EIGHT
Investments for Today and for Your Future
The mint makes it first,
it’s up to you to make it last.
— EVAN ESAR
THE WORLD OF investing is vast and can be complex; so this book is intended as a brief introduction. I’ll do my best to clearly explain the basics of investing without going into too much detail. If some concepts still aren’t as clear as you’d like when you finish reading this chapter, please don’t despair; it becomes much easier once you actually start investing your own money. Think of it as taking a course about the history of Europe and then actually going there to see the historic sites; nothing can really compare with experiencing things first hand, but this is a good place to start.
I hope this chapter will inspire you to read more in the near future.
Investing 101
A tax shelter is a place where you can put your money (i.e., invest your money) to defer or avoid paying tax, either in the form of income tax from employment or capital gains tax. However, tax shelters are not in themselves investments; they are merely the place where you keep your investments in much the same way you keep your car in a garage. The car is the investment, the garage is the tax shelter.
There are three main kinds of investments:
1. Cash or cash equivalents, i.e., assets that can be turned into cash within three months
2. Fixed-income
3. Equity
Cash and Cash Equivalents
Cash is cash and cash equivalents are marketable securities that can be turned into cash in fewer than three months.
Savings Accounts
These are bank accounts which may or may not pay much interest. In the past, investors were treated to double-digit interest payments on savings accounts, so they seemed to be a good investment. However, inflation was also high and, when interest rates are high, inflation takes a bite out of that interest. Today, inflation is extremely low, so interest rates are low as well. Rates can vary quite a bit so it’s good to shop around.
Term Deposits
A term deposit is a loan to a financial institution (e.g., $1,000) for a fixed period of anywhere from a month to less than a year. The longer the term, the higher the interest rate. The money can only be withdrawn at the end of the term. If it is withdrawn before that time there is usually a penalty. The penalty is compensation to the bank for at least some of the interest lost because of your early withdrawal.
Fixed Income
This is where you lend your money for longer periods of time than a year. The borrower (the financial institution) makes interest payments to you and returns principal on a pre-established (fixed) schedule.
Guaranteed Investment Certificates (GICs)
GICs are usually purchased at your local bank or credit union. Issuers of GICs guarantee to pay you interest and repay your principal at the end of a fixed period of time, usually ranging from one to five years. The longer that you allow the bank to hold onto your money (the term to maturity, i.e., when you get your money back from them) the greater the accumulated interest that you’ll be paid on your investment. GICs are based on current interest rates, which are currently fairly low. However, your principal (the original amount you gave/lent the bank) is guaranteed, as is your interest rate. You’re the lender and you have to figure out what’s best for your situation (i.e., Should I tie up my money for a long time?) and also, where are interest rates going? With your mortgage, you worry about locking in to a fixed rate and then the rates could drop. With a GIC, you’d be concerned about the opposite; locking in to a rate and then the rates could go up.
Make sure your financial institution is a CDIC member or insured under a provincial plan.
Some investments are insured up to $100,000 with the Canada Deposit Insurance Corporation (CDIC). The CDIC was established to protect deposits held by member financial institutions in case an institution fails. There is no need to sign up or pay a premium because the member institutions pay to insure their own depositors against losses. However, not all financial institutions are members of the CDIC.
For a complete list of members, visit the CDIC website (www.cdic.ca) and click on “Where Are My Savings Insured by CDIC”. Only deposits at member institutions are insured.
Bonds
Bonds are loans to governments and corporations and are usually in units of $1,000. Unlike Term Deposits and GICs, bonds trade on the open market.
These can be very complex investments, even though they can be a low to moderate risk. You need to decide for how long you’re going to lock in, for example, 10 to 30 years. The type of bond you buy (a Government of Canada bond, a provincial or municipal bond or even a corporate bond), will determine the interest rate you get. Generally, the higher the interest rate, the higher the risk.
A bond issued by a government, such as a 10-year Government of Canada bond, is usually considered to be low risk because the federal government has the taxing power to raise the money to repay the loan. A corporation, on the other hand, could run into trouble and be unable either to pay the interest or repay the principal. If there is any risk of such failure, the borrower (the corporation) will have to pay a higher interest rate to borrow the money from you.
The lower the risk of the investment, the lower the interest that is paid. The interest rate for bonds is quite low, but higher than a GIC. However, a bond can be bought and sold on a bond market before it matures, unlike most simple GICs which can’t be cashed before maturity.
