Investing Principles - Minding the Immutable Forces

If you pretend that the laws of physics don't apply to you and try to fly off your roof, you will be in for a painful surprise. Similarly, ignore certain economic forces and you will suffer investing losses or fall far short of financial goals. Use the forces to guide your investing, and success, while not guaranteed, is much more likely.

Force # 1 - The Risk vs Return Tradeoff
To obtain higher returns, you must be prepared to accept more risk. If you want no or ultra-low risk then returns will be low, perhaps so low that all you may effectively achieve is to preserve the value of the money that you save. If you have figured out that you can save enough to fund your goals, even with miniscule returns, then by all means do so. Most people, unfortunately require appreciable growth and that requires riskier investments.

Force # 2 - Diversification Will Reward and Protect You
Diversification means two things: having numerous investments, not just one or two or three and; having different kinds of investments. The first factor protects against potential problems of one company by spreading things around - the not-all-eggs-in-one-basket principle. The second factor takes advantage of the fact that some years stocks do well, some years it is bonds, other years it is real estate and so on. Right now, for example, the front-runner seems to be commodities, oil especially. The different winners at different times extends to countries as well. Diversification will smooth out market variability and enable you to take on higher return investments.

Force # 3 - Inflation is a Stealthy, Debilitating Menace
Inflation has been low for some time but the recent rise in oil and food prices is worrying. If inflation suddenly shoots up to 6%, 4% interest on a seemingly safe GIC is losing you 2% a year. Bonds and T-bills with their fixed interest return, are susceptible to inflation. The real damage happens over many years. A 2% loss after inflation prolonged for five years will erode the purchasing power of the $100 GIC to $90.57, including the interest, per the Bank of Canada Inflation Calculator. Some solutions for inflation: diversification, equities and real return bonds.
Resource: Libra Investment Management's spreadsheet - shows real (after inflation) and nominal (before inflation) returns on various types of investments 1970 - 2007

Force # 4 - Costs Matter, a Lot
As an investor you will incur various costs: trading commissions, management expenses of mutual funds and ETFs and possibly account administration fees. Every 1% extra in avoidable costs is a 1% reduction in net return. The first post in this blog pointed out the large effect of a 1% difference in return can have over a long period. Calculate your costs and ask yourself whether the cost item is too high; maybe it isn't but sometimes it is.

Force # 5 - Taxes Should Shape but Not Determine
Taxes are a constraining and shaping factor. Since interest income is taxed at the highest rate, income investments should be held in accounts with tax protection, such as RRSPs, RESPs and the new TFSA (to start in 2009). But conversely that doesn't mean you shouldn't buy equities in an RRSP just because they generate capital gains and capital losses cannot be deducted to offset capital gains within the RRSP. Investing in something primarily because it generates a tax benefit is a bad idea - it needs to be a good investment first.
Resource: TaxTips.ca - tax rates and account info

Investment Building Blocks - Securities

Securities are the things an investor can buy. There is a mind-boggling array of securities available to a Canadian investor, but never fear, that potentially paralyzing complexity can be simplified.

Consider a food analogy. At the most basic level, there are ingredients - sugar, carrots, peas, beef, lamb etc which can be grouped into vegetables, meat and so on. Thus we have T-Bills, corporate bonds, government bonds, common and preferred stocks, grouped into categories - money market, fixed income and equities.

Those ingredients can then be bought one at a time or as products grouped and packaged in various ways, e.g. tomatoes by themselves or in a pasta sauce along with beef and perhaps sugar. You can thus buy shares of Bank of Montreal by themselves or within a mutual fund, combined with other stocks or with government bonds or both. Much of the confusing complexity arises from all the available combinations.

The chart shows common securities (i.e. it is not comprehensive). The rows are the basic securities and the columns are the product packages, ranging from an individual security to collective investment structures that combine many securities and many investors. The x's in the chart indicate roughly what can be bought in each product.

Basic Securities:

• Money Market - you lend money short-term (days to a few months), to the government by buying T-Bills, or companies through commercial paper, and get back interest
• Fixed Income - you lend money for years to governments or corporations by buying various types of bonds and get back interest payments plus your original investment, which may go up or down if you sell out before the bond maturity date (repayment date) - Details of GIC and CSB on InvestorEd
• Equities - you buy part ownership in a company through shares and get back profits through dividend payouts or through appreciation of the shares as the company grows ... or not get any dividends and see the shares decline in value if the company does poorly. Details of Split-Share on Wikipedia
  

Product Packages:

• Individual - you buy a bond or share of one government or company either directly or on a market
• Mutual Fund - you buy units from the fund company itself (though usually you do so through a brokerage, agent or financial planner), which passes through any profits to you each year
  
• Closed-end Fund has a fixed number of units, essentially shares, that are bought or sold on the stock market
• Exchange Traded Fund (ETF) is, surprise, a fund that is traded on a stock exchange; unlike the closed-end fund has features that ensure the buy/sell price is very near what the stocks/bonds inside are worth
• Income Trust - a corporate structure in which a company passes through all its profits to you the investor (on which you pay taxes, of course)
  

As you can see, there are many ways to satisfy your investing appetite!

Resources and Further Reading:
Shakespeare's Investment Primer
Gail Bebee's book No Hype: The Straight Goods On Investing Your Money

Reviewing Your Financial Assets

A key step to getting organized for investing is to list what you have already - your assets. Your assets include extra cash (above what you need for your immediate spending), GICs, mutual funds, stocks and your pension. The paid-off portion of your house should be on the list too. There are two reasons to do this:

• to find the gap between total current assets and your total investment goals - how far is there to go?
• as a basis for filling in the gaps or making changes to the mix to achieve a balance - what is called diversification or spreading of risk - of your investments.
  

The most valuable asset of all, especially if you are young and just starting your career, is YOU! Why? Through your talent and energy, you are a money-generating machine. You must therefore consider your age and earning power when choosing your investments. Furthermore, the type of work you do should influence how you invest. (Read more: Human Capital and the Theory of Life-Cycle Investing by Paula Hogan of Hogan Financial Management)

Your income and what you can take out of it to invest is another decision to make. Regular, small amounts over many years can grow to huge totals. Use the Advantages of Early Investing calculator at the Fiscal Agents website to play with the numbers and see what amount would get you to your goal. Above all, just get started, no matter how small the sum, and make the setting aside automatic. Don't rely on yourself to "get around to it" because if you are like me and most other people, it won't happen.

In my opinion, these are the resulting investment do's and don'ts:

• if your job is relatively secure and unaffected by the stock market and you will be receiving an inflation adjusted defined benefit pension that will provide most of your retirement spending needs(does this sound like you, teachers, government and health care workers?), then do invest in the stock market/equities, not GICs or other forms of fixed income
• if your job is susceptible to downturns, do include a healthy proportion of stable fixed income in your investments; especially do not invest only in your employer's stock or even that industry (as a former high tech worker who got laid off and had a lot of plummeting high tech shares, including those of my company, I can tell you the ouch factor is high) though stock purchase plans can be a worthwhile exception
  
• do invest in stocks when you are young and can take the extra risk of stock investing for the potential higher long term returns of stocks to reach the large amounts needed for a comfortable retirement
• if you are just starting out investing with small amounts, then you are better off in collective investments like mutual funds and Exchange Traded Funds (explained in the next post) that spread risk over many companies

Please note that the above is my opinion only and should not be taken as investing advice. Consult an advisor registered with your securities commission if you need help.