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The Smart Canadian Wealth-Builder: Chapters 14 to 18, Understanding InvestmentsCHAPTER FOURTEEN: FIXED-INCOME INVESTMENTSClick HERE to buy the book!
"Before contemplating actual investments, we need to become familiar with the various investment options available, and their associated risks. We'll go slowly. This subject can be overwhelming for the novice investor. There are literally thousands of investment options in existence. By grouping them into main categories, they become easier to understand. Given your concerns, Jenny, you'll probably be at your most comfortable with our first category -- the various Fixed-Income Investments. As the name implies, these investments will produce a yield or fixed-income which is largely predictable. Let's look at the main ones:
"So, Grandpa, you're saying that all these types of investments are really safe, and if we invest in them, we're not likely to lose our money. Is that right?" asked Jenny. "That's right, Jenny, but keep in mind that because they are safe investments, they don't earn you very much. In fact, remember what we discussed about the impact of inflation on your investments? If all your money were for example, in only government bonds, you would be very lucky over the years to even keep up with inflation. So yes, all of these investments are safe, slow and steady earners. On the other hand, they don't contribute substantially to growing your wealth much beyond covering the effect of inflation. If we're to achieve financial independence, we'll need to at least balance these safe investments by also investing in products that can earn us more." "Sounds like you're still suggesting we risk a good part of our hard-earned money, Grandpa. Why not just go to Vegas and take our chances there?" asked Jenny. "By the time I finish explaining in detail the other investment options, Jenny, I think you'll agree that investing in a prudent manner is nothing like the gamble you'd take in Vegas. Look at it in terms you're both familiar with. When you play cards with the family, you're holding a hand with cards of various values. You try to build up a solid winning hand (a portfolio). To do this, you want some high-value aces and face cards (high-risk) which will net you higher points, but if caught with them in your hand at game end (market downturn), it could result in a loss. The boring lower-value cards (low-risk) won't add up to a lot of points (interest), but they also won't lead to huge losses. To win the game (a comfortable retirement), you need, and try to achieve, a balanced hand." "Cards, I understand," commented Jenny. "But with cards I'm only playing with points, not my retirement funds."
"Grandpa, how do you know when you have achieved financial independence?" asked Kevin. "I'll give you my definition, Kevin. It should work pretty well for most of us."
FINANCIAL INDEPENDENCE exists when, without having to be employed, one earns sufficient income from investments, pensions, or other sources, to maintain a desired lifestyle. "I mentioned earlier that bonds are such an important investment option for any portfolio, that they're worth a more detailed examination. Let's talk more about them right now." CHAPTER FIFTEEN: BOND INVESTMENTSA BOND is a debt instrument. It is used by governments, municipalities, and corporations to raise capital. It represents both a promise to pay periodic interest at a set rate (coupon), as well as a promise to repay the principal on a specified date (maturity). "An investor who buys a bond becomes a creditor of the issuer; he is not a shareholder. A bondholder has a priority claim over that of a shareholder, on an issuer's income. This means that a bondholder must receive his interest payments in full, before any dividends can be paid to a shareholder. Every bond has a par value, set by the issuer. PAR VALUE of a bond is the predetermined amount to be paid out on its maturity date. When an investor buys a bond, the price he pays may be above or below par value. This is because the prevailing interest rates in the market may have changed up or down since the bond was first issued. If comparable-term interest rates have decreased since the bond was issued, then the bond will be more valuable and priced higher than when first issued. This is because the interest rate paid on the bond is now more attractive than that of the general market. In this situation, a bondholder who bought at issue date, could sell his bonds for a capital gain." "Whoa, Grandpa!" exclaimed Jenny. "What exactly is a capital gain?" A CAPITAL GAIN is the increase in value of an asset, from its purchase price to its selling price -- not taking into account either interest or dividend payments. "Let's look at the other side of the coin. If interest rates have increased since the bond was issued, it will now be worth less. If this occurred prior to its maturity, and the bond were sold, the selling price would be below its purchase price, to make up for its below-market interest rate." "I guess in that case you would have a capital loss?" asked Jenny. "Exactly, Jenny. But keep in mind that you can avoid the loss by holding on to the bond until its maturity date." "To put all this another way, the interest rate (coupon) attached to a newly-issued bond does not change throughout the bond's life. The original purchaser, and any subsequent buyers on the resale market, will always receive the same pre-determined interest payment. However, the effective interest rate of the bond will change as, until maturity, its market value slides up or down relative to its par value. As you might expect, a bond's market value will approach par value as the maturity date nears. That is because, regardless of prevailing market interest rates, par is the value payable to the bondholder at maturity." "Grandpa, this is a tough one. If we were on a golf course, I'd definitely understand 'par'. I think I understand, but could you please clarify in simple terms, the value movement of bonds, just to be sure?" asked Kevin. "I'll be glad to, Kevin. The key principle to remember, is that individual bond values will fluctuate up or down over time, generally in the opposite direction to changes in market interest rates. These fluctuations matter little to the bondholder if he holds the bond to maturity -- as long as the issuer remains financially sound." "Financially sound? Does this mean that when I invest in a bond, I could actually lose not only my interest earnings, but even my capital investment too?" asked Jenny. "Unfortunately, Jenny, the answer is yes. There are some circumstances under which a bondholder can lose. But with a little care, the risk is minimal:
"When buying an individual bond, it's very important to carefully consider the credit rating of the bond issuer. Bond ratings range from AAA (highest quality) to D (highest risk). If an investor seeks a very low risk to his bond-generated income and invested capital, he should probably avoid individual bonds with a rating below AA." "Sounds a lot like school," observed Jenny. "Aim for an A, avoid a D!" "And I," added Kevin, "cannot believe anyone could be tempted by something called a 'junk' bond!" "You're right, Kevin. Investing in an individual junk bond would be sheer folly. But what some investors do is buy a fund holding a large number of such bonds. This reduces the risk of individual bonds failing. Because of their high risk individually, such bonds pay very high interest rates. The much higher average yield of the corresponding bond funds makes them attractive to some investors. I personally, would never put more than 10% of my total bond holdings into such funds." "There is a category of bonds that can protect the long-term investor against the risk of inflation. In Canada, these are called Real Return Bonds (RRBs). RRBs are similar to regular bonds in all respects but one. The interest rate they pay floats at a fixed percentage above the official rate of inflation. Hence the protection from inflation. RRBs are not great investments when inflation is low. But because their interest rate is pegged at a constant percentage above the rate of inflation, they will outperform regular bonds when inflation is high. Several notes of caution with RRBs:
"Another bond category with which it is useful to be familiar is known as the Strip Bond. Also known as zero-coupon bonds, they differ from regular bonds in that they pay no periodic interest. The interest coupons have been stripped from the purchase price of the bond. An investor buys strip bonds at a discount to the bond's face value, which he will receive at the bond's maturity date. The difference between the purchase price and maturity value is the investor's return. Federal, provincial, municipal, and some corporate bonds are available as strip bonds. Terms may range from less than a year to several decades. Some investors like strip bonds because, not needing an ongoing interest income, they are happy to defer it. They prefer to have the foregone interest reflected in the cash value of the bond at its maturity. An investor can buy this bond and forget it, knowing precisely how much he will receive at a future date. Even though payment of interest is deferred to maturity, these bonds should not be held in taxable accounts. The investment will be taxed as if interest were received annually. These bonds can be a useful investment component of a tax-sheltered account such as an RRSP or RESP. As an example, a family celebrates the birth of a child. An RESP account is immediately established. A deeply-discounted strip bond with a 17-year maturity date is purchased for the newborn's RESP account. This provides a safe and fully-predictable value when the child is ready to begin post-secondary studies."
