Fun day in the beautiful city of Toronto. There’s a 30% chance of precipitation and brokers falling on Bay Street.
But you’re doing good, because you came here.
So by now you’ve resolved yourself to answering the 8 questions, making a small sacrifice today for a large deferred benefit tomorrow and you’re convinced of the magic of compound interest.
If you need a refresher see the below links.
Part 1: 8 Questions
Part 2: Promises And A Plan
Part 3: Acorns To Oaktrees
So where do you put your money?
How’s your mattress? The swear jar? The piggy bank? Joe Pesci?
There are 2 of 3 characteristics one should look for in an investment if one is to hope to make some decent growth.
It’s hard given the hyperbole of what we see in the headlines to trust any investment at all. But remember - media outlets need to sell the products displayed during the commercials, and fear is a great way to get peoples’ attention. (See Sept 11th/WMDs/Anathrax etc.)
So lets ignore the headlines and go back to the 3 characteristics that make up a person that will see value in what I have to write here.
1. Someone who makes decisions on fact and reason, and not emotion.
2. A responsible and loving family member or business person.
3. Someone with potential for growth.
Here’s a few historical facts for you.
Fact: The S & P 500 (a stock index) and the TSX have averaged returns anywhere from 10-15 % over 30 years every 30 years terms since 1932!
So while today is being compared to the Great Depression by CNN let’s not all go setting ourselves on fire and throwing ourselves out of windows based on soy bean futures.
Fact: After the Korean War the S&P 500 dropped 15% in 5 weeks. Six months later it was up 31%, and 36% a year later.
After sputnik in October 1957 the S&P dropped 10% in 3 weeks and was up 8% 5 weeks later & 30% a year later.
After the Nixon resignation it was down 19% but up 30% 5 weeks later and 27% a year later.
After the interest rate rise in Sept 1981 it was down 13% in 4 weeks but up 8% in a month and another 12% a year later.
Iraq invades Kuwait in 1990 and the market drops 20%! HOLY COW! (It’s up 28% 6 months later and 30% a year later.)
SEPTEMBER 11! Markets drop 12% in only 2 weeks. Up 19% 6 weeks later.
The war in Iraq in March 2003, the S & P 500 drops 3% in just over a week and a half, but recovers 19% in a month and 27% a year later.
There are more examples but the point should be clear.
If history has taught us anything about a bundle of companies it’s that they will go down, but they go back up, and on the long term, they continue to go up more than they go down.
The operative words being: A bundle of companies.
The 3 characteristics of a good investment are that it has a long time horizon, that it benefits from compound interest, and tax efficiency (not to be confused with a tax shelter).
There are a number of investments in Canada that have at least 2 of the 3 characteristics. I can only think of two that have all 3 though.
When one is looking for financial security one has to weigh the risk against the reward. The greater the risk, the greater the reward. So it stands to reason that one should look to get a great reward by mitigating the risk.
A longer time horizon does this.
While many banks will argue the merit of bonds, Guaranteed Investment Certificates (GIC’s), or high interest savings accounts with regards to low risk, I question the validity of the low growth of such investments as it relates to the investor.
If you figure that a decent GIC might, if you’re lucky, net you 4.5% over a 3 or 4 or 5 year maturity date you should consider the following:
What is the inflation rate at? (I believe in Canada it is currently sitting around 3.5%, so there goes a chunk of the value of the interest you make on your money.)
What is your marginal tax rate? Because 100% of the interest you earn on non-registered GIC’s, bonds, mortgage funds, treasury bills and savings accounts is taxable as income. So of the 1% you made after inflation you might take home .6% in today’s dollars.
I believe that an investor using common sense can do better. I’m with Dave Chilton of the Wealthy Barber that when your time horizon is 10 years or greater, that mutual funds consisting of equities subject to growth in the form of capital gains is a good choice.
A description of an early British fund, The Foreign and Colonial Trust, notes that it provides, “the investor of moderate means with the same advantages as the large capitalist, in diminishing in the risk of investing, by spreading the investment over a number of different stocks.”
Here’s why they are attractive to investors.
1. Professional Management: Investors pool their money to invest in a portfolio of securities run by a professional manager. These individuals must meet high standard of education and experience before they can be registered by provincial regulators as portfolio managers. So instead of you and your magic 8 ball trying to figure out which stocks to invest in, some trained individual will do it for you.
