PART 2
You’ve been waiting long enough to read about investing, so I’ll start Part 2 with that.
Whether you want to use an advisor or not, the principles of prudent investing are the same. You can save yourself a lot of money over your lifetime if you do it yourself, but if you make a few simple, easily made mistakes, you can end up costing yourself a lot more in lost performance than what you save in fees.
These are heated discussions among investor advocates, DIY investors, and the financial services industry, but they are of little consequence for those just starting out: how much you contribute to your portfolio in the beginning is far more important than pretty much anything else.
Remember the example I offered in the introduction: put $200 per month into a high-interest savings account that pays a measly 1.5% and you’ll have almost $26,000 after 10 years. Invest just $100 per month and to make the same kind of money, an amount just shy of $26,000, you’ll need an annualized return of more than 14% on your portfolio. So even if you use a financial advisor who puts your savings in relatively high-fee funds, you’ll be fine if you just focus on putting money away. Once your portfolio gets to the $50,000 mark, not only will you have more options when it comes to dealing with advisors, you also will have reached the point at which you can start to benefit from more advanced concepts, such as fees. Until then, don’t over-think it. Just put money away and learn the basics of investing to make sure you aren’t dealing with a particularly bad advisor.
After we’ve covered what you need to know about investing, we can tackle the value of financial advisors. The average Canadian will end up using one, and the average, supposedly savvy Canadian has a very polarized opinion about them: they tend to either love financial advisors or hate them. I’m going to show you how to use one effectively, and how to pick them in the first place. But remember, you shouldn’t worry too much about this in the beginning. You’ve got time to figure it out before it really matters. I can almost guarantee that your first financial advisor won’t be your last one anyway.
We’ll also take a more in-depth look at life insurance, including how to figure out how much you need. At the very least, by the end of the book, you’ll be speaking a bit of the same language as your agent, which helps you to make a more informed decision about something so critical.
CHAPTER SIX
I’ll cut to the chase now, and then I’ll explain why it’s the best way to go.
When it comes to investing, you want to use what is called a “portfolio fund.” These are turnkey investment portfolios that don’t require much monitoring at all. They will incorporate all the prudent ingredients of a proper portfolio and do all the work for you. All you have to do is add money and wait.
I use a turnkey portfolio fund for the majority of my investing. I know a lot about investing: I’ve even ghostwritten an entire book explaining advanced investment techniques for a large financial advisory firm in the United States. The book was distributed to their financial advisors, but essentially all the techniques described in it are available in turnkey portfolio funds. For multi-million-dollar portfolios, investors who are paying lots of money to financial advisors need to see that something is being done for the money they pay, so instead of using a turnkey portfolio, they generally build the same overall portfolios using individual building blocks. It makes rich people feel special. The relative costs might be lower, but that’s partly due to the economies of scale.
So when it comes to your investing, do what I do. If it’s a portfolio fund that invests in stocks and bonds, both here and around the world, and it balances itself, go for it. When you are starting out, the fees aren’t that important. Once your portfolio gets to about $50,000, reach out to me on Twitter (@preetbanerjee) and I’ll tell you what to look at next. For the record, I don’t manage people’s money anymore, so I don’t receive any compensation for my recommendations.
In the meantime, in order to work with an advisor (or to become a do-it-yourself investor eventually), you need to speak the language. Let’s look at the basics of what you should know.
RISK AND RETURN
Ask someone who doesn’t know a lick about investing to recite an investing buzzword or phrase, and “risk and return” may be among the first responses. But what does it mean? The phrase refers to the notion that higher returns come with higher risk. Risk, bluntly, is what you can lose. When you start looking at the A+ material on risk, you’ll see that risk is used to describe how much volatility your portfolio experiences, or how much it goes up and down, assuming you have a properly diversified portfolio.