"Grandpa, instead of buying just one bond, can't you hold a bunch of them so that you don't have all your eggs in one basket?" asked Kevin. "I'm thinking that if you spread your investment among several bonds, it would reduce your risk, and reduce the pain of any one bond failing." "That's a very good observation, Kevin. Just like my reference to junk bonds, there are easy ways of diversifying your bond investments:
The upside of owning bond funds is that you achieve broad diversification and reduce risk. The downside however cannot be ignored, and must be carefully evaluated:
The consequence of this difference between individual bonds and a bond fund is twofold:
"Whether you buy individual bonds or bond funds, they serve not only as a solid fixed-income investment, but also, as a great hedge against major downturns in the stock component of your portfolio. When stock markets trend downward, it's generally the result of a sluggish economy, and poor corporate performance. In such circumstances the Bank of Canada tends to lower interest rates. As we've discussed, when market interest rates go down, bond values tend to go up -- because the interest rate at which they were purchased has become more valuable to the new investor. In addition to their other benefits, this stock-market-balancing feature of bonds and bond funds makes them a key component of a well-balanced investment portfolio." "Thanks, Grandpa, for explaining this so thoroughly," acknowledged Jenny. "I know this is kindergarten stuff for you, but for Kevin and me, it's all brand new. We appreciate your patience." "No problem, Jenny. I enjoy sharing this information with both of you. If you really do grasp the basic principles, then every minute we spend on this is worthwhile. You'll find it much easier to manage your lifelong wealth-building efforts. Shall we continue? Since I've just mentioned stocks as an investment option, we may as well discuss them next." "It just may bring me to my knees, Grandpa," moaned Jenny. "But if you take it slowly, maybe it'll get easier." "I've just three words for you, Grandpa," added Kevin. "Simplify, simplify, simplify!" "I'll do my best, Kevin, without overlooking anything important." CHAPTER SIXTEEN: STOCKS (also referred to as EQUITIES)A COMMON STOCK or SHARE, denotes an ownership position (called equity) in a corporation. "A common shareholder has a claim on the profits and assets of that corporation. He in fact, is one of the owners of the company. His ownership interest is in proportion to the number of shares he owns relative to the total number of shares issued. For example, if he owns 1% of the shares, he will have a 1% claim. Common stocks also provide voting rights to shareholders on certain, major corporate decisions." "The risk vs. benefit spectrum of equity investments (stocks) has the widest range of any investment we have yet discussed, except perhaps for 'junk bonds'. Generally, the higher the risk-profile of a stock, the more volatile its trading value. It's therefore worth some extra elaboration to help you understand this trade-off for various types of stocks." "Grandpa, I actually heard of something called a 'Large-Cap' bunch of stocks. What are they?" asked Kevin. "Interesting that you've heard of them, Kevin. They aren't exactly everyday vocabulary. There are actually three broad categories of common stocks. 'Large-Cap' is one of them. By the way, 'Cap' is an abbreviation for Market Capitalization." MARKET CAPITALIZATION is a company's share value, multiplied by the number of shares it has issued. COMMON STOCKS -- THREE BROAD CATEGORIES"Because fund companies tend to use these definitions, it is important that the prudent investor at least be familiar with these three categories of common shares. In order to select the investment category that is right for his level of risk-tolerance, an investor must understand the differences. 1. Large-Cap Shares ($$$$$)A LARGE CAP corporation is a long-established business, among the largest of publicly-traded companies. Although definitions vary widely, it will usually have a market capitalization of over $10 billion. Many corporations in this category pay regular dividends to their shareholders. Often, large-cap shares will be referred to as Blue Chip stocks. In Canada, approximately thirty companies fall into this large-cap definition. While there are no guarantees of positive performance with any common stock, large-cap stocks tend to be the least risky of the three categories, particularly if held over an extended number of years. This is especially so for those that pay dividends. Dividends provide shareholders with regular cash payments which, when added to market-value increases of the stock itself, serve to enhance the overall return to the shareholder. Dividends also serve to moderate the effect of periodic market-value declines in the stock. 2. Mid-Cap Shares ($$$)A MID-CAP corporation's capitalization will generally fall between $2 billion and $10 billion. Mid-cap shares are those of generally solid companies, with the potential to become large-cap corporations. Some may show phenomenal growth and hence great market returns. Others are susceptible to major negative value swings. Some mid-cap shares may also pay dividends. If an investor selects carefully, or is lucky, or perhaps both, he may receive great returns from mid-cap stocks, even in a short-to-medium investment period. However, value volatility risk will tend to be greater than that of large-cap companies. To reduce the downside risk of individual mid-cap stocks, an investor is wise to moderate his risk by using either actively or passively-managed funds. Such funds provide broad diversification across many such companies, and hence reduce the volatility and risk of individual investments. As I said earlier, we'll deal separately with the important subject of funds, and key differences between them, when we discuss the broad category of mutual funds. 3. Small-Cap Shares ($$)SMALL-CAP companies typically have a market capitalization of between $300 million and $2 billion. Small-cap share values will tend to be the most volatile. They are therefore riskier than investments in both large-cap and mid-cap companies. Small-cap companies are very unlikely to pay dividends. The prudent investor with a somewhat conservative risk-tolerance, would be wise to place only a relatively minor portion of his portfolio in this category. Again, broad diversification through various funds is advisable."
