I first read about The Investment Answer by Daniel Goldie, an investment advisor and Gordon Murray, a Wall Street veteran in a New York Times article (see A Dying Banker’s Last Instructions, NY Times, November 26, 2010). The book was billed a sort of investment Last Lecture for Mr. Murray, who was dying from brain tumour. Sadly, just as the book was reprinted for wider release, Mr. Murray passed away.

I ordered the book from Amazon without any expectation of learning something I didn’t know already. After all, when it comes to passive investing, the authors will be preaching to the choir here. But I did want to find out if I can recommend this book to other investors.

The first thing you notice about this book is how thin it is — just 88 pages of generously spaced text. But it is packed with solid advice. The authors recommend that investors make just five decisions:

- Should you DIY or invest with an advisor?
- How should you divide your portfolio between stocks & bonds, small cap & value?
- How should you diversify within portfolio components?
- Active or Passive?
- Rebalancing: how and why?

I was a bit surprised (perhaps it shouldn’t be considering that both authors are associated with Dimensional Fund Advisors) that the authors do not believe a DIY approach is prudent when it comes to investing. They recommend that investors hire independent, fee-only advisors who will act as fiduciaries to their clients.

The book is available on Amazon.ca for $15. Investors of all stripes will find the book interesting and even enriching if they take intelligent action on the five decisions they are faced with. However, I do wish the authors had included a section on further reading for readers interested in an in-depth study of the subject.

Related Reading:

• Book Review: New Rules of Retirement
• Book Review: The Smartest Investment Book You’ll Ever Read
• Book Review: Understanding Wall Street
• Book Review: The Clever Canuck: Investing Made Easy
• Reader Question: Which Stocks Should I Buy?

Book Review: The Investment Answer is brought to you by Canadian Capitalist — Helping you to invest & prosper.

2. Get your legal issues in order
Too many small landlords consider themselves passive investors rather than business owners, says Harry Fine, president of Landlord Solutions paralegal service in Toronto. “You need to understand the law, and it can be very complex,” Fine says. Prospective landlords must take the time to understand all their legal obligations, ensure the property is legal to rent and prepare a solid lease. A good place to start is by joining an association such as the Landlord’s Self-Help Centre in Ontario.

3. Find the right tenants
First the good news. Advertising for tenants is getting cheaper. Southen says he’s stopped paying for newspaper ads and now uses Kijiji.com exclusively. But three checks are still crucial for every potential tenant: a credit report, employment verification and a call to previous landlords. Ideally, you should avoid calling current landlords, as they might stretch the truth to rid themselves of a difficult renter. “Anyone who is not making all three checks is out of their mind,” says Southen.

4. Keep your tenants happy
Southen budgets $800 a year in routine maintenance for every unit he owns. And when something breaks, he sends someone to repair it ASAP. “You need to be responsive, because if a good tenant moves out, it costs you a lot of time and money to replace them.” Cutting down on tenant turnover is his secret weapon for a successful career as a landlord. Whenever a unit becomes vacant, he always re-paints and often re-carpets. “If you keep the place maintained, you will get a better quality of tenant.”

5. Take prompt action on bad tenants
For small landlords with one or two units, a single bad tenant can be devastating. Fine says a quick and aggressive response is necessary to limit the damage if a tenant stops paying rent or damages the property. “You can’t wait three months and hope the problem goes away,” he says. While tenancy law varies across Canada, some savvy tenants know how to game the system for extended rent-free stays. This can mean substantial extra expenses for landlords, as well as lost income.

This post is the fifth in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

One of the most appealing aspects of dividend investing is the tax advantage: dividends from Canadian companies are eligible for a significant tax credit. This credit does not apply to US or international stocks, however — indeed, foreign dividends are taxed as regular income and are subject to a 15% withholding tax. That’s why many dividend-focused investors hold only Canadian stocks in their portfolios.

Income from Canadian dividends is an important part of most retirement plans. But if you’re staking your whole future on a small number of domestic stocks, you should be aware that your investment strategy may be a lot riskier than you think.

