On May 10, I hosted an AMA (“Ask Me Anything”) on Reddit, the online discussion forum, and over 90 hectic minutes I answered as many questions as I could from investors. This week, in two separate blog posts, I’ll present a lightly edited transcript of the discussion, along with some additional comments and links I didn’t have time to provide during the live AMA.
vbally101: I’m newly financially stable, 31, single female, own my home and car. Finally in a full-time job with a salary and benefits and have paid off my debts (with the exception of my car and mortgage). Current annual salary is $90K before taxes. I have about $13K in savings.
My new company has a defined contribution pension plan (7% individual contribution; 6% company matching). I have no other investments and am not sure where to begin. I’m trying to look to the future, but there is so much information I don’t know how to sort through it all.
CCP: Sounds like you’re off to a great start! Taking full advantage of your workplace plan is the place to start, especially if the plan offers low-cost index fund options (most do). You could consider making additional contributions to that plan: your RRSP room will be 18% of your previous year’s salary and it sounds like you’re doing 13% now.
If you still have surplus cash after maxing your RRSP and keeping some aside for emergencies, consider making additional mortgage prepayments: that’s a risk-free, tax-free way to increase your net worth that requires no investment knowledge.
princessdianasauce: I haven’t been investing long enough to have endured the 2008 financial crisis or any extended bear market. However, I have been very disciplined during the market volatility in the last 3 months, and for the entirety of my DIY experience. Do you think that is sufficient evidence to increase my risk tolerance? I am 28 years old, currently using 75% equity, 25% fixed income, but I am considering 85% to 90% equities.
CCP: The market volatility we’ve experienced in the last several months is not a gauge of an investor’s tolerance for loss. Not even close. The true test is when you have lost at least 30% to 40% of your portfolio. In 2008–09, it was closer to 50% in six months. Few people can endure that without panic. You might well be able to stomach a portfolio of 90% equities, but I would make that decision after the next ugly bear market rather than before.
derekcanmexit: What is your opinion of Horizons total return ETFs, which use swaps to deliver index returns in a low cost and tax-efficient manner. Are you recommending these ETFs to clients? They seem too good to be true, and I am afraid I am missing something in the details.
CCP: We’re not currently using these swap-based ETFs with our clients, but I don’t have any objection to them as long as investors understand the additional risks, which I’ve written about a fair bit. Certainly they have done an outstanding job of delivering on their promise of matching their index returns minus fees.
One concern we have is that the government may eventually stop allowing this structure (as they have done with other tax-advantaged products), which could cause investors to sell the funds and realize all of the accrued gains in a single year.
p0u1337: For someone with a defined benefit pension plan that uses up most of my RRSP room, as well as a maxed TFSA, what are some options for the CCP model in unregistered accounts? Currently with HXT and HXS for the simplicity until I figure it out!
CCP: Investing tax-efficiently across multiple accounts can tie people in knots, so I’d urge you not to look for an “optimal” solution, because there probably isn’t one.
In general, I agree with your decision to hold Canadian and US equities in the non-registered account: Canadian dividends can be very tax-efficient, and yields on US equities are generally low these days, so there’s little taxable income. Whether you use HXT/HXS or plain-vanilla ETFs is a different topic, but either is likely to be fine.
If you hold cash or GICs, a non-registered account can also be appropriate, as the interest income is relatively low and therefore little tax would be payable. I would not, for example, hold low-growth, low-income assets like this in a TFSA while holding higher-growth, higher-income assets in a taxable account.
[Note: While my model portfolios are generally more appropriate for tax-sheltered accounts, my colleague Justin Bender offers a model ETF portfolio for non-registered accounts that includes the BMO Discount Bond ETF for fixed income.]
falco_iii: If I can max my TFSA and RRSP and have some left over for a taxable account, where should I put the ETF assets? Can you include that in the next model portfolio? There is an older blog entry but it does not have the current ETFs or TD e-Series funds.
CCP: As mentioned in the reply to p0u1337, above, asset location across multiple accounts is probably the most difficult part of DIY investing. There are very few hard and fast rules, so a full understanding of the situation is essential.
How big are the accounts relative to one another? Where is most of the new money being added? Do you need liquidity? What tax bracket are you in? Are you using index mutual funds or ETFs? Are you willing to use US-listed ETFs or only Canadian?
If you’re simply asking which assets should be the first to go in the non-registered account, it’s hard to go too far wrong with Canadian equities.
Titanmowgli: In terms of rebalancing one’s portfolio consisting of an RRSP, TFSA, and taxable account, do you recommend factoring in that the government owns a certain portion of your RRSP upon withdrawal? Will doing it one way or another affect the level of risk that one is taking on?
CCP: Another common question that doesn’t have an easy answer. The short reply is, no, we don’t manage portfolios that way because it is hopelessly impractical. There are also behavioural issues to consider. If you lost half of the value of your RRSP, would it make you feel better to know that 30% would have gone to taxes in retirement anyway? I doubt it. So I don’t disagree with this idea in theory, only in practice.
[Note: To clarify the background here, some people argue that, for example, if you hold $75,000 in equities in a TFSA and $75,000 in bonds in an RRSP you don’t really have a 50/50 asset mix. Because some percentage of those RRSP dollars will be taxed upon withdrawal, you own less in bonds than you think. Therefore, you should consider after-tax dollars when setting your asset allocation.
The most vocal advocate of this strategy is the author of the Retail Investor website. If you feel you can apply these insights to managing your own portfolio, I welcome you to do so, but I suspect it will defeat most DIY investors. For professionals managing portfolios for multiple clients it is close to impossible, and I am not aware of any firm that does so.
I also encourage you to read a this new article at Holy Potato, authored by John Robertson, who recently appeared on my podcast. John is a very smart guy who understands the math of after-tax asset allocation as well as anyone. But at the end of his blog he concludes that “all these optimization games can bring is a few basis points of extra return,” and the added complexity is not worth it. “My default suggestion is that it’s best to just replicate the same allocation in all your accounts.”]
throw0510a: Someone recommended that instead of putting bonds into non-taxable account, that they should be put into a taxable instead. The reasoning is that since returns are so low with bonds lately that it’s not worth try to save on them with regards to tax-efficiency. The claim is that it is better to put equities in the non-taxable accounts so that one can keep as much of the returns as possible for oneself. How crazy is this idea?
CCP: This idea is not crazy at all. Fixed income can be perfectly appropriate in a taxable account. However, some bond ETFs are particularly tax-inefficient, so if you hold fixed income in a taxable account it’s important to use the right products (i.e. GICs or tax-efficient ETFs).
derekcanmexit: I’d like to know your thoughts on factor-based ETFs? Would you recommend them as a complement to any CCP strategy?
CCP: This is another theory vs. practice issue. I think many of the premiums (value, size, momentum) are real. I just think that in practice they are very hard to capture with an index fund, and the additional costs can easily overwhelm any premium that does exist.
I also worry that once you go down the road of looking for the best way to capture factor premiums you create new behavioural problems. You may find yourself perpetually looking for something better instead of settling into a long-term strategy.
[Note: I wrote a long series of blog posts about factor-based, or “smart beta,” ETFs in 2016. I concluded by arguing that most investors are better off sticking to plain-vanilla index funds.]