Bond Prices
If a $1,000 bond is issued at 5% for 10 years, the purchaser receives $50 every year for 10 years, at which time the issuer will repay the $1,000. If interest rates move up to 5.5% for bonds of comparable quality, the price of the bond on the market will decline to $960 because anyone willing to buy the bond now wants 5.5% on their money instead of only 5%. Since the $50 payment is fixed, the bond price has to decline to $960 to give the new purchaser a 5.5% yield when getting only $50.
Equity
Equity ownership is expressed in units of ownership called stocks (American-English) or shares (Canadian-English). The need for buyers and sellers to interact with each other on short notice led to the creation of stock exchanges.
If a company needs to raise large amounts of capital, it usually offers its shares or debt to the general public. In order to do this, the company has to register with one of the provincial securities commissions in Canada. The securities commissions require companies to provide sufficient basic financial information so that members of the public can make an informed decision about whether or not to buy the securities. The securities commissions also require existing issuers to file financial information quarterly and annually.
However, because shares are listed on a major exchange it does not mean they are without risk. The stock exchanges and securities commissions do not monitor the risk involved in buying a company’s shares.
Types of Shares
There are two primary classes of shares: preferred and common.
Preferred
Preferred shares are much like bonds: they generally have a fixed dividend and their market price moves with interest rates, i.e., upward when rates decline and downward when rates go up. Preferred dividends are also eligible for the dividend tax credit. If the company goes into bankruptcy, preferred shareholders stand after bondholders and before common shareholders for the distribution of the proceeds of any sale of company assets.
Common
Common shares tend to move in relation to the outlook for company earnings. This relation is usually expressed as the “price earnings multiple.” For example, a company expected to earn $2 per share in the current fiscal year might see the market price of its stock trading at $40 (or 20 times earnings). This would mean that investors are expecting a strong performance from the company. The multiple might be quite a bit higher for a company whose earnings growth rate is expected to be substantially above average, or might be lower for a company whose earnings are stable but more slow-growing.
If the company does well or the market expects it to do well, the share price will go up. And the reverse will also happen. Some shares can be conservative and grow steadily; others can be an extremely high risk. There are no guarantees when investing in shares; you can make a huge return or you could lose some or all of your investment. You share in the company’s success or failure. However, the opportunity for growth can be a huge lure, but most definitely shares are not for the faint of heart. You should also be aware that, in theory, common shares tend to move in relation to the outlook for company earnings, but shares can also move based on other factors (such as speculative information) and this can create “bubbles” that burst.
Dividend Reinvestment Plans (DRIPs)
Many major Canadian companies have DRIPs where, instead of you taking the quarterly dividend in cash, the plan purchases additional shares for you (often at a discount to the market price). This continues every quarter and the effect is the same as compounding interest. The plan is a form of automatic savings for you every quarter. Dividend increases provide additional money, so the rate of return can be quite significant.
Portfolio Management
Portfolio management begins with the establishment of your goals. What do you want the portfolio to do:
• Provide for retirement 35 years down the road through an RRSP?
• Educate your children through an RESP?
• Establish an emergency fund in case of a crisis through a TFSA?
Your goal, the length of time you have to achieve that goal, the kind of risk you can tolerate, plus the changing risk-reward ratio of the various asset markets through the years will all have to be taken into consideration when you decide on what you need to own.
Asset Allocation
If you’ve done any investing or studied the subject, you will have come across the term “asset allocation”. It may sound a bit complex, but it just refers to diversification. Essentially, there are three main assets: cash, fixed income and equity (shares). The percentage of each that you should have invested depends not on the current markets or interest rates but on one, or a combination, of these factors:
• How much do you have to invest?
• How many years is it until you will need your funds?
• How much risk or volatility can you handle in your portfolio?
• What is your net worth?
• What is your level of financial education?
A rule of thumb for a portfolio is 100 minus your age for your percentage in equities, with the remainder being divided among bonds and cash.
A young person can tolerate a higher proportion of equities in their portfolio for two reasons: first, because they want to benefit from the long-term capital growth and dividend increases and, second, because they have the earning power to replace any losses. As a person approaches retirement, there is less tolerance of risk; the proportion of fixed-income investments should increase.