Understanding risk

First, a little financial theory. All equity investors face systematic risk, which is simply the risk associated with the market as a whole. Systematic risk cannot be diversified away: even people who own index funds with thousands of stocks are not immune to a market crash.

A second type of risk is called is unsystematic risk: it applies only to investors who hold individual stocks. For example, a company’s share price will fall if it declares lower-than-expected earnings, but such an announcement will have virtually no effect on the broad market.

The important point is that investors are rewarded for taking systematic risk: it is the reason stocks have the highest long-term returns of any asset class. However, investors are not compensated for taking unsystematic risk. Holding a small number of stocks in a portfolio offers the possibility of dramatically beating the market, but this potential is outweighed by the much higher downside risk.

That’s why investors should try to eliminate unsystematic risk altogether. They can do this by diversifying their holdings across many stocks, so that no single company can torpedo their portfolio.

How many stocks do you need?

So how many stocks do you need in your portfolio to eliminate single-company risk? A commonly held belief is that 15 to 30 stocks are enough, so long as they are spread across several sectors. However, recent research suggest that number should be much higher.

An analysis in The Journal of Investing in 2000 found that “even 60-stock portfolios achieve less than 90% of full diversification.” A 2008 paper from Dimensional Fund Advisors argued that a 50-stock portfolio would need to beat the market by 10 basis points per month to reward the investor for the additional risk.

In his review of the research on diversification,  William Bernstein puts it this way: “To be blunt, if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you.”

A narrow slice of a narrow slice

Even if you could properly diversify a portfolio with 30 holdings, there’s still the matter of spreading these across all sectors of the economy. And if you’re picking only from a menu of Canadian dividend-paying stocks, that is virtually impossible.

The makeup of the Claymore and iShares dividend ETFs bear this out. Claymore’s CDZ includes companies that have raised their dividends for at least five years: there are fewer than 40 of these, and about 30% are in the energy sector. Its iShares competitor, XDV, includes the 30 highest yielding stocks in the country, and it’s 52% financial services companies. The broad Canadian market is already poorly diversified, and focusing on dividend stocks just compounds the problem.

Canadians who select individual stocks rather than using ETFs have more freedom, but they can’t avoid sector concentration altogether. They can pick a few telecoms, utilities, REITs, and a railroad or two. But the technology, health care and consumer retail sectors (which make up about 45% of the S&P 500) are all but absent from the mix.

No one cares about diversification when their concentrated bets are working well. But what happens if Canadian banks suffer a crisis like US banks did in 2008–09? We dodged that bullet, but do we really think our financial institutions are immune from something similar? What happens when oil prices fall, as they have many times in the past? Or if foreign competition changes the Canadian telecom space?

Why expose your whole portfolio to idiosyncratic risks like this, when you’re not likely to be rewarded for doing so?

Seeking diversification abroad

It’s not just dividend investors who face risks from Canada’s small, narrowly focused stock market. Even Couch Potatoes who hold the entire S&P/TSX Composite have 70% of their money in three sectors (financials, energy, and materials). That’s why all Canadian investors should give serious thought to addressing their home bias.

If you have a significant portion of your investments in Canadian dividend stocks in a taxable account, consider taking a broader view with your RRSP. A diversified mix of index funds or ETFs (bonds, US and international stocks, and other asset classes) can dramatically reduce the risk of your overall portfolio. Canada is a wonderful place to invest, but there’s a big world out there beyond banks and energy.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Canadians had the reputation of being good savers. Between 1973 and 1993 we saved 10% or more, with our savings rate reaching a peak of 18.5% in 1982. In 1993, four years after Chilton started preaching about how important it is to “pay yourself first,” we began our great slide. By 1999, we’d hit an all-time low of 3.6%. But we weren’t done slipping yet. In 2003, the average Canadian saved just 1.4% of his or her pay. And in April of 2007, the personal savings rate came in at NEGATIVE 1.3%.

Why?

That’s the big question. Why would we just stop saving? What happened to make us think that we didn’t have to put away some money for the future?

