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portfolio makeover

Dushan Milic/The Globe and Mail

Charlie and Katelyn have yet to finish university, but they're already making plans to be financially independent about a decade after graduation.

"Ideally, our plan involves having enough assets to generate a return that would sustain a modest lifestyle," Charlie says.

They don't intend to quit working once they achieve this goal. After all, they haven't spent the time and effort pursuing PhDs to retire early. "We just want to get out of the position where we have to work."

Both in their late 20s, they will graduate from finance programs in the next two years and expect to find good employment in Canada or the United States.

"We're in very high-demand fields so salaries for both of us would be in the range of $160,000 to $185,000," Charlie says.

The couple is already off to a good start in the pursuit of wealth independence. Charlie and Katelyn have more than $100,000 in investments and cash, and before recently switching discount brokers, they had a margin investment account worth $315,000. Using this type of account, they could borrow $2 for every $1 they had to invest.

While risky because it can amplify losses on a bad investment, Charlie is comfortable with a leverage strategy, believing he can generate greater returns over the next few years.

They plan to use a margin account again soon, this time borrowing enough to start with a portfolio of about $350,000 in ETFs, stocks and other investments.

"We also have about $800,000 in real estate [including two rental properties, a principal residence and a U.S. vacation home they own free and clear], so that's why we want to inflate our investments with margin," he says. "We're trying to counterbalance our real estate holdings with another asset class in case it doesn't do well."

Once working, they want to pay down the investment debt and the three mortgages aggressively. Yet their plan has hit a little snag.

They're having difficulty merging their diverging investment styles. Charlie embraces risk and is comfortable with leverage. He prefers investing in distressed companies and even engages in options trades. But Katelyn prefers to "buy and hold." "My investments in the past have been purchases that I would hold onto for years and years."

The couple wants advice to set them on a course to early financial independence, but they're also a bit skeptical about the kind of help they might receive.

"The advisers we've met in the past have wanted to funnel our money into high MER mutual funds," he says. "And it really left a bad taste in our mouth."

Two financial advisers have weighed in on Charlie and Katelyn's situation. Robert Broad, a financial analyst and investment counsellor for high-net-worth clients at T.E. Wealth in Toronto, and Diana Orlic, a certified financial planner and wealth strategist with Macquarie Private Wealth in Burlington, Ont., have the following insights.

The basics:


– Non-registered investments: $75,000 in equities

– Cash: $46,000

– Charlie LIRA: $44,000

– Katelyn TFSA: $20,000

– Properties: $806,000


– Mortgages: $402,708

– Student debts: $49,206

Mr. Broad's tips

1. Katelyn and Charlie are taking on unnecessary risk using margin to build wealth. "I can't see any good mathematical reason to lever up their equity portfolio as an offset to the levered real estate investments," Mr. Broad says. "Investors who went through 2008 with a levered portfolio would likely have very different feelings about risk than Charlie and Katelyn."

Instead of using a leveraged strategy, they should take advantage of their future high incomes to aggressively pay down non-tax-deductible debt – the mortgage on their home.

At the same time, they can invest in a well-diversified portfolio of low-cost ETFs that are periodically rebalanced so that no one asset class is over-weighted. This strategy involves substantially less risk than leverage and would be less likely to derail their goal of financial independence, he says.

If the market should fall 30 or 40 per cent, as it did in 2008 and 2009, then perhaps they can look at an "opportunistic trade" using leverage, but it is not a prudent long-term strategy.

2. Take advantage of their TFSAs. Charlie has been reluctant to use his TFSA because he'd be unable to open a margin account to leverage his money two to one. Yet a TFSA has a lot of value for this couple over the long term because it will provide a tax-free source of income later in life. "Claiming RSP contributions can wait until they are in the top marginal tax brackets, but it doesn't make a lot of sense to give up sheltering money in the TFSA right now especially given that they will likely remain in the top marginal tax brackets for the rest of their lives." If Charlie fully invested in a TFSA over the next 10 years, he'd have about $75,000 in assets, based on a 5.5 per cent return. In 20 years, his TFSA would be worth more than $202,000, and Katelyn's would exceed $260,000.

3. Sell one or even both rental properties to rebalance portfolio. Charlie and Katelyn may find owning these properties a headache to manage once they're working full-time in demanding jobs, raising children and possibly living south of the border.

"When they are earning more than $320,000 in annual family income, they could find it more trouble than it is worth to manage far away real estate for a few hundred dollars a month of additional income."

Furthermore, Charlie is right to be concerned about their over-exposure to real estate in the portfolio. While it's been a top-performing asset class in Canada for several years, a correction in the housing market is expected in the near future. The couple may want to sell the properties soon, realizing capital gains and reinvesting the net proceeds in more stable and liquid assets, like fixed income, to counterbalance the equity portion in their portfolio.

Ms. Orlic's tips

1. Explore a move to the United States sooner rather than later. "All of their meticulous planning in Canada might not easily transfer south of the border because the tax regimes in the two jurisdictions are so different," she says.

"It's probably a good idea to have an in-depth meeting with qualified cross-border specialists – accountants and lawyers – before making this decision." They should also discuss their investment options with an adviser with significant experience with dual citizen clients to help build a portfolio that addresses tax and portability concerns.

2. Scale back timeline. Their plan for a portfolio that can generate enough investment income to support a modest lifestyle in 10 years is likely too ambitious. They might want to consider extending their timeline to financial independence. If they push back their goal another 10 years, they won't need to use margin to try to hit a home run.

Even with increased living expenses when they begin working, they likely will have more than $75,000 a year to invest. Based on a 5-per-cent return, they would have more than $3.5-million in assets, excluding their work pensions and properties, by age 50.

At that stage, providing their investments could yield 4 per cent annually from interest, dividends and capital gains, Charlie and Katelyn could expect a gross annual income of $140,000 without touching their capital.

3. Smooth out the conflict. Katelyn and Charlie's investment styles are more compatible than they think if they employ a "core and explore" investment strategy.

Katelyn's "buy and hold" approach would be the "core" strategy for the majority of the assets held in their portfolio while Charlie's riskier style would be the smaller "explore" portion.

"This would allow him to continue to trade using riskier strategies without Katelyn worrying about their future being jeopardized should an investment lose value."

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