Generally, there will be a place for some equities because of the need for dividend growth and capital gains to offset the erosion of buying power caused by inflation. Cash management will also always be an important part of any portfolio performance since the proceeds of sales and cash deposits kept must continue to earn interest.
Mutual Funds
During workshops, I’ll ask attendees if mutual funds are risky or safe and if they are a good investment or a bad one. As you can imagine, I get every possible answer — and every possible answer is correct!
You can usually get into a fund for $500, or even as little as $25 per month (each mutual fund has a minimum initial investment amount and a monthly investment amount), which you cannot do if you are buying shares or bonds on the open market. Also, if you wanted to save monthly, you can’t do that with T-bills, bonds or even shares, but you can with mutual funds.
The four most popular types of mutual funds are:
1. Money market funds
2. Bond funds
3. Equity funds
4. Balanced funds
Money Market Funds
As the name suggests, these funds invest in investments that repay principal in less than a year. Fund managers buy and sell these investments to maximize the return on the fund. A money market fund can be a good place to park your money for short periods.
Bond Funds
These funds invest in debt with maturities greater than a year. Bond fund managers also try to maximize the fund’s rate of return by trading a portfolio of fixed-income investments of varying maturities and yields by including both government and corporate bonds.
Equity Funds
There is an enormous variety of these funds. They can specialize in certain industries or countries, be high risk or conservative. They can even focus on providing high-yielding dividend income. International funds focus on foreign markets with their associated risks of political instability and adverse movements in exchange rates.
Balanced Funds
This type of fund has a diversified portfolio including cash, fixed income and equity investments in one fund and it focuses on moderate risk and moderate returns.
Advantages of Mutual Funds
• Mutual funds sell units of the fund rather than shares and bonds directly. When you buy a unit, you contribute to a pool of money used by fund managers to purchase the shares and bonds that make up the fund’s portfolio. So, for a small outlay, you can own a piece of a highly diversified investment.
• Mutual funds are usually managed by experienced professionals who spend 100% of their career monitoring and educating themselves about all investment matters.
• Many fund companies with “families” of funds allow you to move from one fund to the other without paying a commission.
Disadvantages of Mutual Funds
• Mutual funds have a similar risk to any other kind of investment. You can lose your investment just as easily in a mutual fund as you can if you purchased shares, bonds, etc., outside the fund.
• The most common criticisms of mutual funds are that they charge too much in commissions and management fees and they often do not outperform the common measures of performance such as the S&P/TSC Composite Index.
High Cost
Commissions
Before you buy a fund you should understand how the commission structure works. There are several types:
• Front-end load funds charge a purchase commission which may be negotiable and vary from one mutual fund company to another (the commissions charged are usually between 2% and 5%). No fees are charged when you sell the fund.
• Back-end loads charge a commission only when you sell and are not negotiable. You are normally not charged a back-end load to move from one fund to another within the fund company’s “family” of funds. You pay when you leave the family. You usually have to stay with the family of funds for five-to-seven years before you can sell without paying any commission. If you sell early, then you pay a commission based on how many years you have been invested in the fund — the more years invested, the smaller the commission.
• Some fund companies have no-load funds.
These commissions may also pay, in part, for the advice that you receive from your financial advisor, therefore your advisor may be motivated to sell you a particular fund. Before buying any fund, it is a good idea to ask your advisor how they are compensated.
Management Expense Ratio (MER)
The Management Expense Ratio (MER) is the percentage of a fund’s annual average assets taken by the fund management company to pay for administrative costs such as bookkeeping, research, legal and custodial services as well as the salaries of managers. The MER can range from less than 1% for some money market funds to almost 3% for equity funds. Canadian MERs have been criticized because they’re some of the highest of any country surveyed by Morningstar surveys.2
Since the return you earn on your investment is calculated after the deduction of the MER, your actual return is substantially less than the total return of the fund. This can be a significant factor affecting the growth of your savings in times of low returns (such as we are living in now). While funds with high MERs may be worth it because of the professional managers they use, it means that those same managers need to work that much harder to earn you a decent rate of return.
Shop around and compare fees for similar funds in other fund families to ensure the fees you could be charged are fair and reasonable.
