Matching – The First Principle of Investing
One of the first things taught in an MBA finance course is the matching principle, which states the best way to minimize financial risk is to match the time period of an asset, for example, your portfolio, to the time period of a liability, such as your investment goal.
Consider the example of parents who are planning to fund a $20,000 wedding for their daughter, Jill, in 18 months’ time. The investment question becomes, “What is the best asset to match this known liability?” Although there are numerous options, we’ll explore three obvious choices: a savings account, an 18-month GIC or investing in a tech stock. In today’s market, the savings account yields nothing and the GIC yields 1.5%. Both have virtually non-existent payback risk, while the tech stock bounces like a yo-yo. In 18 months, the savings account will offer no investment return, the GIC will return $20,450 and the tech stock – who knows? That is the essence of investment risk.
If Jill’s parents rely on a long-term equity investment to fund known near-term liabilities, the risk is that when the liability comes due, the market may be in one of its down-draft periods and the asset may have to be sold prematurely to meet the liability. Investors who “had to” sell equity holdings at the 2009 market bottom to meet living expenses lost all opportunity to participate in the subsequent market recovery. Their short-term need was not matched with their long-term asset. The beauty of the matching principle is that it affords an investor the opportunity to collect the higher returns typically associated with longer-term investment.
What is financial risk? While some may say it is simply asset price volatility, under the matching principle, risk is not having what you expect when you need it. Jill’s parents experience effectively no risk if they buy an 18-month GIC to fund the wedding, and earn $450. They experience the risk of an opportunity loss of $450 if they put the money in the bank. The tech stock, with a payoff that may be years in the future, exposes the parents to the risk they will have a cash shortfall if the shares are down significantly over the 18-month period. The bigger the timing mismatch between assets and liabilities, the bigger the financial risk.
Now think of buying a house. Since a house is a long-term asset, the matching principle says it is appropriate to incur a long-term mortgage to fund the house. By locking-in a known payment stream, the house buyer can minimize the financial risk associated with short-term swings in interest rates for financing the long-term asset.
For most investors, retirement is the primary investment objective, with a time horizon well beyond that of the wedding example above. In fact, most investors’ investment horizons are well beyond the typical 4-5 year market cycle. So what is the best way to fund that long-term retirement liability? With a long-term asset, such as a retirement portfolio, with a long-term payout structure able to match future cash needs.
At Leon Frazer, we believe the best portfolio to match a long-term investment need is one comprised primarily of dividend-growing equities. We believe this for three reasons. First, for longer-term investors, equities have traditionally provided the highest long-term returns, especially when compared to cash and traditional fixed income. Second, dividend-paying equities currently offer a cash return component higher than the yields available from longer-term bonds, while being more tax efficient. This cash can be used to meet any near-term spending requirements from the portfolio. Third, dividend-paying stocks are liquid and decline less during market downturns, so investors faced with spending needs are less affected by the traditional market cycle.
For decades, we at Leon Frazer have matched long-term liabilities for our clients. We do not believe a long-term portfolio is best constructed around holdings created through short-term trades. We continue to believe the best portfolio to meet a long-term need is one that holds long-term assets, like dividend-paying stocks, especially at the current interest rate levels. With a confidence built on decades of investment experience, we do not get flustered when markets turn volatile; in fact volatility affords us the opportunity to add to quality long-term assets at what ultimately turn out to be depressed prices.
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