The last few columns have been haranguing you about managing the risks to the income that funds your quality of life, in part by using insurance. But the goal of financial planning is to build up the wealth that will give you financial independence, to do what you want to do when you choose to END WORK. The past couple of columns have warned you about the rip-offs in the financial industry, including the excessive fees that can hold you back from reaching the objective of independence. Enough doom and gloom.
I promise in the END OF WORK that “the basics of investing are really quite simple when you understand the fundamentals”. This column starts a series on those fundamentals. Let’s start with the choices for investing your money. There are only two things you can do with it.
You can lend it to someone who will promise to pay you interest (you can be a bank!). This ranges from a “high interest savings account” for ½ of one per cent, a Guaranteed Investment Certificate paying 1 to 2%, up to a fund of corporate bonds, possibly including some real estate and infrastructure investments that might average 5%. We call these Fixed Income assets.
The other choice is to buy a piece of the business. You can invest in your own business, on the side of your day job, or full time. A common on-the-side business is rental properties (you can be a slum landlord!). You can buy shares in a corporation, privately or on a stock market or you can buy units of a fund that owns a portfolio of stocks. Instead of a Fixed Income contract for a specified rate of interest for a set term, an equity investment return will be in dividends, the share of the profit paid out to shareholders, and in capital gains if you later sell the shares for more than you paid for them. Unfortunately, most small investors buy high and sell low incurring a loss of capital; not losing your money will be a future column.
The first fundamental of investing is choosing the right balance between lending your money and buying a piece of the business. Conventional wisdom is that your choice of fixed income versus equity investments will depend on your risk profile, your tolerance for market volatility, the ups and downs. If you are a risk-averse conservative investor you should stick to lending your money. If you are more risk-tolerant and aggressive, you should invest in ownership through equities expecting greater returns over the long term, even though short term returns may bounce between wonderful and losses. But let’s face it, we all want aggressive returns with conservative risks.
As a contrarian, I disagree with the risk profile approach. Your risk profile needs to be based on your independence objective. Today’s artificially low interest rates will force you to take on some level of risk (volatility) in order to achieve even conservative return targets. Returns from fixed income assets like savings accounts and GIC’s won’t even cover inflation and taxes. If you rely only on fixed income investments, lending your money, you may not live long enough to save enough for an independent retirement.
Say you set a target of a $1,000,000 portfolio by age 65 to provide the income to support the lifestyle you wish to enjoy. What return will you need to average on your savings to reach your target? You can get by with a lower level of risk if you start soon enough, put enough away or set a more modest target. If you want more, are starting later, or don’t want to commit enough from current consumption, you will need to take on more risk. More risk means you may not meet your target. But not taking on the necessary level of risk will guarantee you do not make your target. You can choose your trade-off between foregoing more consumption so you can retire at 65, or taking more risk where if lucky you may be able to retire at 60, but the trade-off risk is that you may not reach your target before 70.
The August column will look at working out your financial independence objective, considering your investing horizon and how much consumption you are willing to forego now. In the following issues we will get into the other two fundamentals of successful investing. These are diversification, for both sectors and geographies. In a well-diversified portfolio, non-correlated investments will average out for more consistent returns and less volatility, like when commodities are down, financials may be up, when the loonie is down, the U.S. may be up. The third fundamental is consistency in investing. It is more effective than trying to time market ups and downs; you will learn how to make money in the down cycles using dollar-cost-averaging. And we will cover tax effects to get maximum returns, as well as keeping down the cost for money management so you keep more of the returns, and suggest a model portfolio for guiding your own investment choices.
The series will close on keeping your investments in priority. For people who really do have better things to do, family, health and vocation really are more important than investing.
Fredrick Petrie, B. Comm. (Hons.), author of “THE END OF WORK: financial planning for people with better things to do”, provides financial education at www.navigatingfinance.com, reach him at email@example.com or call (204) 298-2900. You can get started at http://www.amazon.ca/END-WORK-Financial-Planning-People-ebook/dp/B00XCY0AJ2/