In Boom, Bust and Echo, David Foot asserted that, “When you are young, you are a borrower. In your 40s and 50s, you are trying to build a nest egg for retirement.” Yet since 1993, as we watched the first of the baby boomers turn the corner to middle age, the savings rate plummeted despite a healthy economy, low inflation and more being written about the importance of saving. Today, there are more people going into retirement with debt than ever before.

Okay, so what we know we should do and what we actually do are totally different things. Whether you want to blame higher taxes, easy consumer credit, a booming housing market or job losses, the reality is that we are not saving what we should. The savings stats are a little like riding a roller coaster these days. According to the Stats Man, by the third quarter of 2009, our personal savings rate had risen to 4.8%. Yipee! By the first quarter of 2010, it had fallen back to 2.8% Awww! This is substantially lower than the 6.2% Americans were saving in the first quarter of 2010. Perhaps we, too, need the stuffing kicked out of us to get back into the savings game.

As a parent it’s hard not to worry about how you’re going to pay for your kid to go to university – especially when the cost of a four-year degree is projected to top $130,000 in just 18 years (right when your baby is headed off to school!).

In the face of such numbers, it’s easy to despair. But you don’t have to – with a little bit of know-how, some free money from the feds, and a reality check with your kids, there are a few tricks that can take away some of the financial pain.

Get free money. That is, if you start saving through an registered education savings plan (RESP). It’s a special savings account that lets your savings grow tax-free. But the best thing about opening an RESP for your child is that it makes you eligible for the Canada Education Savings Grant (CESG). It matches 20 percent of your RESP contributions on an annual basis to a maximum lifetime grant of $7,200 per child. So, if you put in $500 in the first year, the government will give you an additional $100 in grant money. This is one big leg up when helping your kids pay for college or university.

Get more free money! The Canada Learning Bond (CLB) – For kids born in 2004 or later, the Canada Learning Bond is another source of free money to put towards your child’s education – in fact, it can be paid directly into an RESP. It’s worth $500 the first year you have it and $100 for each subsequent year until your child is 15 – a total of $2,000. If you get the Canada Child Tax Benefit, you automatically quality for the CLB.

Do a reality check. Parents put a lot of pressure on themselves to foot the entire bill for their child’s education. And that’s not a great idea – even if you can afford it. It’s important that your kids understand the reality of how much an education costs and what its value is. And they should contribute to the costs, either through summer jobs or a job during the school year. The key is to sit down early with your kids – talk about how much you are prepared to pay for and how much they will be expected to contribute.

They don’t have to go to Harvard. While you want your kid to get the best education, he or she might have to make some choices about where to go based on finances. Talk to your kids about options like scholarships, grants and perhaps sticking to a school close to home for their undergraduate degree to cut costs related to room and board.

Caroline Cakebread is a Toronto-based financial writer and editor. She’s also a recovering academic and the mother of two kids. Check out her personal finance blog for Chatelaine Your Money.

“The good news is that most people overestimate how much they need after retirement,” says Otar. “That forces them to save more.” Starting at age 35, he says a person who makes $100,000 a year and saves about a third of his or her income in RRSPs, tax-free savings accounts and through contributions to CPP will be able to finance their retirement “reasonably well.” As for the assets required, he says that for every $10,000 in pre-tax annual income that a retiree hopes to have indexed fully to inflation, he or she needs about $300,000 in investment assets to start with at age 65. “Based on market history, this amount of assets can provide income for at least 30 years.”

On the other hand, asking someone in their mid-30s to part with 30 per cent of their income is probably unrealistic given other financial demands such as home mortgages and the cost of raising a family. Indeed, one of the biggest dilemmas Canadians face when planning for their retirement is balancing their savings with the need to pay off increasingly weighty home mortgages. Hamilton says the trend toward bigger mortgages amortized over longer periods is troubling from a retirement perspective. “The problem that we have in Canada right now is not a savings problem, it’s a borrowing problem.”