PENNY STOCKS"This is a fourth common stock component of Canadian equities. This category is highly volatile and extremely risky, relative to the three I've just outlined. Although the conservative investor is not likely to invest in penny stocks, it's useful to understand what they are, along with their risk and potential reward. PENNY STOCKS, as the name implies, are those with an individual share value of less than one dollar. As you might expect, penny stocks represent the riskiest end of the spectrum among common stocks. In Canada, they trade primarily on the TSX Venture Exchange. Sometimes you get lucky. For instance, you happen to buy a stock in a fledgling mining company, at 80 cents a share. Suddenly, because the corporation has just announced a major new find, the value zooms to over $8 a share. Very excited by your savvy investing, you're tempted to buy more penny stocks to add to your net-worth. Unfortunately, this winning example is little different than the one-in-a-thousand luck of the individual who hits a jackpot in Vegas. It can happen, but it's very unlikely. Far more penny-stock corporations fail financially, with major losses to their shareholders, than succeed dramatically. On the other hand, many current large-cap companies, such as Canada's own Research In Motion (RIM), founded in 1984 by two university students, once started as a penny stock. Now trading at over $65 a share, it enjoys the highest market capitalization of any equity listed in Canada. Occasional success stories of this nature represent for their original investors, the equivalent of a major windfall. Such examples serve as a beacon for other hopefuls in today's penny-stock market. Unless you are particularly knowledgeable about a specific company, its business, its market, and most crucial, its management, it is generally wise to refrain from investments in penny stocks. Buying penny stocks is often closer to gambling than to investing." "That's what's so scary," observed Jenny. "Even though they call it investing, I've heard of some people who practically throw away their futures on a hodge-podge of what they call 'investments', when what they're really doing is gambling." "You and Kevin won't be among those 'gamblers', Jenny. You're already asking the right questions. Despite the high risk, the lure of even a slight potential for an astronomical return causes a significant number of investors to buy penny stocks. Understandably, this tendency is welcomed by fledgling and start-up companies. Such investments are an important financing vehicle for them. With little to no established track record, issuing bonds is next to impossible. The equity market therefore becomes their main source of both initial funding and expansion capital."
DIVIDEND-PAYING STOCKSA DIVIDEND-PAYING STOCK is one which pays a regular cash distribution to shareholders. "As we saw, penny stocks are at the highest end of the risk spectrum. At the opposite end of that scale are dividend-paying stocks which over time, tend to have the lowest portfolio-risk of any common stock investment. Historically, dividends have accounted for more than 40% of the overall returns of the Canadian S&P/TSX Index. Dividend-paying equities are much better long-term risks because:
"An investor must realize however, that despite these advantages, dividend payments of individual corporations are not guaranteed. A company can reduce or eliminate dividends at any time, particularly if it encounters difficult economic circumstances." "How do these companies decide when to pay a dividend to shareholders, and how much to pay?" wondered Jenny. "It's a major decision, Jenny. The Board of Directors of a corporation must first decide whether it's financially strong enough to pay a dividend. In determining its magnitude, the Board must take into account capital requirements for future growth, and the company's ability to withstand economic downturns. Perhaps most important, the Board must weigh the corporation's continuing ability to sustain or increase the dividend in future years. It knows the market will react very positively to a new dividend announcement. On the other hand, it will react extremely negatively, to future decreases or worse, elimination of a dividend."
"An added advantage of owning individual dividend-paying stocks, is that many such stocks offer the investor a Dividend Reinvestment Plan (DRIP) option. A DIVIDEND REINVESTMENT PLAN (DRIP) offers an investor the option to automatically reinvest all dividend payments toward the purchase of additional shares. No commission is charged for these additional share purchases. Effectively, your current dividends will generate more dividends in the future, through the extra shares bought in this manner." "Is this another example of compounding at work, Grandpa?" inquired Kevin. "Absolutely, Kevin! The extra shares acquired in this manner pay dividends, which in turn buy more shares which pay more dividends, and so on until you sell that particular investment. It's a great example of compounding at work. And here are a few other features of Dividend Reinvestment Plans (DRIPS) which are worth noting:
"This is more like it, Grandpa," enthused Kevin. "I invest enough to meet the minimum share requirement, then just like watching dandelions re-seed themselves, my number of shares keeps increasing. Cool." "It is cool, Kevin. Now you'll understand that I wasn't being insulting when I told you that all of your present portfolio investments are DRIPS." PREFERRED SHARESPREFERRED SHARES issued by a corporation yield a specific dividend which must be paid to its preferred shareholders, before any dividends may be paid to its common shareholders. "Unlike dividends on common shares, dividends on preferred shares must be paid. They are a contractual obligation. If their payment is suspended due to economic difficulties, the company will be considered to have defaulted on its obligation. It will be prevented from paying any dividends to its common shareholders until after the default is first remedied to the preferred shareholders.