2. Diversification and Affordability: Majority of funds sold today are open-ended. So instead of buying open-ended funds on a stock exchange, investors deal directly with the fund company. If you want to buy new units in a fund, new units are created, there is no fixed amount or allowance. You can have a bit of precious metals, a bit of Canadian Natural Resources, and a bit of the banks, all in your small $25 dollar monthly contribution. Instant diversification.
Why do you want to do that? So that when one company goes tits up as we’ve seen many do, and the other companies benefit from that, you have minimal exposure to the one that went sour - and exposure to others that benefit. Ergo, you don’t have to worry about timing the market (buying low and selling high) and freaking out on Bay St.
3. Flexibility: There are many a category of fund on the market with banks and financial institutions today. There’s Asian Market funds, there’s real estate funds, there’s precious metal funds, there’s Canadian resource funds and many many more.
There’s even Ethical funds! Ethical Funds offer the most comprehensive line-up of socially responsible investments incorporating all major asset classes: Canadian income, balanced, Canadian equity, and foreign equity. You can literally invest in a number of companies that focus on promoting the environment.
So no need to sell out to the man.
Mutual funds are also transferable. So when you don’t like where you are, you can transfer your holdings at minimal, if any cost, to you the investor.
Lastly the income choice of how your fund grows is up to you by category. If you have a conservative fund that earns interest, as with the GIC’s much of that interest will be taxed to you as 100% income. But you could find funds that earn growth through capital gains (so only 50% of the growth is taxed to you as income) or in the form of dividends which in Canada are subject to favourable dividend tax credits.
4. Liquidity: With a few exceptions, most mutual funds can be quickly purchased and redeemed.
5. Investor Protection: While not protected by the Canada Deposit Insurance Corporation (CDIC) the way bank deposits are, mutual funds are protected by securities law, independent auditors, Canadian Investor Protection fund and Mutual Fund Dealers Association of Canada Investor Protection Corporation (IPC).
Mutual funds will not make anyone wealthy over night. However, a strategy that involves disciplined contributions over a long period of time to a professional managed bundle of diversified tax efficient equities will provide more security in the long term than many other types of investments available to the investor of modest means.
While not a perfect investment, putting away 10% of one’s income a month, into a well diversified fund of equity bearing investments over 10 years will provide some shelter from the markets on days like today, and substantial tax preferred growth.
For example: If you put away $100 a month into an aggressive portfolio, and we’ll assume it under performs the S & P 500 and only returns 8% in capital gains, well over 10 years indexed to todays inflation you’d have about $19,399. Over 20 years you’d have $64,123.
(Why 10 or 20 years? See the returns of the S & P 500 above over 10 year spans.)
If you put away $200 a month over 20 years and the markets perform as they always have - the earnings would be closer to $152,449.
Not bad, but that’s the magic of a small sacrifice subject to the magic of compound interest creating a large deferred benefit.
Be weary of those who promise “the perfect investment” or the “hot stock tip” or any investment that the bank says is “guaranteed”.
No investment is perfect; if one is hot one day it can be cold another; and finally if a bank ever says something is guaranteed, it’s worth asking who is it really guaranteed for?
I’ve mentioned the analogy before but it bears repeating.
The Titanic sank for 3 reason.
1. Class B metal was used instead of Class A on the spigots. Class A spigots would’ve kept the Titanic afloat 12 hours longer, more than long enough for Carpathia to arrive and save those left in the ocean.
2. Not enough life boats.
3. No binoculars in the crow’s nest.
I’m talking about life boats will keep you alive during a crisis, not racing yachts that perform for show when times are good but that sink during life’s storms.
The accomplished writer John Ruskin said, “Long after the sweetness of low price fades, the bitterness of poor quality lingers.”
This is very true when it comes to investing in your future. Choose quality that lasts over cheap promises.
So mutual funds, when employed properly, are a decent investment that holds 2 of the three characteristics that make for decent capital growth for one’s future.
That is, time, compound interest, and preferred tax treatment.
I said I know of only 2 investments that have all there of those characteristics.
The first one is your primary residence, the second will be for next time.
In the mean time, go set up your 10% pre-authorized chequing payment to a fund today at your bank or trusted financial institution. Make sure the money comes out on your pay day, that way it’s gone before you can spend it.
Pay yourself first, as Chilton would say.
See you later for Part 5, and enjoy the Thrillers better known as the headlines on CNN.
Party websites & Links:
