Thursday, 26 June 2008

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: - tax rates and account info

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