So now you have some money saved away and you are looking at all the options to put it to work for you. Well, let me tell you that this is the step most people get lost in. There are thousands of different investment vehicles and even more ways to invest your money. You can buy stocks, bonds, etf’s, hedge fund, derivatives, private equities, master limited partnerships, REITS…. And the list goes on.
Where do you start? How can you make sense of all the options? If you’re like I was when I got in the industry you get mesmerized by stocks and stories of people buying a $2 stock and having it go up to $50 and making a killing. This is the holy grail and trust me, it’s what everyone wants. What’s talked about less however, is people buying the $50 stock and having it go down to $2.
I have had many people over the years say to me they look at investing like gambling. People are afraid of risk and let’s be honest, no one wants to lose money. The interesting thing about having conversations with clients over the years is that people at first start off looking for the highest returns and say they are comfortable taking risk and they can handle the market fluctuations. That is, until the markets go down.
The biggest flows of money into the mutual fund industry in the US was in 2007 and the beginning of 2008 which was the top of the market. And then the biggest flows out of the mutual fund industry was in the spring of 2009… the bottom. What this means to me is that the majority of average investors took on more risk than they could handle and likely didn’t understand what it is they were invested in.
A major lesson we all need to learn is that we can’t control the markets, they will do what they are going to do and NO ONE can accurately predict them with any real consistency. The financial services industry is full of analysts that try and tell you they know what is going to happen but be very wary of this advice. They might tell you they will pick you the best performing funds but research shows, that last years best performers are rarely next years.
So where does that leave you with your savings?
The first step is understanding the basics, and then control that which is in your control. You can control how you are invested and you can control the price you pay for those investments, that’s it.
So let’s start with the first thing within your control and make it simple. I know this is going to be an overly simplistic breakdown and I can already hear the complaints I’ll get about what is left out but bear with me.
There are 3 general categories of investments that you can put your money in! Simple right?
The first thing is cash. This is what everyone is familiar with, it’s the bills in your pocket and the money in your bank account. But what do you mean when you say cash as an investment?
Well, you can put it in a high interest savings account or you can buy a term deposit or a GIC (guaranteed investment certificate) or several other short term notes and cash like alternatives. This is often considered the least “risky” option because your dollar is guaranteed by whoever issued the term or holds the account or note. For instance, you can buy a bank issued 5 year GIC; which means you turn over your money to the bank for 5 years and in return they pay you a set interest amount per year that is usually compounded and paid out at maturity. The range of returns right now on cash (as of October 2015) is 0.60% for a high interest savings account to about 2% for a 5 year term depending on the issuer.
So let’s say you have $1000 and you invest into a 5 year locked in GIC paying 2%. At the end of 5 years you will get your $1000 back plus $104.08 worth of interest. No risk right? Wrong… in 5 years do you think your $1000 will still be able to buy as much as it does today? The risk with low interest rates, is that inflation will erode your principle. Let’s assume inflation is 3%, this means every year you own that GIC you are guaranteed to lose money. The easiest way I find to illustrate this concept is to think back to when you bought your first home, or even when your parents bought their home, what did they pay? And what would you pay today? That’s inflation.
Now that’s not to say cash is a terrible investment, if you need a specific amount of money in a certain time period or to if you need money to fund your lifestyle in the short term, cash is still king and it should be part of everyone’s portfolio.
The second thing you can invest your money in is bonds. Bonds are issued by corporations and governments. This is often an unknown market as it is not generally talked about on the news but if you think of Canada’s federal debt which stands at around $612 billion, this is all funded by bonds.
So what is a bond? Essentially a bond is a loan, you can take that $1000 and give it to the government and in exchange they will give you a piece of paper that says in 30 years they will give you the full $1000 back and they will pay you a certain percentage as an interest payment every 6 months for the 30 years they have your money. Now there are many different types of bonds with lots of different features and maturities but let’s just keep things simple for now.
So what’s the risk? Sounds like a great investment because you will get your principle back and earn interest along the way. Well, there are basically 2 different risks, the first is that the entity that issued the bond goes bankrupt and doesn’t pay you back, referred to as creditor risk.