But what you need to know now is that taking on higher risk does not mean you automatically get higher returns. It means you have the potential for higher returns. You could take on more risk and end up with lower returns, or negative returns, or even lose all your money in extreme cases. If investors are willing to take on risk, it is only rational for them to expect to be compensated through a higher potential return on their investment.
The greater the potential return, the greater the risk. This is a fundamental relationship. However, it should also be noted that the relationship is not linear. Rather, for every extra unit of potential return you desire, you should expect a disproportionately greater amount of extra risk: risk grows exponentially with potential return. Figure 6.1 illustrates the relationship.
From a 30,000-foot perspective, cash (in the form of a high-interest savings account or guaranteed investment certificate) is essentially risk-free. But low risk also comes with the guarantee of low returns. Right now, cash investments are paying about 1%, but you know you’ll get your 1% consistently.
Figure 6.1: Risk grows exponentially with potential return on investment
The long-term average return is greater on investments that promise higher returns, but so is the range of returns, and so is the risk. If you buy one single stock, it’s possible to more than double your money (a 100% or greater return) or lose all of your money (a negative 100% return).
DIVERSIFICATION
The term “diversification” is routinely used to mean not putting all your eggs in one basket, in order to reduce risk. If you have six eggs all in a basket and you drop that basket, all your eggs are ruined. But if each egg has its own basket, then your chances of dropping and destroying all your eggs declines dramatically.
Consider the investor who purchases shares in only one stock. If the stock doubles in value, the investor is delighted that he or she has earned a 100% rate of return. If, on the other hand, the company goes bankrupt, the investor loses 100% of his or her original investment. If the investor instead purchases shares in 100 different companies in equal dollar amounts, then the effect of one company going bankrupt would be to reduce the portfolio’s total value by no more than 1%. If one company doubles in value, it similarly produces only a 1% increase in the value of the portfolio. Of course, the prudent goal would be to pick 100 companies that each represent a solid long-term investment. While one or two may become bankrupt, one or two are likely to double or triple in value and perhaps the majority will yield an average of 6–8% over the long term.
Diversification can reduce risk, but it can’t eliminate it. There is a certain amount of risk in any market that can’t be diversified away. Think about what happens if an economy is heading into a recession. There is a tendency for everything to go down because people have less money to spend on everything they usually spend money on.
STOCKS VERSUS BONDS VERSUS CASH
There is no rule that says a portfolio can only be made up of stocks. You can also own bonds and cash. There are other options as well, but these are the big three you’ll need to worry about for now. So what’s the difference?
Stocks are commonly called “equities” because they represent ownership, or equity, in a company. They tend to be more volatile in price, and over the very long run, stock markets are expected to have higher returns than bond markets and cash. They are therefore expected to be much riskier. A portfolio made up entirely of stocks can lose 30% or more of its value in a year. It can also gain 30% or more. On average, stocks are expected to return 6–8% over very long periods, but the ride can be extremely unnerving.
Bonds are commonly referred to as “fixed income,” because they pay a set amount on a fixed schedule. If stocks represent ownership, bonds represent a loan to a company. If you buy a bond for $1,000, it’s as if you are lending out $1,000. Until you get it back, you get interest payments of a fixed amount, on fixed dates. Bonds can fluctuate in price, and not all loans are good ones. Having said that, bonds, or fixed income investments, are considered to be less risky than stocks overall. They can still lose money in a given year, but the range of possible returns is generally muted compared to stocks.
Cash is considered risk-free. It won’t lose money, but it won’t gain much either. Low risk, low return. The cash component of a portfolio can be in the form of money in a high-interest savings account, GICs, and less ideally these days, in a money market mutual fund.
Very few portfolios are 100% allocated to any one of these categories. Typically, you might see a mix like this: 55% invested in equities (stocks), 40% in fixed income (bonds), and 5% in cash.
ASSET ALLOCATION
An “asset class” can be defined as a group of securities that tend to behave in a similar fashion relative to one another—and are constructed and regulated according to a common set of rules. So stocks, fixed income, and cash all can be considered asset classes. Asset allocation is the actual distribution of money across different asset classes.