"You're kidding! The owner of preferred shares owns part of the company, receives a more or less guaranteed dividend payment, but has no say?" questioned Jenny. "And the common-shares holder also owns part of the company, receives a slightly less secure dividend payment, but gets some say," continued Kevin. "Weird!" "Because of their preferred-dividend feature, the market prices of these shares tend to be less volatile than those of common shares. On a risk scale, preferred shares would fall between the somewhat riskier dividend-paying common stock of the company, and its more secure corporate bond. Due to their slightly-higher risk profile compared to bonds, the yield (dividends) on preferred shares will tend to be somewhat higher than the yield (interest) on the same company's bonds."
"Grandpa, you've mentioned funds as an effective way to diversify investments," commented Kevin. "Can I presume that this includes all these different stock investments too?" "Yes, Kevin. A huge variety of funds exist for pretty well all the products we've talked about since our discussions first began." "This might be a good time to stop today. But when we return next Saturday, it makes sense to spend some time better understanding these funds. Usually they're called Mutual Funds." "We're in mutual agreement about calling it quits for today, Grandpa," agreed Jenny. "My brain is just about overflowing! It's been interesting. But I'm curious. What about real-estate related investments? Way back when we started these discussions we talked about Great-Grandma and Great-Grandpa investing in real estate. How does that fit in with all these financial options?" "You're right, Jenny. We should cover that subject too. Real estate investments are an important way of adding to our net-worth. We've talked about it, but only as it related to ownership of our personal home. Since you've raised the subject, let's delay our discussion on mutual funds, and instead begin with a discussion of real estate investment options when we meet next Saturday. Then we'll return to understanding mutual funds as an investment vehicle. How about lunch first, as usual? See you around noon?" "No argument there, Grandpa. Thanks. See you then," echoed Kevin and Jenny. CHAPTER SEVENTEEN: REAL ESTATE INVESTMENTS"Here it is, our fifth Saturday already. I don't know about you, but I'm impressed by the number of topics we've discussed." "Just don't expect us to pass a test," retorted Jenny. "It's so beautiful outside, what do you say we have our chat in the fresh air, on our balcony?" "Great idea, Grandpa," replied Kevin as Jenny nodded her head in agreement and led the way to the outdoor deck. "For starters, remember we agreed that generally, we buy our own home primarily as a comfortable and secure place to live? Only secondarily do we view it as a proven, excellent long-term investment. There are however, a number of other options for investing in the real estate sector, in which our primary purpose may well be the potential investment value. In some cases it may be a fortunate combination of both personal enjoyment and the expectation of long-term appreciation." 1. THE SECOND HOME"Long a favourite of many Canadian families is the second home -- in most cases, a cottage. About 9% of Canadian families own a second home. As with a family home, most second homes are bought primarily for family lifestyle. However the investment value may play a greater role in the purchase decision, than it does with a primary residence. Canadians are well aware that cottages, particularly those on a waterfront, have over the past decades, increased dramatically in appeal, and therefore, value. Many have in fact, shown a capital appreciation often greater than that of the owner's principle residence. Once a homeowner's main residence is substantially mortgage-free, purchasing a cottage property can bring great satisfaction to the family, as well as superb long-term growth in the homeowner's net-worth." "I'd love to be able to afford a getaway cabin one day," mused Jenny. "I remember how much fun we had when we rented them for family vacations." "Well, I'd rather have a little ski shack," reflected Kevin. "Hey, Jenny, you get the summer place and I'll get the winter one. That way we'll have one of each in the family!" "It costs nothing to dream. Not only is a second home both a getaway haven, and a great investment, but it can also work for you, by earning income. It could be rented out when not in use by family. You could even be fortunate enough to not only cover your ongoing operating and maintenance costs, but also put a few extra dollars in the bank." "Because your country cottage, ski chalet, city condo or farm getaway is a second residential property, tax issues will force you to make a key decision when selling."
"When you sell the property you have designated as your tax-exempt primary home, you are not required to report a capital gain on the sale. However, if you subsequently sell your other home, you must report, after all costs and improvements are factored in, any profit on the sale. You will then be assessed the capital gains tax on that profit." CAPITAL GAINS taxes in Canada are currently assessed at your marginal tax rate, on 50% of the increase in capital value of your investment. "Grandpa, it'll be a long time before either of us have one home, let alone two! But just in case, how would we decide which home to select as tax-exempt?" asked Kevin. "Most likely, Kevin, you would exempt the one that had gained the most in value. But the best idea is to consult with an accountant just before you make the first sale. That way he can point out the tax consequences of choosing one home over the other, and guide you in the correct procedure to follow."
