One Way to Adapt to a 0% Environment

02/13/2012 11:00 am EST

Focus: STRATEGIES

Rob Carrick

Columnist, The Globe and Mail

The barbell strategy balances zero-risk investments with riskier choices that have a big potential payoff, writes Rob Carrick, reporter and columnist for The Globe and Mail.

On a rising risk scale from one to 10, penny mining stocks are a definite 11.

But there they are in the retirement plan of Sheldon Dong, vice-president of income strategy at TD Waterhouse. Dong’s not gambling with his retirement money. Rather, he’s trying to earn a decent return at a time of historically low interest rates.

Three-quarters of Dong’s retirement plan is invested in government bonds, where yields of 2% are considered a home run these days. To try to bump up his overall return, he uses penny mining stocks for the remaining 25%.

Dong calls his strategy the "risk barbell"—divide your money into a safe portion ruled by today’s low interest rates and a portion that seeks much better returns by bench-pressing risk at whatever weight you find comfortable.

"I do the extreme risk barbell," he said. "I don’t recommend that for the average client, but you get the idea."

We live in frustrating times for investors and savers. The precarious state of the global economy has kept interest rates low since 2009, and there’s virtually no chance of a significant rebound any time soon.

If bonds, guaranteed investment certificates, or high-rate savings accounts play a big role in your finances, you have to adapt. The conventional way to do this is to:

  • Aggressively search for the best rates possible: For high-interest savings accounts and CDs, compare rates; ask your broker whether it has access to third-party vehicles from alternative banks, trust companies, and credit unions offering premium rates.
  • Incrementally add more risk: Mix some corporate bonds with your government bonds. Or add a bit to your holdings in dividend-paying common or preferred shares at the expense of bonds.
  • Invest in diversified income products: There’s an ever-increasing number of mutual funds and exchange traded funds that package bonds of all types and dividend stocks together and pay monthly income at higher levels than bonds or CDs alone.

Dong describes his risk barbell as a simple, if decidedly non-traditional, alternative. He’s careful to offer the warning that "what I’m preaching is not what the firm [TD] is preaching."

But if you’re desperate to wring better returns from your portfolio without a massive spike higher in risk levels, the barbell is worth investigating.

You’ll find a mention of the barbell strategy in the influential book The Black Swan: The Impact of the Highly Improbable, by Nassim Taleb. In an interview several years ago, Taleb described the barbell as satisfying the desire to have a "guaranteed floor and maximal upside" and "the right mixture of greed and paranoia."

Dong says he starts a dialogue with clients about the barbell by asking a simple question: "If you were to give me $100,000 to invest, how much of that total can you not afford to lose one penny of during the worst conditions imaginable?"

This is a more practical approach than the risk-tolerance questionnaires often used in the financial industry. They ask whether you consider yourself aggressive or conservative as an investor, and how you would feel if the stock market fell 20%, or something like that. With Dong’s barbell approach, you apply real dollars to the question of how much money you can accept losing.

As practiced by Dong, the side of your barbell devoted to zero-risk investments goes into high-interest savings accounts, short-term CDs, and government bonds. "I tell the client you’re protected for that amount so you can sleep well at night. But you’re only going to earn 1 to 2%."

The menu of risky investments in a barbell is wide open. In addition to Dong’s penny mining stocks, some very risky choices include aggressive options strategies, venture capital, and small-capitalization stocks.

Dong takes a much gentler approach in helping clients crank up returns. He suggests adding corporate bonds, high-yield bond funds, and dividend-paying preferred shares and common shares.

As an example of the type of dividend stocks to look at, he mentioned a pair of banks—Canadian Imperial Bank of Commerce (CM) and Bank of Montreal (BMO)—that yield close to 5%.

Dividend stocks are often mentioned as a way for investors sick of low rates to bump up their returns. In fact, blue-chip dividend payers had a great 2011, even while the S&P/TSX composite index fell 11%, and many offer yields in the range of 3% to 4%. But for the safety-conscious investor, dividend stocks are in no way interchangeable with bonds and GICs.

None of the Canadian banks cut their dividends during the worst of the financial crisis, but their shares were massacred. CIBC went from over $100 in October 2007 to just below $38 in March 2009. You can’t ask someone to get out of CDs and into bank stocks without bearing this loss in mind.

Your choice of risky investment is a key factor in deciding how much of your barbell to keep safe. Just a bit of a hyper-risky investment mixed in with your bonds and CDs has the potential to juice your returns, whereas you’ll need a bigger helping of comparatively tame choices such as dividend stocks to make a serious difference.

Whatever risky investments you choose, Dong said the barbell should provide a safe, solid foundation that helps you hang on to them through whatever the market brings. "You can have volatility for years and years, but you’re not forced to sell your stocks at a loss."

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