McCurdy generally recommends that clients contribute to RRSPs and then use the refund to pay off a mortgage quicker. However, a growing number of advisers argue that people are likely better off paying down debts by the time they are in their 40s, and then turn their attention to saving for retirement. “My philosophy is to get totally debt-free and that includes the home mortgage,” says David Trahair, a chartered accountant who has written books challenging the thinking behind traditional retirement planning strategies. “The vast majority of people are going to need money in their RRSP. But if you’re trying to save while you’re in debt, you’re essentially cancelling out the saving.”
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As well, Hamilton warns that there’s a point where an unwavering focus on retirement can become counterproductive if “you have to live like a pauper your whole life, like it was a prison sentence.”
At the end of the day, the key is investing that hard-earned cash wisely. For many, that will mean a traditional portfolio that consists of a mix of stocks, bonds and guaranteed investment products such as GICs. Many advisers also recommend that the percentage of funds invested in stocks and other risky instruments be re-calibrated to become increasingly conservative as the age of retirement draws closer. “For our clients, we have a rule: 100 minus their age,” says McCurdy. “That’s the most they should be investing in the stock market.” Still, if there’s any good that came from last year’s market meltdown, it’s that it taught people a badly needed lesson about the immutable relationship between risk and reward, which had apparently been forgotten after a half-decade of ballooning market returns.

Back in Sault Ste. Marie, Lach says he would do things differently if given a second chance. “You have to get in early, put some money away every month and let it snowball,” he says. While that doesn’t guarantee freedom from financial headaches, it could help make sure you will have enough extra cash to Rock and Roll All Nite when your favourite band comes to town—providing that security doesn’t confiscate your walker.

Also missing from the equation is the fact that most retirees’ daily expenses are a fraction of what they were during their working years. They’re not driving to work and paying for gas and parking every day, and they’re likely spending less on eating out or treating themselves to pricey specialty coffees. Many also choose to move into smaller homes or apartments, which can result in a reduction in property taxes. It all adds up.

In fact, the average Canadian retiree lives on about 50 per cent of their previous earnings, according to Hamilton. And nearly a third that could come from the Canada Pension Plan or Quebec Pension Plan and Old Age Security benefits.

Of course, just because most people retire on half their previous income doesn’t mean you should too. It all depends on what you plan to do during your retirement years, says Diane McCurdy, a financial planner in Vancouver. If your dreams include travelling the world, playing golf and restoring vintage automobiles, you will likely need considerably more money than someone who plans to watch television and eat the occasional meal out with friends. McCurdy adds, however, that even if people have an idea of the type of lifestyle they would like to lead following retirement, they often have no idea how to go about achieving it. “People don’t know what to do. They do what their friends have said, or their advisers, or what they read in the paper.”

Simply having a plan is half the battle. Lach, for one, says he wishes he’d spent more time thinking about his retirement while he was still working, but like most of us he was distracted by more immediate financial concerns. “I never really sat down and thought about it. It’s one of those would’ve-could’ve-should’ve things,” says Lach, adding that provincial rules about accessing locked retirement funds also played a role in aggravating his situation. Locked-in accounts are usually set up when a person transfers money out of a pension plan because they are leaving a job or, in the case of defined contribution pension plans, have retired and want to manage their own investments. Unlike money accumulated in RRSPs, most provinces limit retirees from accessing more than a small percentage of the cash each year.

But perhaps the biggest challenge faced by Lach and millions of other Canadians is recovering from last year’s stock market crash. During the darkest days of 2008, it was common to see economists and financial experts telling Canadians to avoid “crystallizing” their losses by selling into a falling market. It makes sense to avoid buying high and selling low, but it’s also incredibly difficult to sit on the sidelines and watch your retirement dreams slide away by the hour. Lach gave in and began selling last September. “I said, ‘Whoa, this has got to stop.’ ”

The economic crisis of the past year has underscored one fundamental weakness of retirement plans. No matter how well thought out, most end up relying heavily on an equity component to do the heavy lifting. And even a modest plan can be thrown out the window when promised returns evaporate. While the markets have regained ground over the past year, it will still be some time before the levels reached in early 2008 are pierced.