I’ve already suggested what a typical portfolio allocation might look like, but there are a number of possibilities. For example, you might have 70% of your portfolio in equities, 30% in fixed income, and no money allocated to cash. Equities, fixed income, and cash are the asset classes and, in this case, 70/30/0% is the asset allocation. When an asset allocation does not include an allocation to cash (as is often the case), 70/30/0% is usually referred to as simply 70/30%.
One of the fundamental assumptions of asset allocation is that the best-performing asset class changes from year to year and there is no reliable predictive tool for determining ahead of time which asset class will be the best performer. Therefore, combining asset classes is a prudent strategy to reduce the overall risk of the portfolio. Often, if stocks are going down, bonds might be going up. But note that it’s possible for stocks and bonds to go down in value at the same time too. Both asset classes are expected to go up over the very long term, but each class has its own cycle.
The more stocks you have in your portfolio (as a percentage of the overall portfolio), the more volatile your portfolio will be. The more fixed income you have in your portfolio, the less volatile it will be. But because stocks have historically outperformed bonds, people often weight their portfolio too heavily in stocks, hoping to get their money to grow faster. They think they understand that the increased risk means a bumpier ride, and they think they can ride out the storms. But when the storms come, they often quickly find out they can’t.
Generally speaking, people put too much equity in their portfolio. A useful rule of thumb is that your age should be your percentage allocation to fixed income. So if you are 30 years old, you should have 30% fixed income, and therefore 70% equity. If you are 50 years old, you should have 50% fixed income and 50% equity, and if you are 65, you would have 65% fixed income and 35% equity. This is not a bad rule, and it’s in line with the overall theme of this book, which is to not over-think things. Just set your portfolio’s allocation to fixed income to be as close as possible to your age. I say “as close as possible” because many investment firms will have a set of turnkey portfolios with set allocations. For example, they might have conservative, moderate, and aggressive options, which are 35/65%, 60/40%, and 75/25%, respectively (the first figure in each case representing the percentage in stocks). Just pick the one that comes closest to following the rule.
REBALANCING
Since different asset classes are expected to conform to different patterns, it is possible and probable that the target asset allocation will be violated through the normal-course market movements. On a broad level, if the portfolio has a 50% weighting to equities and 50% to fixed income, and through normal market movements stocks go on a bull run and increase by 20% while bonds are flat, then the portfolio will drift to an allocation closer to 60% equities and 40% bonds. A portfolio with an asset mix of 50/50% will have less risk than a portfolio with an asset mix of 60/40%, so it’s necessary to bring the portfolio’s overall asset allocation back in line with the original allocation.
There is a double-edged ancillary effect to rebalancing because portfolio return variance can be reduced while long-term returns may be either increased or decreased. By rebalancing back from 60/40% to 50/50%, you are, in essence, buying low and selling high.
Take the case where stocks run up 20% in short order: by selling off a portion of the equities to bring back the allocation to 50% equities and 50% fixed income, you are selling stocks at a potential high. A portion of the proceeds are then used to purchase additional bonds, which are at a potential low, because they’re flat and the expected long-term performance of bonds is net positive. So constant rebalancing reduces the return variance of the portfolio. However, it also is possible that you are selling the stocks before their bull run is over. In this case, less of your portfolio is subject to the exceptional performance that could be afforded by a bull run in stocks resulting in a lower potential return for the portfolio overall. Rebalancing too frequently reduces long-term portfolio return, while rebalancing too infrequently increases the portfolio return variance. Therefore, the goal of rebalancing is to find a strategy that finds an appropriate balance of these two opposing forces.
Once again, if you simply follow the investing recommendations later in this section, you won’t have to worry about rebalancing. Nonetheless, the information is presented here in case you opt to use a different strategy.
RISK-PROFILE QUESTIONNAIRES
A risk-profile questionnaire is a simple tool designed to find the right asset allocation for your portfolio. It generally consists of 10–15 simple multiple-choice questions. If you answer the questions and your score is indicative of someone who doesn’t like risk, the asset allocation recommendation is going to be weighted more heavily in fixed income and cash than equities. Conversely, if your score shows you have a high tolerance for risk, your recommended asset allocation might be more heavily weighted to stocks. That means you can expect high risk and the potential of high returns, but the possibility of high losses as well, especially over the short term.
Risk-profile questionnaires are ubiquitous with investment transactions in Canada, but they’ve come under heavy criticism in some quarters. Do we put too much “stock” in them? Or are they just not good enough?
It would be hard to meet with an investor today who hasn’t completed a risk-profile questionnaire. But given how often investors switch gears with their investment strategies, largely because of their inability to stomach risk, it seems that the questionnaires are ineffective. President of the Investor Education Fund (IEF.ca) Tom Hamza notes that there are two levels of risk: “Actual investment risk, and the risk that comes from not knowing about what you are investing in. Actual investment risk is magnified if you don’t understand the basics of the products that you are investing in. We see a lot of people magnify the first risk with the second because they haven’t taken the time to understand their investments.”
Anecdotally, financial advisors note that sometimes investors answer the questions as if they are taking a test. They select the answers they think a successful investor would choose instead of those that reflect what they really feel. For example, a staple question is about the degree of loss in a given year you could tolerate before feeling uncomfortable. The possible responses range from none to moderate double-digit-percentage losses. Some might be inclined to select the highest degree of loss because they’ve seen some compelling statistics about the virtue of holding tight through the bad times and the trade-off between risk and potential return. Taking on the risk an aggressive investor is comfortable with when you are actually a conservative investor is a tall order.
The fact that many of these questionnaires are completed in under 5 minutes should be enough of a clue that they aren’t sufficiently nuanced to form the basis for long-term investment decisions. Some can be completed in under 60 seconds. These assessments, at best, should be used as one of many different tools when assessing the risk tolerance of an investor.
Imagine filling in a 5-minute questionnaire about a prospective spouse as the sole criterion for spending a life together. Sure, we all have boxes that need to be ticked off when it comes to what we are or are not looking for, but there’s obviously much more to it. The next time you are presented with a risk-profile questionnaire, it should be accompanied by a lengthy discussion about risk. Otherwise, the results are worth the time you put into it, which is very little.
TIME HORIZON
They say it’s “time in the market” and not “timing the market” that breeds the most successful investors. Over the short term, it’s impossible to know what your returns will be like. Over the long term, the probability of a positive return and for stocks to outperform bonds, which will outperform cash, is greater. But how long is long?
Long Term Is 10 Years or More
In a recent academic paper, “Investing for the Long Run,” a long-term investor is described as someone with little or no specific short-term liabilities or demands for liquidity relative to the amount of capital invested.1 Translation for retail investors: you shouldn’t need to touch the money in your portfolio for at least 10 years. One of the main advantages of having a 10-year investment horizon, according to the authors, is that long-term investors have the ability to ride out short-term fluctuations. Well, in theory, that’s one of the advantages. In practice, it can be very difficult to keep your cool when stock market returns make the headlines on a daily basis.
A prudent long-term portfolio has a few simple rules:
1. Ensure you have multi-level diversification.
2. Rebalance when necessary.
3. Don’t take on risk you can’t stomach.
4. Keep fees low.
Multi-level diversification means you diversify not only by holding many securities within the same asset class, but also many different asset classes. But as simple as that sounds, even professionals often can’t stick to the plan. The California Public Employees’ Retirement System (CalPERS), one of the largest pension funds in the world, had an exposure to equities of 70% of its portfolio in 2007. One year later, market performance brought that allocation down to 52%. CalPERS then sold off equities in the portfolio to bring the allocation even lower, to 44%. They changed their strategy mid-swing. They panicked.
In 2008 they sold a $370 million stake in Apple. Had they held onto it, it would be worth around $900 million at the time of writing. That increase would be even greater if they had rebalanced back to the original plan, which would have entailed buying more stock, not selling it.
It should be no surprise to learn that CalPERS has a new chief investment officer. If you’ve been making changes to your investment strategy on the fly, it might not be the plan that’s not working. It might be you not working the plan.
Short Term Is 5 Years or Less
Any money you need to withdraw within 5 years should be in cash or GICs. The short-term performance of stocks and bonds within a 5-year period is too unpredictable. The last thing you want is to have less money to spend than you originally planned. In other words, if you need the money in 5 years or less, keep it away from the stock market.
That leaves us with the medium term, a time horizon between 5 and 10 years. In this case, you can split the difference. If your long-term risk profile suggests you can handle 70% equities and 30% fixed income, cut the equity allocation in half to 35%. Your portfolio allocation should now be 35% equity and 65% fixed income.
Most risk-profile questionnaires ask you about your time horizon and then use that information to make an asset allocation recommendation. But risk-profile questionnaires are all too aggressive in their recommendations. The aggression doesn’t matter when markets are strong because returns are turbocharged, but after the credit crisis and market meltdown in 2008, it became apparent that a lot of people can’t stomach as much risk as they thought they could. The experience led them to bail out of their investment portfolios at the worst time possible—after they had fallen in value.
It’s buy low, sell high, remember?
ACTIVE OR PASSIVE MANAGEMENT (TO START)?
Here’s a crash course in active versus passive investment management. I hemmed and hawed about including it, but it’s been a hot topic in many books and newspapers, so I thought I would acknowledge that. But I’ll do what I’ve done throughout this book and just give it to you straight. You are better off with passive management (also known as indexing); however, finding an advisor who provides passive management when you don’t have a big portfolio is difficult. Luckily, when your portfolio is small, the difference between active and passive management matters less than it will later, when your portfolio has grown. Active investment management involves trying to beat the market. Passive investment management simply tries to replicate the market. Because active management requires the skill of an investment professional who analyzes what investments to make, it costs money. The analyst’s team of research associates cost money, too. Passive investment management has no manager: a computer could literally manage the portfolio because all it has to do is hold the same stocks that the market holds in the same proportions. Now, if you take all the active investors in the world and put them together, they collectively get the market return because they, in fact, make up the market. So if the market returns 5% this year, some of those investors made 7%, and some made 3%, but on average they collectively earned 5%, before costs.
All the passive investors also earned the market return. Since they weren’t trying to beat the market, but rather just do what the market did, every single one of them earned the market return of 5%, before costs.
Passive investing costs less than active investing, so after costs the passively invested dollar must beat the average actively invested dollar. Every investment firm and every financial advisor will try to tell you that their active manager is more astute than everyone else’s, but the truth is that there is no way to identify who will outperform the market going forward. For years and years, thousands of doctoral candidates have been trying to identify a reliable predictor of future investment performance. Their collective efforts have yielded no results. In fact, mutual fund companies are required to put a disclaimer on any advertisements that boast about their past performance reporting to indicate that “past performance may not be repeated.”
Because of all of this, most people are better off in a low-cost, passively managed portfolio. You might get a better return with an actively managed fund, but chances are you won’t. This hard truth has been proven time and time again by academics with no bias and without deep pockets. Unfortunately, the industry with lots of bias (they make a lot of money selling actively managed investments), and incredibly deep pockets, will do anything to convince you otherwise.
The good news is that it doesn’t matter if you’re just starting out. The differences are inconsequential. Over time they add up, but you’ve got time to do your homework and make up your own mind.