"By the way, interest or dividends earned on investments are taxed differently. They are not included in the calculation of capital gains. Of course as we have discussed, if your eligible capital asset is held in an RRSP or a TFSA, any capital growth, interest, or dividends, are not taxed within either plan." "By 'capital asset', Grandpa, do you mean only financial investments, or can Kevin's ski shack or my cottage also be held in an RRSP or a TFSA?" asked Jenny. "I should have been more clear, Jenny. No, a real estate asset cannot be held in either a TFSA or an RRSP. However, under some circumstances, a first mortgage in a real estate property may be included as an RRSP investment. Before considering that however, it would be wise to consult an accountant to make sure that your mortgage qualifies, and that you follow the complex rules imposed by the Canada Revenue Agency on such a registered investment." 2. RENTAL-INCOME PROPERTY"Think back to our early get-togethers, when we chatted about your great-grandparents' investments in rental properties. Because of their underlying property value and rising income stream, they were an excellent long-term investment. Over the long term, a rental property's value should increase in roughly the same proportion as personal residences in the same area. As always, several cautions are appropriate:
3. MORTGAGES"Mortgages as an investment can be made available on a direct basis, to both individuals and developers. More common however, is the purchase of a share in a pool of mortgages managed by a third party such as a mortgage fund. Many companies, large and small, exist for the sole purpose of lending funds as mortgages. These firms may choose to invest in first mortgages, second mortgages, or a combination of both. By creating a pool of funds, raised from individual investors, the mortgage fund managers acquire the necessary financial resources. An ownership share in a pool of mortgages reduces investor risk through diversification. These mortgage-based investments can produce impressive returns for the investor, at times in the 9 to 12% annual range. Again, a few cautions:
"Kevin, are you thinking the same as I am?" asked Jenny. "We'll probably be old and retired before we can handle more than our own mortgage, let alone invest in someone else's." 4. REAL ESTATE INVESTMENT TRUST (REIT)A REIT is a corporation or trust that uses the pooled capital of many investors to purchase and manage income-property (an equity REIT) and/or mortgage loans (mortgage REIT). REITs can be bought as individual stocks in either a corporation, or an individual trust. Again, maximum diversification will be achieved if these products are bought as a REIT Index Fund, such as the iShares CND REIT Sector Index Fund (XRE). REIT investments offer an investor a number of advantages:
Investors must accept however, that despite the promise of attractive yields at time of purchase, the returns will fluctuate over time, as will the value of the investment itself. REITs therefore are not a fixed-income product. For some investors, their potential for much higher yields may compensate for the higher risk level." "Jenny, maybe investing in a REIT is the closest we'll ever get to being landlords," mused Kevin.
"It's important to understand, Jenny and Kevin, that in no way have our discussions exhausted all of the many and varied investments available to investors. In addition to those we've touched upon, there are many other, often very complex investment options, such as:
"Grandpa, my eyes are crossing!" exploded Jenny. Don't let it worry you, Jenny. Actually, my advice is to always stick to the KISS principle of investing: "That doesn't sound very politically-correct, Grandpa," retorted Jenny.
"Wow, Grandpa, there's a lot more to this investment game than I thought!" exclaimed Kevin. "Now I'm beginning to understand why so many people get confused, and why so few of us do really well with our investments," added Jenny. "You are both so right. It can be very complicated. What is important right now however, is that you gain a sufficient understanding of the investment categories we've discussed. This will equip you in future, to more intelligently decide the best fit for both your own investment plan and your risk profile. I promise that when we finally begin to discuss your personal investment decisions, I'll share with you some simple techniques that should serve well over the long term, to help you make smart and uncomplicated investment decisions." "Grandpa, the word 'simple' is music to my ears. But I really hope you're keeping good notes for your book," interjected Kevin. "It's for sure we'll need it!" "Grandpa," added Jenny. "You really have talked a lot about investment risk. I'm not sure though I really understand how anyone can actually manage that risk. Can you tell us how a person can deal with risk and still be able to sleep at night?" "That's an excellent point, Jenny. It's almost impossible to separate investment and risk. And since you raise it, I think it would be appropriate to discuss that topic now, before we turn to my long-promised mutual fund discussion." CHAPTER EIGHTEEN: INVESTMENT RISK"Jenny, hopefully I'll now answer your concerns on risk, and help you see how an investor can understand and manage the role it plays in making investment decisions. Remember, we agreed that if we're to grow our net-worth by much more than the level of inflation, prudent measures of risk are necessary in our investments. But to be ready to assume that risk, we must understand it. We must know both how to balance it against its potential benefits, and when to vary our level of risk-tolerance. First you need to understand the risk-versus-benefit tradeoff, over the long term. These figures show the actual, compounded annual rates-of-return for different Canadian investment categories, over the 67-year period between 1940 and 2007:
By comparison, during this same period annual inflation in Canada averaged 4.0%. The next set of figures shows the growth of a single Canadian dollar invested in 1940, in each of these three categories. It assumes that all income from each investment was reinvested annually, through to the end of 2007. This example is for illustrative purposes only since realistically, one would be unable today to invest only one dollar.
These results show the huge incremental returns achieved by stocks over an extended time-frame, as compared to those of the much lower-risk bonds and T-Bills." "By the way, Grandpa, this looks like another example of the power of time and compounding. It sure works miracles," observed Kevin. "You're so right, Kevin. It's the power of compounding that makes all three of these growth figures so dramatic. Despite the benefits of compounding, did you notice the compelling differences in value growth between the three asset classes? As you both made abundantly clear throughout our discussions, you acknowledge the importance of controlling risk in any investments you make. Given that none of us is too likely to be dealing with a 67-year investment time-frame, we need to strike the right balance for us, between risk and potential return." "You'd better believe it, Grandpa," exclaimed Kevin. "I'll be lucky 67 years from now, if I can remember the name of my bank, let alone what I have in it!" "History shows us that equities, while providing a dramatically higher return over the very long term, have much greater volatility over shorter time frames. We need therefore, depending on our stage of life and investment horizon, to balance our investment portfolio to produce what is for us, an acceptable level of risk." "Grandpa, you've convinced me that we have to take some risk when we're investing," said Jenny. "But I still don't have the faintest clue how I'll get a good night's sleep. I'll be a nervous wreck!" "I think this next part of the discussion should help chase away those nightmares, Jenny. Controlling risk effectively may at first seem a daunting task. You'll be relieved though, to learn that investment risk can be broken down into simple, individual risk elements:
Each of these individual elements is easy to understand; most are easy to manage. Let's examine these risks one at a time, and see what we can do about reducing their negative impact on both your portfolio, and your peace-of-mind." 1. EXPENSE RISK"We've all heard that 'location, location, location' is the single-most important criterion when buying a home or an investment property. By the same token, when making financial investment decisions, perhaps the three most important considerations over the long-term are 'expense, expense, and expense'. Let's elaborate, using a real-life example: Remember our young friend, Sam? Let's say she inherits $100,000. She wishes to invest it for the long-term, in a well-diversified, Large-Cap fund. Sam has narrowed her choices down to either an actively-managed mutual fund, or an exchange-traded fund. The management expense ratio (MER) on the actively-managed fund is 2.5%. On the exchange-traded fund it is 0.5%. We'll define all these terms in our pending discussion of mutual funds. For now, it simply indicates the difference in fees that Sam will have to pay for the management of her potential investment. We'll make the assumption that over the 40 years before Sam retires, both funds will be able to achieve an average annual return of 7.5%, before expenses. This is a reasonable expectation in view of the very long-term time frame. At the end of 40 years, a comparison of the two options shows Sam the difference in end-values:
Earlier we learned about the positive power of compounding. However, compounding can either work for you, or against you. In this example, the adverse compounding effect of an extra 2% annual MER cost ends up eroding more than half the potential return on Sam's investment. The extra annual 2% management fee in this example, would cost Sam $793,000 over a 40-year investment time frame. Another way of looking at this, is to conclude that by reducing her investment expense by 2%, Sam could more than double her total investment gains over a 40-year period. The message in Sam's case is a simple one, and leads to the next tip."
