You’ll hear lots of advice about what to put in your RRSP. Less common – but probably more valuable – are tips about what to avoid.
Here’s tip number one: Don’t chase performance. The widespread habit of buying whatever has already been surging is a recipe for underwhelming returns.
Investing themes often run for a few years, then fall off dramatically. Recent history provides lots of examples, from the dot-com craze to the U.S. real estate boom to mining stocks.
Right now, investing for income is enjoying a feverish popularity that suggests a reversal could be in the offing.
Investors have piled into REITs, junk bonds, high-yield dividend stocks and preferred stocks. With interest rates so low, anything with a reasonable payout has attracted legions of fans.
Look at any of these high-yield areas and valuations appear pricey.
The Bloomberg Canadian REIT Index, for example, is just a hair away from a record high. Its gain over the past three-and-a-half years is approximately 75 per cent, about 10 times the advance in the S&P/TSX composite index. Demand is so strong for REITs that a record amount of financing – in excess of $8-billion – was raised by the sector in 2012.
Meanwhile, junk-bond yields have tumbled in the United States to record lows near 6 per cent. They are now below the Standard & Poor’s 500’s earnings yield (earnings as a percentage of stock prices), which is currently hovering around 6.6 per cent. This is highly unusual – even in the runup to the financial and economic crisis of 2008, the appetite for risk never got to the point where junk-bond yields fell below the earnings yield.
Stocks with generous dividends have also soared to levels that may not be sustainable. “High-yield stocks are as pricey as they’ve been since the early 1950s,” notes AllianceBernstein investment officer Joseph Paul in a recent Institutional Investor article. U.S. stocks with yields 20 per cent or more above the market now claim a decades-high share of the S&P 500 basket, he says.
One usually reliable sign that an asset class is becoming overly popular is a rush by the financial industry to launch new products. This we have in spades. As Raymond James Ltd. financial adviser Joe Timmath reports, brokers are “being inundated with market pitches for income products” from fund and investment companies. If history is any guide, it “will end in tears,” Mr. Timmath warns.
There are concerns that low yields on high-grade bonds are causing investors to abandon their asset allocation strategies and focus narrowly on high-yield securities. “As a result, individual investors may be compromising their long-term strategy and assuming more risk than they would normally take,” declares Doug Cronk, a pension-fund analyst who blogs at Institutional Investing for Individual Investors.
Many investors now have portfolios that are vulnerable to interest rate increases. Whenever rates begin to climb in response to a pick-up in the economy, high-yield stocks, REITs and other income securities could see total returns erode – if not in absolute terms, then relative to the market.
Many high-yield securities also come with elevated credit risk, particularly junk bonds. Their yields may look tempting now, but after adjusting for corporate defaults, actual payments could turn out to be a lot lower – even below what would have been obtained on safer fixed-income securities, analysts warn.
If high-yield securities are to be avoided, where should your RRSP contributions go? Floating-rate securities, with yields that move in tandem with interest rates, are one possibility. Mr. Paul has another intriguing suggestion: “Add more cyclical, deeper value stocks that have been lagging on doubts about the economic recovery and future earnings.”
These alternatives not only have reasonable valuations, but can also enhance diversification and make portfolios more resilient to fluctuations in the economy and interest rates. Just don’t expect to hear them being widely recommended this RRSP season.