Let’s assume you have $100 per month to contribute. If the market return is 7% for the next 5 years, then an actively managed portfolio fund that pays a financial advisor a fee might cost you 2.50% per year, meaning the return your money earns is 4.5%. On the other hand, a passively managed portfolio fund with no advisor to pay might have a fee of 1.0%, so its return is 6%. If we fast-forward 5 years, the more expensive, actively managed portfolio fund is now worth $6,714.56. The passively managed portfolio fund is worth $6,977.00. After 5 years, the difference is $262.45. If you’re getting assistance from a financial advisor, the extra $262.45 over those 5 years could be a bargain. If we keep fast-forwarding, however, after 40 years the actively managed portfolio grows to $134,115.07, while the passively managed portfolio grows to $199,149—a difference of more than $65,000. So at some point, you’ll want to address costs, but it’s not critical over the first few years, assuming that you’re building up your portfolio slowly. It’s more important to get going.
If you want to learn more about low-cost, DIY investment portfolios, I recommend The MoneySense Guide to the Perfect Portfolio by Dan Bortolotti. Dan is also the author of the brilliant blog CanadianCouchPotato.com, which focuses on index investing for Canadians.
WHAT TO INVEST IN
If you want the least amount of hassle, do the following for any portfolio you aren’t planning to touch for at least 10 years: set your target fixed income allocation to your age. So if you are 30, you’ll have 30% in fixed income and 70% in equities. Next, you’ll want a turnkey portfolio mutual fund. This is a fund made up of several underlying funds that have been strategically placed together to create a diversified portfolio. It will have exposure to stocks and bonds from around the world. It will also automatically rebalance. All you have to do is add money to it. You can do this either with an advisor, or by yourself.
If you use an advisor, chances are you will be given a questionnaire to fill out. If you have a small portfolio, or are starting one for the first time, the advisor is most likely going to offer you a portfolio fund of some sort that has relatively high fees and penalties for leaving. That’s okay for now.
For example, the fund might have a management expense ratio (MER) of 2.5%, which means 2.5% of the value of the fund is deducted for fees every year. You won’t see it happen, it just happens. There might be a penalty of 5% (which you will see) if you take your money out within the first few years (see the section on mutual fund compensation in Chapter 7 for more details). All of this gets lots of attention from investor advocates, but if you’re investing only $100 per month, you’re looking at roughly $15 in fees over the first year, and $45 for year two. At the end of the second year, you would have contributed $2,400 and if you needed to withdraw it all for an emergency you could pay a redemption fee of $120.
Are these fees relatively high? Yes. Are they absolutely high? A fee of $180 for financial planning assistance is a bargain. A fee of $180 for nothing but investment advice is stiff.
If you feel you can set up a mindless portfolio fund on your own (anyone can really), my first choice for a new investor is one of ING Direct Canada’s Streetwise funds (check for their new name in 2014). These funds have an MER of 1.07% and are butt-simple to set up and maintain. Until you get a more sizeable portfolio, and until you get to an A+ with investment portfolios, these funds are fine. (Full disclosure: I have consulted for ING Direct Canada in the past, and there is a reasonable expectation that I will do so in the future.)
The account-opening process will contain a simple risk-profile questionnaire. If the recommended portfolio fund is within one notch of your target asset allocation, you’re good to go. If it’s way off, err on the side of caution and pick the fund with the lowest risk (weighted most heavily to fixed income) between the two options. To change your selected fund, you just have to go back and adjust your answers on the risk-profile questionnaire to be less risk-seeking. It will give you a less risky fund to invest in once you change your answers.
I realize that they’ve put together their questions based on industry research, but the entire industry must use the same consultants because the various risk-profile questionnaires out there all are similarly too aggressive in their recommendations. The proof of the pudding is in the eating. People bailed on their recommended portfolios en masse during the credit crisis. That should be enough for the industry to realize the questionnaires aren’t good enough, but not much has changed since.