"When we talk about investment costs, MER costs may not be the only expense. We have to include all other costs such as:
To minimize the potential high costs of investing in stocks and in many funds, online discount brokerages are available. Using a discount service can result in the cost of your purchase or sale being as little as one-tenth that charged by a full-service broker." 2. ADVISOR RISK"Given the relative complexity of the investment world, it's understandable that many of us prefer or require financial planners or investment advisors to assist us." "Ha!" interjected Jenny. "Here I am having a nervous breakdown about all of this, and you call it 'relatively complex'?" "Financial advisors or planners can be very helpful. Unfortunately however, we often end up consulting an advisor who also sells financial investment products. He is both an advisor, and a vendor of specific products from which he earns fees. Even though, by law, any potential conflict of interest must be revealed to the investor, it is often glossed over by investors themselves as being not terribly important. The conflict however, does become an issue if the advisor guides the client toward an actively-managed mutual fund for example, when a comparable product, such as an exchange-traded fund also exists, but at a much lower cost. The advisor can't be blamed for encouraging clients to invest in one of his mutual funds. That fund gives him an initial purchase fee, as well as an annual trailer fee of perhaps 0.5% of the entire value of the investment, for as long as the client holds it." "That's probably why," quipped Jenny, "I've heard the comment that even as your mutual fund is crashing in value, your financial advisor may be buying a new set of luxury wheels!" "Grandpa, would 'Buyer Beware' be another of your famous tips?" asked Kevin. "To be fair, Kevin and Jenny, advisors are generally very honest individuals, trying to earn a living. Simply put, unless they are truly independent, they have no incentive for pointing out comparable investment options with much lower fees. Many advisors probably believe in fact that their recommended fund will through better performance, more than make up for its higher fee. If they were correct, then this would be a win-win scenario for both the advisor and his client. We'll examine actual performance differences when we finally get to our mutual fund discussion. Truly independent financial advisors do exist. They do not offer for sale, specific products. Usually you will be charged either an hourly, or a flat fee for their advice. The cost in this case is well worth it. The independent advisor, having nothing more to gain, will provide totally objective input and advice." "Grandpa, you're an anomaly," chuckled Jenny. "You're our advisor, you have nothing to sell, and you're free to boot! What a deal!
3. TAX-EROSION RISK"To refresh your memory, Jenny and Kevin, investments within TFSA or RRSP accounts are tax-protected." "That fact is pretty well etched into our brain now -- but I guess it doesn't hurt to keep reminding ourselves," agreed Kevin. "If however, your portfolio is invested outside these accounts, its value, no matter how well-invested, will be severely eroded by income taxes."
"Let's look at a few facts about income taxes on investments outside TFSA or RRSP accounts:
"So what exactly does this mean for us when we're investing, Grandpa?" asked Jenny. "The simple rule, Jenny, is twofold:
"Before you ask, I'll clarify. Because it is taxed the most severely, an interest-generating investment should be in either a TFSA or RRSP account. It doesn't matter which account, if you are not drawing down the earnings. If however, you are planning to draw income in the shorter term, try to favour your TFSA, because you will pay no tax on your withdrawals. Withdrawals from RRSPs on the other hand, attract full taxes as if they were earned income. That tax penalty is usually mitigated by the retiree withdrawing funds from an RRSP, because he has likely dropped to a lower tax-bracket than when he was contributing." "So in withdrawing funds from an RRSP or RRIF, the retiree will usually pay less tax on the withdrawal than the amount of the tax refund he received when he originally made the contribution? Is that correct, Grandpa?" asked Kevin. "Generally, that's true, Kevin. But remember the original contributions are likely to have grown dramatically over time. More actual tax will eventually be paid on withdrawals, but only because the amount withdrawn will be far greater than originally contributed." "So originally, you might have received a tax refund of 40% on the $10,000 you contributed to your RRSP. Once you retired, your marginal tax rate may have dropped to 28%, but it will be applied to say, the $30,000 that the investment had become?" asked Jenny. "That's exactly the point I was trying to make, Jenny." 4. INVESTMENT-TERM RISKa) Fixed-Income Investment"Generally, your missed-opportunity risk is greater, the longer the term of your fixed-rate investment. Consider for example, a 5-year GIC. Because the return of your principal is guaranteed, your capital risk is zero. However, your interest rate is locked in for the full five years. This means you lose any opportunity to take advantage of higher rates which may become available before your GIC term ends. To partially compensate for this risk, longer-term fixed-income investments usually pay a higher return than those offered for shorter terms." "Fixed-income investments certainly are attractive to those of us who like to feel safe," commented Jenny. "Maybe we just have to live with their being locked in for some years." "There is a way, Jenny, to reduce this risk of locking in for the longer term. You can ladder your fixed-income investments."
