Mid-Term Investing for Stable Growth and Capital Preservation
The mid-term portion of your financial plan is intended to provide low volatility growth to cover your cash flow requirements for 3 to 6 years from now. Review the account at least annually, but no more than twice a year. After each review, bring the cash up to 48 times the amount of money you need monthly based on your budget. The growth in the account typically will cover inflation occurring over the next few years. This provides the extra funds needed to counter inflation.
There are times when you should consider putting more than 48 months into the account. One example would be when last year's return in the long-term account was above average. Some clients will any gains over either 15 or 20 percent, depending on their preferences into the mid-term account.
Another time to consider increasing the mid-term account is when media starts discussing a possibility for a recession. There should be no reason to put more than 60 months cashflow into this part of your total plan!
What Investments fit in This Plan?
The target is to earn 5 to 8% from our mid-term investments.
If your
key financial objective is to purchase a home within the 6 year time horizon, then your target may need to be more aggressive. If you are trying to build a down payment in order to buy property, then your investments must have a return greater than the percentage increase in the real estate market. Long-term growth in the real estate market has been averaging around 7.5% for major Canadian centers, so you'll want a higher return than that. As a prospective home buyer you are balancing risks. Your choice is between the risk of volatility in the investments versus the risk of never being able to own a home. Sadly, nothing in life comes without some tradeoffs!
What types of investments should be considered for mid-term investing? The key goal of this account is to provide stable growth with good protection of the amount invested. Which investments provide these features? Bonds maturing in 3 to 6 years (when held to maturity), dividend paying larger companies, and the funds which specialize in them. Let's look at these in a bit more detail.
Mid-Term Bonds
In our article
Investing in Bonds, we describe how bonds work in more detail. What's relevant here is that bond values - especially long-term bond values - increase as interest rates fall. This makes investing in bonds more appealing if rates are high and are expected to go down in the future.
Do not invest bonds with expirations beyond 6 years. These are long-term investments and would dilute the purpose of the mid-term account.
Bonds with 2 to 6 year maturities are also affected by interest rate changes. Our second objective is to keep the volatility of this account as low as possible. If bonds are an attractive alternative for you, then you can reduce this volatility by holding the bond to maturity. You should sell the bond if the return to maturity drops below 4%.
Remember to apply the laddering of bond maturities, as per the discussion in
Short-Term Investments! Money is moved from this account to the short-term account at least once a year. You don't want all the mid-term money locked in!
One way to overcome this issue of being locked in to your bonds is to purchase Mutual Funds specializing in Bonds. As with any mutual fund, you can sell your fund at any time. Shorter time horizons to bond maturities in a fund generally imply less volatility in that fund.
Dividend Paying Stocks
In our article
Investing in Stocks, we show how the volatility of stocks varies significantly. One key consideration is the size of the company that issues the stock. Larger companies generate significant profits. They recognize that owners want some of this cash distributed as dividends which provide then with tax-preferred income. The ratio of the annual dividend payment divided by the stock's price is referred to as the yield of the stock. As the stock's price declines, the yield rises, increasing the desirability of the stock when compared to prevailing interest rates.
Dividend paying stocks usually decline less, and more slowly, than other stocks. The quality of the companies involved also means that the stock price usually recovers quickly when the market turns positive. While the market rises slowly, downturns tend to be short and steep. An analysis of Mutual Funds specializing in these dividend-paying stocks shows that most do not lose value two years in a row! This makes them ideal for mid-term investing! We value the capital preservation these provide for the mid-term account!
If you have the time to properly research companies which might be investment targets for you, or the willingness to pay someone who has done the research for you, then invest in dividend paying company stocks. Just remember that your research should not end with the purchase of a stock. Successful investors continuously monitor the companies in which they are invested!
If you prefer using your time on non-financial interests, then invest in Mutual Funds. Look for a manager with a long term record of success in this time frame. Alternately, buy Index Funds if you are comfortable with the investing in all the companies in your chosen index. I generally recommend one of these options, as they are less work for busy people!
Tax Considerations
On average, this portion of your plan will have the higher returns than the short-term account, but lower returns returns than the long-term account. As such, this account can be held in a registered account such as a TFSA or RRSP, if you have one. If you are currently using the 3-Plan model for monthly income, then it is likely that your short-term plan is no longer in a registered account. In this case, consider doing the annual transfers from this account to your short-term account in December. Withdrawals from an RRSP or RIF are subject to tax withholding mandated by the government. Doing the transfers in December shortens the time that the government withholds your money, should you be entitled to a tax return each year!
If your mid-term account is not in a registered plan, then you will receive tax forms from the company holding your investments every year. Remember to plan for this potential tax liability. Talk with your accountant or tax advisor before the end of the calendar year to plan.
Please see
Short-Term Investments and
Long-Term Investments for our recommendations on those portions of your overall portfolio.