Poor Performance
Another major criticism of mutual funds is that they generally don’t outperform the main indices that are usually taken as proxies for the market as a whole. For example, the S&P/TSC Composite Index is usually taken to represent Canadian shares; the Dow Jones Industrial Average and S&P 500 are taken to represent the U.S. market. The annual percentage gains and losses of these indices plus the indices on other major overseas markets are taken to be the standards against which individual portfolio performances are measured. The test is whether the choices of a highly paid fund manager can beat the performance of a collection of shares listed on a stock exchange.
Index Funds and Exchange Traded Funds
For many people the solution to this under-performance problem has been to buy index funds or Exchange Traded Funds (ETFs), which track the return of a major index (such as the S&P/TSC Composite Index). Today, there are many index funds and ETFs on the market that track many different indices. You can buy one that tracks a Canadian equity index, a Canadian bond index, a U.S. equity index, international equity index, and more. Because index funds and ETFs simply mirror how the index performs, there’s no real management involved. As a result, the MERs are often less than 1%.
Index funds and ETFs are similar in concept because they both track an index, but there are some differences.
Index Funds
• Trade like a mutual fund because you can only purchase them at the end of each day when the price is determined.
• May need to pay a commission similar to mutual funds but many are no-load.
• MERs are much lower than most mutual funds, but tend to be higher than the MERs for ETFs.
ETFs
• Trade like shares because you can purchase them throughout the trading day and have the ability to specify the price at which you are willing to buy or sell.
• You pay a commission every time you buy or sell.
• MERs tend to be lower than index funds.
An equity mutual fund management team needs to make great picks from accurate research and forecasts in order to beat the market as measured by the indices. But even if they come close or do better than the market in a given year, because the MER with an actively managed fund is substantially higher than that of an index fund or ETF, mutual fund managers have to do much better than the market and do it every year. Because many mutual funds under-perform their benchmark indices, a number of financial experts suggest that an index fund or ETF might be a better option for some investors.
Cryptocurrency
The world’s social media platforms and financial markets are abuzz about cryptocurrencies — a form of digital currency that exists only in virtual form. Cryptocurrencies are theoretically designed to let you store, send and receive value (like money) without any third parties (like banks or credit card companies). As of August 2018, there were over 1,600 different cryptocurrencies in the marketplace, the most popular being Bitcoin, Litcoin, and Ethereum.
Although popular, cryptocurrencies are a risky investment and securities regulators and other investor protection agencies have warned the general public about the risk of investing in cryptocurrencies. Among other things, cryptocurrencies:
• are not legal tender (i.e., it is not legal money)
• can be difficult to sell or exchange
• can fluctuate in value significantly
• are susceptible to theft through hacking
• are repeatedly the source of fraud or a scam
To learn more about the risks of investing in cryptocurrencies visit getsmarteraboutmoney.ca, a Canadian investor focused resource that contains useful information about cryptocurrencies — https://www.getsmarteraboutmoney.ca/invest/investment-products/cryptoassets/
Robo-Advisers
Robo-advisers are digital platforms that provide automated, algorithm-based financial planning services with little to no human interaction. A typical robo-adviser collects information from clients about their financial situation and future goals through an online survey, and then uses the data to offer advice and/or automatically invest client money.
In some parts of this word, robo-advisers provide financial advice or investment management online with no human intervention. In Canada, however, this is not the case because such services can’t be entirely automated and must have a human adviser involved in the decision-making — though communication will not normally involve the face-to-face meetings and regular personalized contacts that are typical of traditional financial advisory services.
The primary advantages of using robo-advising services are lower fees and ease of access. While the primary disadvantages include lack of personalized service and lack of face-to-face communication.
The learn more about robo-advisers, including if such a service is right for you, review the Guide to Online Investment Advisers published online at getsmarteraboutmoney.ca, a Canadian investor focused resource that contains useful information — https://www.getsmarteraboutmoney.ca/plan-manage/getting-advice/finding-an-advisor/guide-to-online-investment-advisors/ .
Easy Action Steps
1. Take the time to truly understand your financial goals before investing or making changes to your investments. Just because the markets change, your portfolio shouldn’t, unless your situation has changed (e.g., marriage, divorce, death, job loss).
2. Take a good look at the risk level of your investments. Most of us think we can handle more risk when markets are doing well but, when markets decline, too many sell and realize a crushing loss. You’re better off being in a safer investment if it will help you sleep at night.
3. Make a point of finding out what your professional is charging you. If they’re evasive or make you feel uncomfortable, shop around for a second or third opinion.