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investor clinic

Recently, a reader sent me the following e-mail. I'm going to use it as a jumping off point for today's column, because I believe it points to some common investing pitfalls.

Hi John. I love dividends, so I really enjoy your articles. I was recently stopped out of most of my energy stocks (about 20 per cent of my equity portfolio, so maybe a good thing). Unfortunately, I was under water on Baytex Energy. I've been buying Canoe Income Fund and enjoy the 9-per-cent plus dividend. Is this a safe place to park the cash until it looks safe to get back into energy, or maybe forever? For background, my husband is retiring with a company pension and we have about $250,000 that will be converted to an RRIF. We have spoken with an adviser who is supposed to come back with recommendations.

The first comment I would make is that allocating 20 per cent of your portfolio to a sector as volatile as energy – whose fortunes are tied to unpredictable commodity prices – was asking for trouble. (Like I need to tell you that!) I am guessing that, like a lot of retail investors, you were attracted by the fat yields of Baytex and other energy producers, but we now know those yields were far from risk free (Baytex, for example, slashed its dividend by 58 per cent in December). It's true that the S&P/TSX composite index has a roughly 20-per-cent weighting in energy, but that's a reflection of Canada's resource-heavy economy and shouldn't serve as a model for your own portfolio.

Second, you mentioned that you were "stopped out" of most of your energy stocks. Let me ask you a question: If you were such a big fan of energy stocks, why did you place stop-loss orders instructing your broker to sell them after they had dropped in price? Wouldn't it have made more sense, if you really believed in the long-term prospects of these companies, to buy more at the lower price? The fact that you were ready to bail when things turned sour indicates that you never saw these stocks as long-term investments anyway. And if that was the case, why were they in your portfolio at all, let alone at such a high concentration? It's worth remembering Warren Buffett's quote: "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes." (For more on why I don't use stop-loss orders, read my column online.)

Third, you said you are "enjoying" the yield – currently about 9.8 per cent – of the Canoe EIT Income Fund (EIT.UN). But have you ever wondered how the fund can pay such a high distribution? You'll find the answer on the fund's website under "Tax." In 2014, 32.9 per cent of the distribution consisted of return of capital (ROC). In 2013, ROC accounted for 48.4 per cent and in 2012 it was a whopping 65.8 per cent.

ROC arises when a fund pays a fixed distribution that is higher than the dividends, interest and realized capital gains that the fund generates. To make up the difference, the fund must dip into its own capital. This, in turn, exerts a drag on the fund's net asset value. You can see this effect in EIT.UN's unit price: Five years ago the fund traded at $12.60; Friday it closed at $12.31. So, in exchange for getting a large distribution, investors have given up any capital growth over the past five years (assuming they took the distribution in cash instead of reinvesting it in the fund). This is not necessarily a bad thing – funds that distribute ROC can be suitable for people who need steady income – but investors need to understand that there is no free lunch.

Is EIT.UN a safe place to park cash until it looks safe to get back into energy? The problem with trying to time the market in this way is that, once it looks safe to get back into energy stocks, I can guarantee you they will already have risen in price, perhaps dramatically (they're already well above their December lows). Then you may wonder why you sold them in the first place! As for the riskiness of EIT.UN, the fund profile indicates that it invests primarily in Canadian and U.S. stocks, so you are taking on equity risk as you would with any other fund that's exposed to the stock market.

Finally, you mentioned that an adviser is going to recommend where to put your $250,000 in retirement savings. That's fine, but I would urge you not to blindly accept whatever the adviser tells you. Otherwise, you could end up with a portfolio full of high-fee investment products that enrich your adviser at your expense. It's your money, and you should be deciding how to invest it to maximize your return. You and your husband might wish to explore low-cost mutual funds or exchange-traded funds, for example. Google "low-cost Canadian funds" and set aside a few hours for reading.

Whatever you decide, remember that there are no shortcuts with investing. As tempting as it is to trade in and out of sectors or reach for the investment with the highest yield, these are really just manifestations of short-term thinking. The best way to create wealth is to build a low-cost, diversified portfolio, and then get out of the way so time and compounding can do their work. As the legendary value investor Benjamin Graham's once said: "The investor's chief problem – and even his worst enemy – is likely to be himself."

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