"Risk-free investing. Yes, it does exist."
These words are featured prominently in a financial institution's ads we're seeing this season. And every time I see them, it sets me off. Why? Because investing is all about taking risk. Without it, we get risk-free returns (currently 1-2 per cent). François Sicart, chairman of Tocqueville Asset Management in New York, captured it best when he said, "I never invest in a situation in which I cannot lose money."
Investors should go on full alert whenever they hear the words risk-free and safe. Our industry throws them around too freely, or at least, allows them to be misinterpreted too easily.
Bill Gross of Pimco recently coined the phrase "safe spread" to describe his firm's use of corporate bonds, U.S. agency mortgages and emerging market bonds to enhance yield. Certainly Pimco has been astute at navigating the credit markets, but putting "safe" and "spread" in the same sentence is a dangerous precedent. The reason their clients receive a higher yield is because they own bonds with a greater chance of default. They're taking more risk.
In some quarters, investing in gold is presented as a safe strategy. The shiny metal is perceived to be a store of value at a time when governments are doing their darnedest to devalue their currencies. Owning gold has merit in terms of diversification, and may indeed produce positive returns, but it should be recognized for what it is - pure speculation.
Gold generates no income, so it's difficult (or should I say impossible) to value. And with 80 per cent of it locked up in vaults, the price is driven by how investors are feeling, rather than supply and demand. It's the ultimate sentiment-driven asset.
Another prevailing sentiment these days is that having all your investments in Canadian securities is safer. Canada has a stable government, sound banking system, healthy housing market, strong currency and abundance of natural resources. Why would an investor go anywhere else?
Well, there is a flip side to the all-Canada, all-the-time story. At a fundamental level, Canada is now running chronic trade deficits, despite the commodities boom, and the quality of exports is deteriorating - we're now shipping logs from British Columbia instead of wood furniture from Quebec. We have failed to penetrate the emerging markets or develop industrial leadership in anything other than energy and raw materials. And it's not clear if Canada is going to participate in the manufacturing renaissance that's beginning in the U.S.
As the Canadian economy becomes more resource dependent, so too have Canadian investors. Owning an index-like portfolio of Canadian stocks means having a large exposure to the highly cyclical industries, specifically energy (24 per cent of the S&P/TSX composite index), materials (17 per cent) and industrials (5 per cent). A bulk of our economy - health care, consumer products, technology and utilities - accounts for just 10 per cent of the index's capitalization.
So while we take comfort from Canada's strong economy and world-beating market returns, our portfolios have become more speculative, higher priced and increasingly focused on a few industries. And going forward, returns will be constrained by some of these same comfort factors, namely a less competitive currency and dearly priced real estate market.
What To Do
What can you take away from all this?
First, a prudent investment strategy involves owning a combination of risks, including Canada, Europe, Asia, emerging markets, dividends, growth, resources, large caps, small caps, bonds, real estate and cash. Canada alone does not represent a well-diversified portfolio.
Second, it is possible to have a safer Canadian portfolio by owning stocks that more closely reflect the Canadian economy and less closely the S&P/TSX's industry weightings.
Third, nobody knows when the resource boom will end, but it's important to remember that it's a cycle, not a secular trend. For all commodities, high prices lead to more supply (higher production, innovation) and less demand (delayed purchases, substitution), which ultimately translates into lower prices and sales volumes.
And finally, in pursuit of safety, you should be careful what you wish for. You may end up with risk-free returns.