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portfolio strategy

Gen Y investors are confused about the stock market and it's not their fault.

Meet a woman we'll call "Jane" – 26 years old, working full-time and saving like a machine. She's thinking of buying a house in five years and looking for some suggestions on how to invest roughly $80,000 already set aside for a down payment.

"I've been told that since I'm young I should tolerate more investment risk because it will pay off in the long-term," she wrote me in an e-mail. "However, given my short time frame for wanting to buy a house, I feel like I should be conservative and protect my principal as much as possible so I can put it toward a down payment. What is the best investment strategy?"

Thanks for asking, Jane. It gives experienced investors like me a chance to address the confusion we have created for younger investors about the stock market and how to use it. A simple rule to consider: zero in stocks for short-term savings goals over the next five to seven years, and mostly stocks when investing for the long term.

A 26-year-old could justifiably have 80-, 90- or even 100-per-cent exposure to stocks for long-term investing, with the rest in bonds. But if you're a parent or grandparent passing out investment advice to millennials, don't just blurt that out. Let's let Jane explain why.

"In my very short existence on this planet, I've seen two kinds of big stock market meltdowns," she said in an interview. "I understand that if you're playing the long game, those things don't matter – you have to ride things out. I get that intellectually, but it still terrifies me."

You push gently to get someone like this to invest in stocks for the long term. You can explain that the S&P/TSX Composite Index has averaged 8.8 per cent annually over the past 30 years (including dividends), but you have to recognize that the 33-per-cent decline in 2008 and drops of roughly 13 per cent in 2001 and 2002 made a big impression. Investing for short-term goals is much simpler because stocks are off limits.

The message of caution in the short term is important because not all millennials are as wary about stocks as Jane. "I often get questions where people are asking if they should be investing in stocks for a short-term goal," said Ben Felix, an investment adviser with PWL Capital in Ottawa who works with a lot of Gen Y clients. "I often have to deter them."

The reason is it's possible to lose money in stocks over a five-year span. Real-life example: The S&P/TSX Composite was down 0.05 per cent annually for the five years to May, 2013, an outcome that would have turned $80,000 into $79,800. With an annual return of just 1 per cent, that $80,000 grows to $84,081 over five years.

Mr. Felix's suggested approach is appropriately boring for someone with Jane's personal lack of risk tolerance and her expectation of needing her money in five years to buy a house. Keep the money in high-interest savings accounts and guaranteed investment certificates.

Older investors may scoff at the low returns on savings accounts and GICs because they remember days when interest rates were considerably higher. But Mr. Felix said the millennials he talks to lack that long-term perspective and are more accepting of current rates. At least to some degree. Jane is using a big-bank savings account for some of her house down payment money and wonders whether she can do better.

Mr. Felix said he could build a five-year ladder of GICs for a client such as Jane, with a blended interest rate of 2.06 per cent. The money would be divided into five chunks and invested in equal amounts in GICs maturing in one through five years. GICs coming due could be reinvested so they have all matured in time for Jane when she's ready to buy.

High-interest savings accounts from online banks and trust companies that are members of Canada Deposit Insurance Corp. offer rates as high as 1.5 to 1.75 per cent (check the website for current rates). It's easy to set up automatic electronic transfers into these accounts from a chequing account every payday.

Jane's onside with the argument against stocks for her down-payment savings, but some aspiring home buyers are hard to dissuade about holding stocks. Mr. Felix recently spoke to some young people who rationalized the risks by saying they hoped to buy in five years, but would be willing to wait a few extra years if needed to let the stock market bounce back from losses.

Here are some flaws in this reasoning:

– Stress may cause people to miss out on a stock market rebound by selling at a low to protect against further losses.

– The stock market could crash in years four or five of your ideal five-year home-buying window; as we've seen, stock markets can be underwater even five years after a big decline.

– Rising house prices in some cities are causing young buyers to hurry up rather than slow down their house purchase.

– Life-cycle events such as marriage and having kids can dictate an earlier than expected house purchase.

Stocks can give you double-digit returns over five years if you catch a bull market rally, but the risk of losing money outweighs that. So stocks are for the long-term, millennials. Ignore them for your house down-payment savings.

Finally, a quick word about the type of account that Jane should use for her house down-payment saving strategy. Mr. Felix suggests using a registered retirement savings plan for up to $25,000 of down-payment savings. That amount is the maximum you can withdraw tax-free from an RRSP under the federal Home Buyers' Plan. Jane would also get a tax break from her RRSP contribution that could be added to her savings. Additional down-payment savings could go into Jane's tax-free savings account, Mr. Felix said. The recent increase in the annual TFSA contribution limit to $10,000 from $5,500 will help in this regard.

How the stock market can eat your house down payment

A woman we'll call Jane plans to buy a house in five years. She's saving industriously and has built a down payment that currently amounts to $80,000. Here's what could happen to this money if exposed to the volatility of the stock market.

Year One:

Her stock market investments rise 10 per cent to $88,000

Year Two:

Her investments rise 7 per cent to $94,160

Year Three:

Her investments fall 5 per cent to $89,452

Year Four:

Her investments fall 20 per cent to $71,562

Year Five:

Her investments rise 10 per cent to $78,718

What happens if Jane keeps her money in safe investments?

After five years of using a five-year ladder of GICs with a blended annualized return of 2.06 per cent, her down payment will be worth $88,587.

Note: With a five-year GIC ladder, you invest equal amounts in GICs maturing in one through five years. In keeping with the plan to use this money to buy a house in five years, the maturing one-year GIC is reinvested in a new four-year GIC after Year One, the maturing two-year GIC is reinvested in a three-year GIC and so on through the years until everything matures at the end of Year Five. The five-year result shown here assumes that today's rates are constant for the whole five years. If rates rise, a GIC laddering strategy would allow you to benefit as you reinvest maturing investments.