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I recently discussed how preferred shares work as an introduction to preferred shares for fixed income. As it turns out, the timing was good as Dividend Ninja made a purchase of preferred shares bringing up the question; Why not buy the common shares? Since the purchase of preferred shares was PWF and they happen to have a common share with a near dividend yield, the dilema was understandable.
- PWF Perpetual Preferred Shares @ 4.80%
- PWF Common Shares Dividend Yield @ 4.71%
As you can see, the yield is very close but the investments have a different purpose in a portfolio. It’s not the company but the purpose that matters in this case.
Preferred Shares vs Common Shares
If you were just looking at comparing the investments then the pro’s and con’s would stack up like this.
Pros of Preferred Shares over Common Shares
- Dividends are paid first over common shares in the case of bankruptcy
- Fixed yield for the term (no dividend cuts)
- Relative stability in share value based on interest rates
Pros of Common Shares over Preferred Shares
- Possible dividend increase which would bring the yield above the preferred shares
- Appreciation of the common share price can grow the investment value overall
What about asset allocations?
This is where the decision is really made. When you have a portfolio of a certain size, you start distributing your risks through asset diversification such as common stocks, fixed income, and cash. Within each you can then diversify based on sectors and such .
The real decision that you need to do is what investments you need to purchase. If you are looking at fixed income then the purchase of PWF for that segment of your portfolio can do the job. For others, it may be a junk bond ETF. The goal remains the same.
Portfolio Diversification
As mentioned, the portfolio diversification is really important and everyone should track it. There is by sector within a stock diversification but you also need to include fixed income as well. Below is my allocation target in green and my current status in red.
I put together a mind map quickly to highlight the decision tree and also to assess the percentage you would want to allocate for each. It needs to be reviewed and adjusted as your finance evolve or change to make sure it’s still appropriate. As you can see, I have been covering a little more of the fixed income as it’s lacking in my portfolio above.
I have obviously not mentioned ETFs or mutual funds as they actually can fall in equity, fixed income or cash. They can provide you with the diversification all together or mirror particular areas of investing.
Readers: Do you see yourself owning preferred shares?
Image courtesy of David Castillo / FreeDigitalPhotos.net
PIE, thanx for the mention of course!
Yes you are exactly right, the purchase of the “preferred shares” in my case is asset allocation, as like a fixed income investment. This will help smooth out volatility on the equity side of my portfolio, especially during times of market downturn. Interest rate increases remain the only problem here…
I want to make an important point though, that I am not using preferred shares to replace the bond component of my portfolio. Although I did sell some bond holdings, the investment in preferred shares is still an equity investment.
Your article brings up an interesting point about asset allocation. Since you are weighted heavily on financials over your target, have you considered (or would you even consider) selling and rebalancing your portfolio? That would make an interesting post.
Cheers
The Dividend Ninja
@Dividend Ninja
I am not selling them as they are good investments and it’s really just a matter of a couple of years for everything to balance itself.
I am overweight in finance and the rebalance will happen with new money
With that said, if an amazing deal was to show up, I would make a change.
I will always own common shares or in a mutual fund. I wish I had enough discretionary income to buy preferred and still be diversified. Warren Buffet shored up Bank of America by buying preferred and guaranteed him 1a 10% return on his investment.
The point should be negative (or little) correlation to one another. Not to own every type of investments as your mind map may imply.
Correlation of:
Russell 3000(IWV) vs Emerging markets (EEM) is almost 1
Russell 3000(IWV) vs Europe (EFA) is almost 1
From your mind map, if you own something similar to a domestic index, buying international or emerging markets is a complete waste. You are overly doing it – creating a false sense of safety. If we were Croatia, ok… but economis like Canada or US, please…
Similarly, Russell 3000(IWV) vs Financials (IYF) is almost 1. So having “too much” financials is not really an issue. Having only financials could be. I wouldn’t agree that you have too much financials for proper risk management. How you came up with 15%?
Russell 3000(IWV) vs Bonds (AGG) is -0.6
So if asset allocation is your goal, and you don’t believe you are smarter and can beat the 32,000 Wall Street analysts… then buy IWV and AGG, and nothing else. You’ll get market returns from both and be extremely well diversified.
From your chart, you appear to very well diversified in common stocks (considering that in aggregate the correlation is likely above 0.8 anyway).
Real estate and fixed assets should be added to your portfolio if you wish to have other than your current state of illusionary diversification. But buying pref shares of one or two company would likely not do it… ETF/funds of bonds/pref would be better.
@Goldberg
Thanks for your comment. I am not sure where you are going with your comment though … Nobody is comparing different ways of diversifying. To everyone their strategy, the purpose of the post was to highlight that buying a preferred shares of a company with a common stock doesn’t have the same purpose as buying the common stock. The diversification mind map is not a diversification strategy either but just highlighting where some investments fall under. Some might disagree about whether a preferred share is equity versus fixed income and that’s fine. It’s a matter of defining what is what. I think everyone should create their mind map and define what works for them with whatever investment they want.
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