Not everybody is buying the prevailing wisdom about the stock market’s ability to deliver superior performance over the long term. Jim Otar lives in Thornhill, Ont., near Toronto, and is the author of Unveiling The Retirement Myth, a book that challenges many of the assumptions made by the financial planning industry. He claims that the average baby boomer hasn’t saved enough money and, as a result, is at risk of running out of money in their retirement. That’s not because they have underestimated what level of income they will need, but because they may not have enough assets to generate it. Most traditional retirement plans are not designed to withstand traumatic events such as a severe market downturn or an extended bear market, he argues. Instead, he says they rely heavily on unrealistic growth projections that don’t match the market’s actual performance. As a result, someone who is fortunate to retire at the start of a bull market might be okay, but Otar believes that most retirees who retire at some other point in the cycle won’t be as lucky.

He uses an engineering metaphor to highlight the point. A civil engineer would be fired on the spot for designing a skyscraper in Miami that was only able to withstand the city’s average wind speeds. What happens when a hurricane comes along? Similarly, retirement models that assume “average” market returns gloss over the fact that many people will enjoy significantly less upside from their investments, although a much smaller number will enjoy substantially more. In fact, Otar claims that, based on actual market history, the risks of having one’s retirement portfolio ravaged by the market are actually greater than meeting or exceeding the average rate of return.

“The good news is that most people overestimate how much they need after retirement,” says Otar. “That forces them to save more.” Starting at age 35, he says a person who makes $100,000 a year and saves about a third of his or her income in RRSPs, tax-free savings accounts and through contributions to CPP will be able to finance their retirement “reasonably well.” As for the assets required, he says that for every $10,000 in pre-tax annual income that a retiree hopes to have indexed fully to inflation, he or she needs about $300,000 in investment assets to start with at age 65. “Based on market history, this amount of assets can provide income for at least 30 years.”

On the other hand, asking someone in their mid-30s to part with 30 per cent of their income is probably unrealistic given other financial demands such as home mortgages and the cost of raising a family. Indeed, one of the biggest dilemmas Canadians face when planning for their retirement is balancing their savings with the need to pay off increasingly weighty home mortgages. Hamilton says the trend toward bigger mortgages amortized over longer periods is troubling from a retirement perspective. “The problem that we have in Canada right now is not a savings problem, it’s a borrowing problem.”

McCurdy generally recommends that clients contribute to RRSPs and then use the refund to pay off a mortgage quicker. However, a growing number of advisers argue that people are likely better off paying down debts by the time they are in their 40s, and then turn their attention to saving for retirement. “My philosophy is to get totally debt-free and that includes the home mortgage,” says David Trahair, a chartered accountant who has written books challenging the thinking behind traditional retirement planning strategies. “The vast majority of people are going to need money in their RRSP. But if you’re trying to save while you’re in debt, you’re essentially cancelling out the saving.”

As well, Hamilton warns that there’s a point where an unwavering focus on retirement can become counterproductive if “you have to live like a pauper your whole life, like it was a prison sentence.”
At the end of the day, the key is investing that hard-earned cash wisely. For many, that will mean a traditional portfolio that consists of a mix of stocks, bonds and guaranteed investment products such as GICs. Many advisers also recommend that the percentage of funds invested in stocks and other risky instruments be re-calibrated to become increasingly conservative as the age of retirement draws closer. “For our clients, we have a rule: 100 minus their age,” says McCurdy. “That’s the most they should be investing in the stock market.” Still, if there’s any good that came from last year’s market meltdown, it’s that it taught people a badly needed lesson about the immutable relationship between risk and reward, which had apparently been forgotten after a half-decade of ballooning market returns.

Back in Sault Ste. Marie, Lach says he would do things differently if given a second chance. “You have to get in early, put some money away every month and let it snowball,” he says. While that doesn’t guarantee freedom from financial headaches, it could help make sure you will have enough extra cash to Rock and Roll All Nite when your favourite band comes to town—providing that security doesn’t confiscate your walker.