Putting together an investment portfolio is sort of like going grocery shopping (we’ll just ignore the junk food part). As with nutrition, you want a balanced plan that gives you the various investment groups required for your long-term financial health. Much like all the main food groups, each component of a good portfolio plays a role in your overall investment strategy.
So what are the key components of a well-run portfolio? In a nutshell, they generally are:
- Equities (stocks)
- Fixed income
For most people, equities over the long run will provide the most capital growth. Especially with interest rates so low on bonds right now, the chances of making outsized capital gains in the fixed income area are pretty slim. Solid equities also pay dividends, which gives an income component in addition to the potential for capital gains. Depending on the stock in question, it may provide a measure of inflation protection. In other words, so long as the company has real assets and a viable business plan, its shares may rise to offset consumer price inflation.
By contrast, fixed income investments can be hit very hard if unexpectedly high inflation hits. To understand why this is, imagine you buy a long-term bond that pays 3% interest per year. The next thing you know, inflation is running at 10% (unlikely, but just roll with this). You may very well get your initial investment plus 3% per year back, but if the value of money has been depreciating quickly, what you get returned to you will not have nearly the same purchasing power as what you invested.
Fixed income products have two main roles in an investment portfolio. First, they protect your capital. As opposed to a stock which can easily go down, with a fixed income investment, you will at least be repaid your initial investment, unless the issuer defaults. This ensures that you don’t lose money. In addition, fixed income investments are attractive because they offer predictable income to those who purchase them – a trait particularly important to those in retirement.
There are a number of different fixed income products available. On the most conservative side, you can buy Canada Savings Bonds/Canada Premium Bonds. The yield is very low but your principal is considered very secure. You can also buy longer-term government bonds that are actively traded. While there isn’t a heightened risk of default, you can suffer a capital loss if interest rates rise after you’ve bought the bond.
On the riskier side, you can also buy corporate bonds. Depending on the financial situation of the company issuing them, there’s the potential for higher returns but also high risk. Notably, a company whose bonds have a high interest rate is likely to be a “junk bond” issuer. In other words, there’s at least a chance the company may default and you won’t get your money back.
Another possibility for the fixed income component of your portfolio are GICs. As with something like a Canada Savings Bond, your principal is secure. Your interest will be higher than a savings bond, and unlike savings bonds, GICs are sold year-round.
GICs are also something to consider in lieu of the final part of your portfolio: cash. Cash or its equivalent definitely has a role to play in a portfolio. It serves as an emergency fund in case you need access to funds quickly. In addition, it’s never a bad thing to have some cash on hand, in case the stock market drops significantly and you spot an investment opportunity.
One approach to consider is to put some of the cash component of your portfolio into cashable GICs. So long as you find one that yields more than a high interest savings account, it can have the benefits of cash but produce decent income at the same time.