A Case of Mistaken Identity
Each year, as the snow begins to melt and temperatures rise, farmers begin to turn their fields in anticipation for the upcoming growing season. What will line the rows this year? Zucchini? Celery? The farmer thinks back to the previous year’s market and remembers that heirloom tomatoes were fetching nearly twice the amount that his potatoes were. Eagerly wanting to increase his return at the market, he plants nearly all tomatoes and in the process, neglects his old faithful: the humble potato.
Throughout the growing season, his tomatoes become infested with aphids which prevents the tomatoes’ ability to grow. The farmer watches on, helpless, as his cash crop never gets off the ground. The cold weather wasn’t his fault – mother nature is under no one’s control. As the Sunday markets come and go, his decision not to plant his tried and true crop alongside the heirlooms means he has nothing to deliver. Blinded by his desire for a better yield, the farmer failed to understand the range of outcomes and has learned a tough lesson in crop diversification.
Just as a smart farmer plants security crops in his field, so too should an investor in their portfolio. When we think about a safety crop for investors, we look to high-quality fixed income investments. The primary role of the fixed income in your portfolio is to be a risk management tool – designed to protect you from the volatility inherent with owning stocks. The need for a greater fixed-income allocation becomes even more important for investors who are drawing income from their portfolio or for those who find the volatility associated with owning stocks more uncomfortable.
Failed Equity “Harvest” Years & The Role of Fixed Income
S&P/TSX Composite Index versus The Bloomberg Barclays Canadian Aggregate Bond Index
2003-2020 YTD (May 31)
Source: Dimensional Fund Advisors
In years when the weather is perfect and your tomatoes are being sold each week at a great price, it can be tempting to look at potatoes in your stall and think: why did I waste valuable field space to grow those? For an investor, it’s the same as comparing your performance to that of a stock only-portfolio and wondering why you have an allocation to fixed income.
The challenge with being an investor and a farmer is you can’t know in which years you’ll have an aphid infestation, or when a bear market may set in. So, what can you do to protect yourself against the unexpected? Let your personal risk tolerance and investment objectives guide you in finding the right mix of field space to dedicate to fixed income investments vs. equities and once you find that sweet spot, stick to it. Through the good harvests and the bad.