LADDERING is the staggering of investment maturities over various terms. "The intent of laddering is to help smooth out the impact of interest rate fluctuations, and to allow a gradual reinvestment at current rates. This strategy also prevents drastic changes to the earnings generated by your fixed-income portfolio. For example, you decide to place $25,000 of your investment portfolio in GICs or bonds. You split it into five individual investments of $5,000 each, with 1,2,3,4,and 5-year maturities. The first matures after one year, the second in two years, and so on, until the fifth reaches maturity in five years. At the end of year one, you will reinvest the now-matured one-year investment (with or without the interest earned) in a new 5-year term. Repeat the procedure each year, with every subsequent maturity."
"As an added benefit, this 5-year laddering strategy also provides for the investor, annual access to one-fifth of his invested capital." "So, Grandpa, if I eventually decided to go back to school for a PhD or something," asked Kevin, "I could crater one-fifth of my GIC investment each year, and still leave the other GICs earning me interest till I need more money the following year?" "That's exactly how it could be done, Kevin."
b) Equity Investments"For equity investments, the risk is different. The shorter the time frame, the higher the risk, whether invested in stocks, or in equity mutual funds. We do know that over many decades, a well-diversified portfolio of high-quality equity investments has consistently outperformed all other categories of investments, by a wide margin. Equity investments, unlike fixed-income investments, have neither an underlying guarantee of value, nor of regular dividend payments. They are subject to the ups and downs of the economy, and to the changing fortunes of individual corporations. Equity market returns in the shorter-term do not gravitate around the high, average long-term gains. Instead, they tend to spike above or below the average. This extreme example will illustrate: In 2008, the TSX Index plummeted by approximately 35%. However, over the preceding 67-year period, from 1940 to 2007, it produced on average, an annual rate-of-return of 10.6%." "This is frustrating, Grandpa," complained Jenny. "If I invest in stocks for a short time, I might lose money. If I invest for a really long time, like my whole working life, I'm likely to make a great deal. But then, because of inflation, it will be worth less anyway. Yikes!" "It isn't as bad as it seems, Jenny. Although time is only one investment risk factor, this TIP may help simplify your decision."
5. LACK-OF-DIVERSIFICATION RISK"Putting all your eggs in one investment basket, or even in a limited number of products, is clearly a higher risk than investing across a wide range of options. Let's consider a few examples:
6. POLITICAL and CURRENCY RISK"If you, as a Canadian investor, were to invest in only one nation's financial products, it should be Canada. That's where you live. That's where you'll spend the benefits of your investments. By sticking to Canadian investments only, you won't encounter exchange-rate risks. You'll be earning returns in the same currency that you spend. Also, if your investment is held in taxable vehicles outside an RRSP or a TFSA, it's important to keep in mind that advantageous dividend tax-credit rules are applicable to Canadian investment products only. Canada, however, represents barely 3% of the world's investment opportunities. By limiting yourself to Canadian-based investments only, you may be missing out on some great growth opportunities. On the other hand, if your investments were to include those of other countries, such as for instance, Brazil, Japan or Germany, you'll add a major new dimension to your risk exposure, namely political and currency risk. Global diversification is worth considering for every long-term portfolio, but only with the appropriate level of currency protection, and with due regard to political risk. Currency risk can be substantially eliminated through Canadian currency-hedged ETFs or other funds. You will pay a slightly higher annual fee for the hedge cost, but you will have eliminated the currency risk. There is no real hedge available, other than wide multi-national diversification, against the risk of, for example, a third-world country defaulting on its government's bond obligations. The prudent investor is wise to ensure that any international fund in which he invests holds only a small proportion of its total investments in the products of less politically-stable countries." "I'm sorry, Grandpa," interrupted Jenny, "you just lost me again. The only hedge I know about is the one in our back yard, and I know that's not what you're talking about. So what is a 'hedge'?" "Sorry about that, Jenny!" A HEDGE is an action taken to protect against an unfavorable price move of an investment product. "Now I understand -- I think," replied Jenny. "And now you'll understand the next TIP."
"Failure to hedge foreign financial products greatly magnifies the investment risk. If an international investment were to decline due to cyclical economic or political upheaval for instance, and at the same time, the currency-value of the investment falls, the double-whammy could be catastrophic for your portfolio. On the other hand, the opposite can also be true. If the international investment value were to increase dramatically, and its currency-value relative to the Canadian dollar were to rise at the same time, you could stand to make a huge return. Relying however, on two key factors moving in the right direction at the same time, is more akin to speculating than to prudent investing.
7. HIGH-FREQUENCY TRADING RISKIn today's world of easy, accessible, and inexpensive online trading, the temptation for frequent trading -- buying or selling of almost any financial instrument -- arises all too often. Many of us, believing in our abilities as independent investors, trade too often, at times making several online trades weekly, or even daily. For the most part, these individuals are not investors. At best they're traders; at worst, gamblers." "This reminds me of another question, Grandpa," interjected Kevin. "Remember on our last trip to Mexico, you were talking with a woman who said she pays for all her vacations with her earnings as a day-trader? Exactly what is a 'day-trader'?" A DAY-TRADER is an individual who buys and sells a financial instrument in the same trading day, and often, multiple times in the same week. "That sure sounds like gambling to me," exclaimed Jenny. "Why would anyone want to take that kind of risk?" "It definitely is not an activity for the faint-of-heart, nor for those who cannot afford to comfortably absorb losses. I'm certain that a very small percentage of day-traders do quite well, but in the greatest majority of cases, trying to outguess the market's movement in such short time spans is not a winning strategy."
"We already know how very difficult it is to time the market properly. The odds of making frequent, successful, buy-and-sell decisions over extremely short time-frames, are very slim to none. This point is important enough to merit another TIP, a corollary to the previous one."
"Etch the following in your brain. It won't let you down:
Prudent investing is not the impatient flipping of investments in a perpetual search for the get-rich-quick fortune. Trying for a quick return is best left to buying the odd lottery ticket or heading to Vegas for a fun holiday. It is not for the prudent investor." "After all this, I doubt I'll have the nerve to buy even a raffle ticket," quipped Jenny.
