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.

Setting Investment Objectives

First things first, what are your investing goals? What will you want to spend on in future and when? The big chunks of money matter most, naturally. Think of big life events which have financial implications.

1) Retirement - retirement is an inevitable voluntary or involuntary point when investment build-up turns to withdrawal (an exception perhaps is the richest man in the world, investor Warren Buffett, going strong at age 78). To figure out the investment nest egg – your objective - estimate your retirement spending, subtract pension income sources, then obtain the lump sum objective by multiplying the missing income by 25, which assumes a conservative 4% withdrawal rate that should avoid ever running out of money. (e.g. in the simplified chart below, the green amounts are what might be required for a current $75,000 salary). The estimation process can get more sophisticated, and a future post will get into more detail. Given the large lump sum that most people would need, this is, or should be, investing priority one.



Resources:
InvestorEd Retirement page on How Much? - unbiased advice, includes downloadable budget spreadsheet
FiscalAgents Tools - have fun with four different retirement calculators
The New Retirement Book by Sherry Cooper - especially chapter 9, How Much is Enough? - summary at BMOIL, review, buy

2) Education - an undergrad university program costs over $6200 a year on average according to a Stats Can press release. Add in books, possibly residence and the total can climb to $15,000 p.a., or $60k for the degree. The wildcard is how much you plan to have the kids finance themselves through summer or part-time jobs, or loans.

3) House - the investment target usually will take the form of a down payment, no less than 5%, better 10% or more (see The ABCs of Mortgages at the Financial Consumer Agency of Canada). The amount you will need (house price booms excepted) and when you will need it is under your control.

4) Inheritance/Legacy/Charity - as people get older, consideration often turns to what they will leave behind. Our friend Mr. Buffett decided not to die first and announced a few years ago that he was donating $31 billion! to charity. Giving is perhaps the easiest investing goal to handle since the amount - whatever is left over - and the timing - whenever you kick the bucket - can be completely passive and flexible.

5) Vehicle, Sabbatical, Wedding, Funeral or other significant future expenditure. Smaller and more controllable amounts but they can enter the mix.

What does the above imply for the Investor?

You should consider:

• a mix of types of investments with faster growth over the long haul, like equities and those with stability, like bonds or cash, for shorter term objectives;

• use of retirement accounts, like RRSPs, education accounts like RESPs and flexible accounts like the new TFSA.

• setting priorities and possibly deferring some items, as total spending may exceed your saving capacity and the maximum realistic returns on investments

A Process to Build a Sound Investing Plan

"If you don't know where you are going, you might end up someplace else." Legendary baseball player and manager Yogi Berra's words (and other delightful quotes here) apply perfectly well to DIY investing. A bit of simple and straightforward planning will yield significant benefits - having the right amount of money at the right time in one's life. It will also provide the confidence and peace of mind to withstand the inevitable shocks along the way.

Following a certain sequence of steps or a process will make it all seem natural and will avoid going down the wrong path, saving the DIY investor time, effort and money. This blog will therefore go through a series of posts illustrating and explaining these topics:

1. Setting Investment Objectives: why are you investing? retirement, education, sabbatical, inheritance/legacy, house, vehicle, other significant future expenditure; or perhaps even gambling / speculation / entertainment; this determines, or helps determine, target amounts, time frame, types of investments / portfolio mix, type of accounts (RRSP, RESP, TFSA etc)
2. Taking Financial Stock: what do you have now and what is available to invest? assets vs liabilities; income vs expenses; effect of job stability and work pension or stock purchase plan; human capital; investing monthly cash or a lump sum
   
3. Investment Building Blocks: the Range of Securities & Products Available: "the ingredients", such as stocks, bonds, cash, GICs, T-bills, CSBs, Income Trusts, preferred shares; mutual funds, ETFs, REITs, ETNs, PPNs, seg funds
   
4. Investing Principles: what are the important rules for success in the investing world such diversification, risk vs return relationship, taxes, inflation
   
5. Risk - How Much Can You Afford and How Much Can You Put Up With?: risk as loss and volatility
   
6. Diversification and Avoiding "Diworsification": the difference between many holdings and different holdings; non-correlated assets and asset classes
   
7. The Written Investment Policy, Don't Invest a Cent Without It: asset classes to hold and in what proportions, under what conditions and/or how often to buy or sell; benchmarks for tracking and how often to review
   
8. Account Choices: Regular/taxable, RRSP, TFSA, RESP, Informal Trust, Formal Trust, Mutual Fund, Wrap/Discretionary
   
9. Broker Choices: comparative factors - trading costs, admin fees, range of accounts, research tools, service and telephone support, foreign exchange in registered accounts; convenience or fee reductions for family holdings, links to banking

Hopefully, we can thereby avoid later saying as Yogi did, "We made too many wrong mistakes" and instead become competent investment players who hit for a decent batting average.

Why Be a DIY Investor and What Does It Take to Succeed?

As the inaugural post on this blog devoted to DIY investing, a good question to answer is why do it in the first place, why not just leave it to an adviser? Another pertinent question is what kind of personality is needed to succeed?

Why DIY?

• 100% focus on your own interests - most financial advisers are honest and conscientious about catering to your financial needs but DIY offers you the unlimited opportunity to tailor your investments to your own needs and circumstances with as much fine tuning and departure from standard solutions as you wish.
  
• cost savings - the DIY approach using a discount broker such as BMO Investorline and others that only execute trades and provide no advice can save you money and boost returns; one of the objectives of this blog is to find and discuss those ways. Even a small savings compounded over many years can have a dramatic effect. The attached chart shows that a seemingly insignificant 1% extra return per year boosting returns from 7 to 8% can create a one third greater end amount after 30 years - $10,000 grows to $100,000 instead of only $76,000.

• pride of self-reliance - just as business owners often remark on the satisfaction they receive from being in charge, a DIY investor can gain satisfaction from the feeling of being in control of his/her own destiny; it's the "I did it my way" feeling.
• intellectual challenge and fun - there's no need to play Monopoly when you have the stock market; it's real money and the thrill is all the greater. Not only that, if you play the game properly - another aim of this blog is to show how that is done - you can minimize the chances of losing. Successful DIY investing can be done quite simply, but it also offers to those who get hooked, a wonderful world where you need to read, to learn and to think. For many people with more free time, such as those reaching retirement, it offers an enticing way to keep the mind active, broadening and deepening knowledge in an ever-changing field.
• community and socializing - there are many DIY investors around; most are happily passive, reading news, websites and blogs such as this one but for those who wish, the web welcomes all comers with comments, questions and opinions. Hang around a while, participate and you get to know others and enjoy the pleasure of a shared interest.

What Kind of Personality is Suited to DIY?

Your personality and behaviour is the crucial issue. From the early days of investment giant Benjamin Graham in his book The Intelligent Investor, through all the academic research that has detailed it since (summarized neatly by Richard Deaves in his book What Kind of Investor Are You?), all agree that the key to success is how you handle yourself. You must avoid the errors of over-confidence, impatience, procrastination and being too emotional. If you are among those who are naturally planners, who look forward and are willing to defer immediate gratification and wait for longer term results, who are self-controlled and self-disciplined, who can accept that not every investment will turn out a winner and who are able to bounce back from setbacks, who do not assume they automatically know better than everyone else and are willing to learn, who tend to keep an even keel and not have excessive reactions to losing or winning, then you are among those most likely to succeed as a DIY investor.