TO DIY OR NOT TO DIY
A friend once asked me about dumping his financial advisor so he could save money on fees. He said he had been seeing a lot of positive mentions of low-cost index funds and wondered if that was the way to go. It is true that index funds are appealing for various reasons: they have lower costs because you don’t have to pay for a star fund manager and his or her staff of researchers. They also are tax-efficient because the portfolio doesn’t get tinkered with a lot, and so on. There is no shortage of proponents of index investing. But what does using or not using an advisor have to do with active versus passive investment strategies? Not much, as it turns out.
I believe my friend assumed that financial advice comes at a high price, and do-it-yourself investing is cheap. That’s a one-dimensional way of looking at things. If instead we look at it from a two-dimensional perspective, we can plot the pros and cons on an adviceor-no-advice axis, and an active-or-passive-management axis. Now we have four broad conditions: DIY with passive strategies; DIY with active strategies; use an advisor with passive strategies; and use an advisor with active strategies. In the real world, there are many more possibilities, such as investors who use an advisor for the bulk of their portfolio and manage their own smaller account as well. Both portfolios could involve a blend of active and passive strategies.
And here’s the kicker. It’s quite possible that an investor using active management through an advisor can end up better off at the end of the day than a DIY investor using a passive strategy. (It’s also not always a given that the active-advisor route is the most expensive after calculating exchange-traded fund commissions for some DIY investors. I’ve seen some pretty active DIY accounts using passive products, and this qualifies as active management.) Once you factor in the ancillary planning expertise of a good advisor, which might encompass tax planning, estate planning, insurance planning, and much more, the average 1% fee for advice can be a bargain.
But it’s not always about cost.
Many DIY investors have explained to me that they decided to take their finances completely into their own hands, mostly because of some level of frustration with the returns they were getting. Maybe they felt they were being gouged, or they were sick of their advisor hiding when the markets turned south, and perhaps they just felt that every phone call or meeting was attached to a sales pitch of some sort.
I’m a big fan of DIY investing, but I’m also a fan of advice and financial planning. I think most people would agree that good advice is hard to find, and therein lies a large part of the problem. We don’t mind paying a bit more when we feel we are getting value for our money.
In addition to the apparent savings, one of the other major reasons people take up DIY investing is that the barriers are very low. A few mouse clicks and you can carry out your own trades.
Contrast the predicament of an individual who is looking for a financial advisor and one who is looking for, say, a builder. If you hire a contractor to fix the foundation of your house and they’re too slow, expensive, or unprofessional, you might fire them and have someone else take over. If that second contractor is similarly inept, you would probably suck it up and invest a lot more time finding a third contractor, whom you would vet much more carefully. You would persist in searching for a third party to handle the project because it’s clearly a large undertaking due to the physical, equipment, and time requirements. You’re not likely to attempt it yourself. But when it comes to investing, the DIY option appears to be more manageable. Certainly, there are DIY investors who have learned the ropes out of sheer frustration, and manage quite well. They may hire a fee-only advisor to help with a financial plan for the less sexy estate, tax, and retirement planning.
Some people constantly switch strategies and end up with a hodgepodge of investments, with no regard for the overall portfolio construction. And then, of course, there are those who buy high and panic when markets dip and then sell low and lose much more money than mutual funds with the highest fees would cost them. Not that I’m recommending that you invest in high-fee mutual funds, mind you.
What I would suggest is to take the time to figure out what makes a good advisor a good advisor. That’s more than just checking to see if they’re a certified financial planner (CFP) or possess one of the myriad other credentials out there. You need to roll up your sleeves and invest some time to learn at least the basics of their lingo, the basics of the “cost matters hypothesis,”2 diversification, how advisors get paid, portfolio construction, and more.
If you can learn the language your advisor speaks, you will be better able to find one of the good ones and determine the value you are receiving for the extra cost.
RRSP OR TFSA?
You would have to have been living under a rock if you haven’t heard of registered retirement savings plans (RRSPs). But then, financially speaking, many people do live under rocks.