The second, is that the value of the bond can change between the date it’s issued and the bonds maturity. Because you own a piece of paper you can trade it, maybe you don’t want to hold it all the way till maturity, maybe you need your cash back ahead of time or maybe you just want to buy a different bond. Even though it is not generally discussed on the financial news, there is a market for bonds. The global bond market is actually about twice the size of global stock markets.
And because you can trade it, the value of the bond will change along the way. The change in value is influenced by the demand for the bond, current interest rates and the strength of the issuer. Right now, a government of Canada 30 year bond is yielding 2.36% and you can likely get closer to 5% from a corporate bond as corporations have to pay more to entice investors then the federal government, given they aren’t backed by the taxpayer.
The third thing you can invest in, and what is usually thought of first when thinking about investing, is stocks. All a stock is, is an ownership share in a publically traded company (or a private company but we are keeping things simple for now). Ford, Telus, TD Bank, RBC Royal Bank, Blackberry, Microsoft, Facebook and Apple are all examples of publically traded companies that you could purchase stock in from an exchange.
In its most basic form, as an owner of a stock, you own part of a company and its future profits. If the company makes more money next year then it does this year the stock price goes up and if it earns less money the price goes down. I know that’s overly simplistic, but essentially, that’s what a stock is. There are many other factors that influence price but we won’t cover them here.
The US stock market from 1950 to 2015 returned an average of 11.3%, the Canadian Stock market’s return was 10% over that same period. That doesn’t mean you earned 11% every year as I’m sure you remember the crash of 2008 where the markets lost around 40% of their value, but over an extended period of time, 10-11% is the average.
Now, back to what you can control, you can control how you are invested. The amount of cash, bonds and stock in your portfolio is what is referred to as asset allocation. Which essentially means which assets do you allocate funds to from your savings. Generally, the more stocks you own, the more “risk” you take as their value tends to fluctuate the most. Bond values also fluctuate but as there is an underlying value to the principle that will be paid back, they fluctuate a little less than stocks.
The most important decision you can make is how you are invested! I never recommend to anyone that they hold only one type of investment. In a study published in 2001 titled “Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?,” researchers Roger Ibbotson and Paul Kaplan confirmed that more than 90% of the variation in portfolio return is explained by asset allocation decisions. It’s not the choice of individual stocks or bonds that drives your returns. It’s your asset allocation that makes most of the difference for you in the long run. As the saying goes, it’s never wise to put all of your eggs in one basket.
How you invest your savings is a very personal choice and it depends on a multitude of factors. The most important being what is the money for and when is it going to be needed. The shorter time horizon you have, the more conservative you should be, and by conservative I mean the more cash and bonds you should hold. If your time frame is less than 5 years, it’s probably wise to own very little stock if any at all.
The investment industry does a bad job I think of explaining risk to people. We say “conservative” investments or “aggressive” investments and the more “aggressive” you are the higher your returns will be. But in the world of the financial industry, being more “aggressive” just means you own more stock, and this doesn’t guarantee higher returns based on your time horizon. Being “conservative” means you own more cash and bonds but again, this doesn’t guarantee returns.
So what is risk? I define risk as the potential for your money not being sufficient to fund your needs and your lifestyle when you want it to. At the end of the day, money is meant to be used, spent and enjoyed. As great as having an investment account is, it’s that experience, or that time that money buys you, that really matters.
As I have highlighted above, there is “risk” in whatever you do. The trick is to find the balance that works for you and your situation. I recommend that you sit down with a financial planner when setting up your investments to make sure you go through your needs and wants. It is very important to find someone that has integrity and that isn’t just trying to sell you whatever their company offers. I recommend dealing with someone that has a large range of products to offer so that there is less chance of conflict in what they recommend to you.
The last thing you can control is cost, and there is always a cost. The financial industry is extremely complex and so are the fees that get charged for the varying products they sell. Make sure you understand what you are paying and what value you are getting in return. As with anything, the cheapest option isn’t necessarily the best but there should be no need in this competitive world to pay more than you have to. Also, investing isn’t like shopping, just because you are paying a high price, doesn’t mean you are getting a premium product! I will talk more on fees in a future post.
Hopefully this post has demystified the world of investing a little bit. My goal here has been to outline the basics and then we will go deeper into the many options out there.