grant funds including the CES Grant. Government restrictions on a maximum of $5,000 in the first 13 weeks of your child’s program, might leave you searching for extra funds, tempting you to grab some extra cash from the RESP to add to the $5,000. Avoid this redemption, if possible. Think long-term. Investing is often about deferring tax. Redeeming early undermines a registered plan’s tax-deferred growth potential just as leaving college or university early may limit your child’s future possibilities. Even worse, if the program doesn’t qualify, you’ll have to repay a portion or the entire CES grant!

Wait a minute … Didn’t you start this plan to give your child an advantage?

Yes. And knowledge will help you graduate RESP complexities with honours.

• Get permission for an early withdrawal – And get it in writing. You can exceed the $5,000 limit on the withdrawal of RESP earnings by requesting permission in writing from the Minister of Human Resources. Avoid withdrawing plan capital (and a repayment of CESG funds), but make your request early. By making the request as soon as you can, you’ll get a timely response and be able to determine if this plan works for you before school begins.

The government could request a payback …

• Strategic withdrawals avoid paybacks – The government may ask you to pay them back the CESG grant money if they see earnings remaining in the plan after your child graduates or leaves school. Avoid the potential CESG payback, be sure to use the plan’s earnings before withdrawing contributions.

Part Two is here.

Gold riot

Warren Buffett’s thoughts on gold or how looking at the return on gold might reduce the glitter

The riot over gold has calmed down a little, however, there is still significant interest in the metal. An interesting perspective on gold comes by way of value investor par excellence, Warren Buffet.

Will all the gold that glitters glitter less?

There is no denying gold has had a great run. What people forget when gold performs spectacularly is that it has often caused investors an enormous amount of pain as well. Gold is volatile. It soars, but it has also come down very hard throughout its history – part of the reason that most recommendations limit gold to about 5 per cent of a portfolio (in order to smooth out volatility).

Gold has performed very well this year and over the last few. The S&P/TSX Global Gold Index has doubled the S&P/TSX 60 this year. But gold’s performance comes with a lot more volatility. The fact that gold is such a big sector within the Canadian stock market has been advantageous this year. Gold often kept the Canadian market buoyant when other stocks turned downward. It acted as kind of a built in hedge. However, should gold turn south in a significant way, it will also hold the Canadian market back because of its large weighting. In fact, by just holding an index fund or ETF tracking the S&P/TSX 60, you have about 20 per cent exposure to the materials sector, and, a large portion of that is in gold. The broad Canadian market has a lot of gold exposure already.

Unfortunately, gold is on everyone’s tongue lately.

But what does Buffett say about gold?

Gold just sits there

Buffet has become wealthy by being a value investor. He believes in goods and services and buying the undervalued companies that deal in them.

If you don’t listen to Warren Buffett at some level, you’re odd. Whether pundits agree with him or not, his opinion is focused on and respected. Buffett says there is no place for gold in his portfolio – intriguing, because, unlike Canadian investors who have seen appreciation in their currency, Americans have been dealing with a declining dollar, resulting in the rush to gold as a hedge against devaluation. Throw in the troubles in the world economy, the devaluation of the Euro, etcetera, etcetera, and the rush to gold isn’t exactly surprising.

Buffett’s logic on the metal is definitely interesting. He thinks gold is useless.

That’s right. Useless.

Buffet on gold:

“(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Ah, the Ziggy Stardust gold analysis …

In Fortune, Buffett recently said:

“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States,” Buffett said. “Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

A very, very interesting illustration …

Buffett has stayed consistent with his messaging on gold.

• Expensive to store
• Has no practical use
• Doesn’t generate income

Of course, some of the large players that mine gold do generate income, but Buffet’s talking more about buying the metal itself.

The S&P/TSX Gold Index has done very well in the last ten years. It has returned about four times the S&P/TSX 60. However, during the dog days of the financial crisis, it collapsed along with everything else, and that collapse wiped out all gains since about 2002. Gold has recovered spectacularly since then though not without some equally spectacular volatility. Without a doubt, placing a big bet on gold increases risk immensely. If you’re looking to steer away from volatility, putting more than 5% of your portfolio into gold could leave you with a nasty surprise.

Gold stocks, because of their leveraged positions with respect to gold perform even better than the metal, generally, yet that outperformance goes the other way in a hurry at times. So, gold stocks can be a great hedge, but they also have some explosive volatility built into them – volatility which can go either way faster than most people can monitor.

The big question is which way will gold go in the near future? And, how much has the risk premium for holding gold increased?

For Canadian investors, this question doesn’t hinge on a declining currency. Our market has a huge piece of gold already. If you own the broad market, you’re already exposed to gold. That can be a good thing or a bad thing. In the last ten years, it’s been a great thing, but all good things come to an end. Are we closer to the end of gold’s aggressive increases or is there still room to shine?

For the average Canadian investor, if you just own the broad market you have exposure to gold and its advantages. At the same time, should gold have a significant correction, you’ll feel it.

Buffett’s comments on holding gold bullion (even though it’s easier to do with ETFs now) bear some thought. Expensive to store. No practical use. No income.

Looking for value makes one a big fan of dividend-paying investments. Canadians already have exposure to gold. Would you take a flyer on gold at these prices? Such an idea may have lost its sheen.

If you are a trader, that’s one thing, but if you are an investor, polishing gold may leave less of a glimmer lately.

Now, if there were a significant correction in gold, that would change things, but right now gold looks like its bumping its head on a ceiling. Whether that will be temporary or longer lasting depends on many different interconnected moving parts within the economy.

The questions it’s prudent to ask yourself with every investment are:

• Am I likely to get the same return on my investment next year?
• Will I get even half of that return?
• Am I using sensible portfolio approaches regarding the construction of my investment portfolio?

A portfolio of gold stocks I was looking at recently has returned over 70 per cent year-over-year. The broad market has returned less than a third of that. Over 50 per cent of that return has come in the last six months. Recently, this portfolio has pulled back 6 per cent – and it is a broad portfolio that has increased over 800 per cent over the last ten years.

Is it cheap? Does a correction of 6 per cent add much value? …

Not exactly a huge pullback.

Every Canadian investor who holds the broad market holds gold. Loading up on gold may not be the best of all portfolio moves. At this point in time, Canadian investors find themselves in a different situation compared to their American counterparts.

The gold rush may not be over but there certainly are a lot of people panning in the stream.

 

For an update on gold stocks, gold bullion and dividend-paying stocks click here.

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