Many people equate RRSPs to—drum roll, please!—retirement planning. They’ve been around for a long time (since 1957) and, until recently, have been the de facto method of saving for retirement, besides, or in addition to, pension plans.
Things got much more complicated when tax-free savings accounts (TFSAs) were introduced. Many people are now opting to save into a TFSA instead of an RRSP for their retirement. Others are using a mix of both. These two tax-sheltered accounts are similar, but there are nuanced differences between them. Let’s start by looking at RRSPs.
Many people think that they buy RRSPs every year—that the RRSP is the investment. No. Think of an RRSP as an account. You can hold a wide variety of investments inside this account. An RRSP can be set up as a high-interest savings account or a guaranteed investment certificate. It can hold stocks, bonds, and mutual funds, or it can hold a combination of these different options.
The reason many Canadians save into an RRSP is because they are tempted by the dangling carrot of a tax refund. You know that if you earn $100, part of that goes to the government in the form of income tax. But, up to certain limits, money put into your RRSP isn’t subject to income tax. Now, what normally happens is that you get paid, and taxes are taken out of your pay at source, before you have access to your money. Let’s say you made $50,000 before tax. You might pay $10,000 in income tax, which is taken off your paycheque. But if you put $1,000 into an RRSP account over the year, in the eyes of the government, you only have to pay the income tax owed by someone who earned $49,000. Since you paid the tax a $50,000-earner was supposed to pay, but are only supposed to have paid the tax a $49,000-earner was supposed to pay, you get back the difference at tax time.
Sounds great, right? Well, not so fast. Eventually, the piper has to get paid. The trade-off is that when you take money out of your RRSP account in the future, it gets treated as salaried income, meaning it is subject to tax. So an RRSP is a giant tax-deferral mechanism. While you are deferring income tax, you hope to grow your savings by investing it as you (or your advisor) sees fit.
Another benefit of an RRSP is that many Canadians will be in a lower tax bracket in retirement than they were in their working years. That means you save paying tax at a higher rate when contributing to an RRSP and end up owing tax at a lower rate when taking it back out. For these basic reasons, coupled with the length of time that the RRSP program has been around, it’s a very popular savings (and investing) option for Canadians.
A few years ago, the government introduced the tax-free savings account (TFSA). The account was originally designed as a short- to medium-term savings plan, but due to its structure, has become a very popular retirement savings vehicle as well. Let’s look at how it works.
It’s almost exactly the same as an RRSP—with this big difference: you don’t get any tax savings upfront, and you don’t have to pay any tax down the road when you take funds out. So what’s all the hoopla about? Well, to a certain extent, there’s just a lot of hair-splitting going on. Everybody’s financial situation is different. To make a long story short, there are so many variables at play in determining which plan or account is better for you that there is no clear winner. At least not in a way that can be recommended for everyone. Just Google “RRSP versus TFSA” and you’ll see there is no straight answer.
So here is what you need to know if you are just starting out. If you use an advisor, do what he or she says. If you aren’t using an advisor, use the TFSA first. Don’t over-think it. The differences are too close to call and all the variables that affect the calculations are constantly changing. The RRSP versus TFSA analysis is an A+ discussion. The easy A is just having a long-term savings account. Focus on having savings for the long term and you’re beating the majority of Canadians out there.
One place to look for a great analysis of the RRSPversus-TFSA debate is in The Wealthy Barber Returns by David Chilton. His first book, The Wealthy Barber, is one of the most famous books in Canada. Not just for personal finance, but for any type of book, period. His latest effort offers up a number of valuable financial lessons on a variety of topics and is definitely on my recommended list.
1 Andrew Ang and Knut N. Kjaer, “Investing for the Long Run” (November 11, 2011). Available at SSRN: http://ssrn.com/abstract=1958258 or http://dx.doi.org/10.2139/ssrn.1958258
2 The cost matters hypothesis essentially states that the higher the fees (the cost of financial intermediation), the lower the returns of the investors as a group.