8. THE 'SURE-THING' INVESTMENT RISK"Unless it's a GIC, or other guaranteed investment, there is no such thing as a sure-thing investment. If someone tells you there is, run the other way fast! By the time the average person learns about a truly exceptional investment opportunity, you can be sure many others are also aware of it. Chances are that by the time you buy in, the price will already have reflected the higher value."
9. MARKET-TIMING INVESTMENT RISK"Regardless of when you make a major investment in the equities market, you are always at risk of making it just before a major downward market correction. This could in the short term, see your initial investment plummeting. No matter how we reassure ourselves that the investment will serve us well over the long haul, such a quick drop in the value of our investment can be traumatic. It may even lead us to doubt the very wisdom of investing in equities. But a simple technique, available to all of us, virtually eliminates that risk. Remember our Pay Yourself First strategy? We talked about combining it with an automatic investment program that regularly diverts 5 to 10% of our gross income to specified investments. This same approach can benefit our portfolio, even during periods of equity downturn. During downswings, our regular contribution to our portfolio will buy a greater number of units of our chosen investment product, at the lower price. This tends to average-down the per-unit cost of our earlier purchases. Once the market recovers and turns up again, our portfolio will recover more quickly than had we not averaged-down."
10. INFLATION RISK"As Jenny continues to remind us, the effect of inflation is a key factor in the actual future value of our investments. We saw how the purchasing power of our investments can be eroded, even by modest 3% annual inflation rates. This impact becomes even more dramatic when continued over several decades. Inflation is a fact of life. For your investment portfolio, it presents such a huge potential risk, that it warrants more emphasis. Investing exclusively in fixed-income instruments presents the real risk that over time, our returns may barely keep pace with inflation. On the other hand, equity indexes, pretty well world-wide, but most certainly in Canada and the U.S., have over the decades, dramatically outpaced inflation. So why not invest everything in either an index-based equity product, or in individual, high-quality equities?" "Trick question, right? I think we answered it earlier, Grandpa," retorted Jenny. "We know there's an added risk from having too many eggs in one asset class, or any other single basket." "You really have been listening! Good for you, Jenny." "And, Grandpa," added Kevin, "we know the three magic words this time.... 'balance, balance, balance' -- a little bit of this, a little bit of that." "Well put, Kevin!" 11. AGE-RELATED RISK"In your 20's -- your early investing years -- your investment strategy is not unduly risky, even if 70 or 80% of your entire TFSA and RRSP portfolio is in equity-based products. This is especially so if the majority of these investments is in dividend-paying equities. At this age, you have the advantage of the magic power of compounding and time. As we have seen, these two factors dramatically reduce risk while at the same time, enhancing your ultimate returns. On the other hand, a 55-year old investor who plans to retire at 60, and who plans to draw on his investments as soon as he retires, will need a much different mix. By this age, his portfolio should have gravitated toward a more conservative investment mix -- perhaps 60 or 70% in fixed-income investments, with only 30 to 40% remaining in riskier equity-based products."
"Over shorter periods of for instance five years, stocks can be highly volatile. The near-retirement individual cannot afford during his last few working years, to risk a significant portion of his portfolio on the possibility of an equities downturn. On the other hand, he must still protect against inflation. Knowing that he may live into his 90's, he still needs to keep a portion of his portfolio in equities, or he risks outliving his funds." "Grandpa, is there some easy formula that we can use to determine the best mix at various ages?" inquired Kevin. "Unfortunately there isn't one that fits everyone, Kevin. We each have different circumstances and personal levels of risk-tolerance. These differences will influence how we build, balance, and manage our individual portfolio. Let's look again at a real example:
For those without a significant pension plan or other safety-net, the reverse will be true." "A public-sector career looks better and better," quipped Jenny. "What do you say, Kevin, should we go for municipal, provincial or federal?"
12. THE LACK-OF-A-PLAN RISK"It's important that each of us, as potential investors, educate ourselves on:
All of this knowledge however, will prove to be of little value if we don't have an individualized plan. Take the vehicle owner who gets into his car. He knows how to drive, but has no idea of where he wants to go, how best to get there, or how long it will take. The driver needs a destination, and a travel plan to reach it. So too, does the investor need both a goal and a plan. He needs to determine his:
These various elements are all part of what is commonly referred to as a FINANCIAL PLAN. A Financial Plan is so critical to an investor's success that we'll make time on a future Saturday to dig in and really understand what we mean by such a plan."
"Grandpa, that's quite an eye-opening insight into investment risk," observed Jenny. "What amazes me, is that when you break risk down into its individual elements, it's so much easier to understand -- and not so scary." "I'm glad you now see that, Jenny. Not only is risk easy to understand, but also, relatively easy to reduce to acceptable levels. As a result of today's rather lengthy discussion, I hope we've laid the foundation for your becoming wise and prudent risk-takers. If you succeed in blending this with the other information you've acquired, you should both become very successful wealth-builders." "Grandpa, you keep teasing us with this 'wealth-building', but we still have to get to the good part -- the actual investing," prompted Kevin. "Patience, we'll get there, Kevin." "Actually, I'm beginning to see how, if I plan it right, I can actually become a millionaire," added Kevin. "But I'm still worried about inflation chewing up the value of my million bucks." "And that's why, Kevin, I said that one million dollars may not be the right objective for you. This will become more clear when we eventually put together a customized financial plan for each of you." "I'll probably be as grey as Grandpa by the time we get around to it," muttered Kevin to Jenny. "I heard that, Kevin! But first, I've been promising we would delve deeper into mutual funds, particularly the pros and cons of actively and passively-managed funds. I think though, you've had enough information for today." "You can say that again, Grandpa!" two voices echoed in stereo. "Let's meet again for lunch before we head back to our place next Saturday. Is that still OK with both of you?" "You've got a deal, Grandpa," replied Jenny. "But if we can talk about something other than wealth-building during lunch, we'll buy you the dessert!"
UNIQUELY CANADIAN -- A PRACTICAL STEP-BY-STEP GUIDE TO WEALTH-CREATION
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