Zach Davidson, an investment adviser at National Bank, answers questions about beating inflation in a retirement portfolio.
What do we know about the effects of inflation on a retirement portfolio over time?
It’s important to remember that with retirees living 20 or 30 years in retirement, it is very difficult to meet their income needs with fixed-income investments alone.
Even with low or moderate inflation, purchasing power declines significantly over time. An income that comfortably covers all expenses today won’t do so in 20 years. In a higher inflation environment, of course, the impact is much greater.
With today’s longer life expectancies, is it wise for retirees to consider including equities in their retirement portfolio?
Equities can offer protection against inflation through capital appreciation and dividend growth. With interest rates near 30-year lows, it’s difficult to grow a portfolio by investing only in fixed income. There are many companies that have a terrific track record of providing income and growth, and many that have done a very good job of returning capital to investors.
Many retirees avoid equity investment entirely, viewing it as too risky. Are there ways to manage and minimize the risk?
Definitely. There’s always risk in investing. When you’re holding only cash or GICs with guaranteed returns, you are safe from market risk, but exposed to inflation risk through loss of purchasing power. Investors also tend to see fixed income as safe and equities as risky, which is a bit of a fallacy. While your income may be guaranteed with government bonds, for example, the purchasing power of that income and your capital return, should you sell the bond before maturity, is not. We’ve had a great bull market in bonds, and fixed income investors have done very well, from both income and capital appreciation. But there is risk to holding bonds, especially in a rising interest rate environment.
To minimize all types of risk, it’s important to have a balanced portfolio that meets an individual’s objectives and long-term financial plan. Balance is really the key.
How does a balanced portfolio reduce overall risk?
There is no free lunch in investing, but there are many ways to allocate capital. Whether it’s managing your investments so that you don’t own too much of an individual company, or holding exchange-traded funds that offer diversification through sectors or securities, there are many ways to reduce the risk in a portfolio.
In an extreme example, going back to 2008, the Toronto market was down just over 40 per cent. But a balanced portfolio of fixed income, preferred shares and common shares would have been down about 15 per cent. It would also have come back more quickly.
Looking back at the past decade, investors could be forgiven for believing that the returns on equities don’t justify the market risk. Is that misguided?
When we look at history, it’s clear that markets move in cycles; what has worked for the last decade isn’t going to work going forward. It’s important to be well diversified and focused on the long term. Investors can often be thrown off-course by short-term news or market events, and it’s easy to make key timing decisions at the wrong time. That’s where having a solid, long-term investment plan will pay dividends in the long run.
You mentioned dividend growth – is that an important consideration when building an investment portfolio?
Enbridge is a good example of a company that everyone knows. In the last three years, they’ve raised their dividend by 15 per cent each year. They’ll probably do the same next year. They’ve doubled their dividend over the last five years, and grown their dividend every year since 1995.
You have to be comfortable with the company and be prepared to hold the investment for the long term, but there are many companies that have a similar track record.