Newsletter March 5, 2011
InvestorsFriend Inc. Newsletter March 5, 2011
First – Time and Beginning Investors
First-time and beginning investors often wonder where to start.
To new investors, almost everything is confusing. Stocks, bonds, P/E ratios, TSX index, the market is up 200 points, then down 100 points. Oil, gold, silver, GIC, RRSP, RESP, Tax Free Savings Account. What does it all mean and where do we start? What are the good investments, what are the scams?
I liken the process of learning how to invest to the process of learning a foreign language. At first everything sounds like gibberish. But if you learn a few words and if you have someone to practice with, then a few words can grow into more words and phrases. Soon you have a little island of knowledge and you can grow from there. There are unlimited individual words to learn. But you never need to know all the words. The structure and syntax and grammar rules for the language are always of great importance. If you learn how to make a word into the past tense that can be applied to many words. Once you learn enough and have a good base of knowledge you are able to start learning new words on your own. At some point you will know more than enough to get by, but you will never know every word in any language. Nor will you ever need to.
Learning to invest is similar in many ways. Rest assured that no one is an expert in all areas of investing. Some people know a great deal about investing in mutual funds and nothing about investing in stocks. Some know stocks but not bonds. Only a small percentage of investors have much knowledge in the area of options. Fewer still know much about foreign currency trading. Some investors specialize in certain commodities or commodity stocks. Warren Buffett is perhaps the most successful investor in history. Yet he has consistently said he restricts his investments to certain types of companies and avoids others that he claims are too complex for him to predict their earnings.
If you are just getting started investing or otherwise have limited knowledge, don’t worry. You can always start investing now while you continue to learn and broaden your scope.
To get started investing you need two things. 1 Money – either ready cash or a commitment to contribute cash regularly each month. 2. An identified product to invest in.
When I talk about beginning investors, I am not talking about merely saving money in a bank account. I am talking about getting started in investing in stocks and bonds (including investing in stocks and bonds through mutual funds).
One of the confusing and intimidating aspects of getting started investing is simply all the jargon and abbreviations. You’ll probably find that you will learn the jargon and abbreviations a little at a time as you go. You can always look up terms in Google as needed.
Most beginning investors need the assistance of a financial advisor of some kind. This can be, for example, a representative from Investors Group or from an insurance company. You can also ask to speak to a financial advisor at any bank branch.
Most investors will start out investing in mutual funds rather than in individual stocks and bonds.
Investing in individual stocks and bonds requires more sophisticated financial knowledge or the services of a more sophisticated (and usually higher cost) financial advisor and it requires a certain minimum amount of money. Mutual funds are ideally suited to the situation of getting started in investing.
Many people are convinced to start investing in mutual funds by a financial advisor from Investors Group or an insurance company. These financial advisors often find new customers at trade shows (of almost any kind) where they set up booths or by personal referrals or by direct mail advertising. These advisors will usually make house calls, especially for initial referrals when they are trying to get your business as a new customer. If you come across such an advisor that can be a good way of getting started investing.
If you are trying to get started investing and don’t happen to already have a friend or relative or other such person in the business then the best approach is probably to ask to speak to a financial advisor at your bank branch. Using a financial advisor at your bank branch will probably prove convenient in terms of transferring money into an investment account, both initially and on a monthly basis.
With mutual fund investing you will not typically be charged any fee to set up an investment account. And you will not directly pay any fee when you buy additional mutual funds each month. Instead, the mutual fund company will make its money essentially by keeping a portion of the money that you would otherwise have made. If the stocks and/or bonds within the mutual fund earn an average 7.5% in a year you may receive only 5.0% with the mutual fund company effectively deducting their “cut” before you ever see your share. Additionally if the stocks and/or bonds in the mutual fund lose 7.5% in a year, you may see a loss of 10.0% as the mutual fund company more or less reports to you a loss of 10.0% because they took out their 2.5% fee.
Many financial commentators would advise you to avoid mutual funds because of the fees that often are in the range of 2.5%. However, there may simply be no feasible alternative for those just getting started investing small amounts of money. Also in the early years of an investment program, what really matters is the amount you save up each month, and a 2.5% fee should not initially be a big concern. For example imagine you invest $300 per month and end up with $3600 after one year. 2.5% of that is $90. It would be difficult to argue that $90 was a very high price to pay for the opportunity to invest in a diversified group of stocks and/or bonds and to have a financial advisor to talk to as often as you wished during that year. And at the end of the year you would have paid 2.5% in fees but 97.5% of the money you invested that year would still be in your account (plus or minus the gain or loss in the stock market).
Now imagine that after 5 years of investing $300 per month you have $21,000 invested. ($3600 times 5 or $18,000 in contributions plus say $3,000 in gains). Now in the sixth year you might pay $21,000 times 2.5% or $525 in fees to the mutual fund. At this point the 2.5% fee is starting to get more noticeable since it represents almost two months of your $300 per month contributions. But it still may be less than you would pay in fees if you attempted to invest in individual stocks and bonds. And you would not likely find a financial advisor willing to take the time with you to pick individual stocks for $525 per year. (Keeping in mind that the financial advisor would face trading charges to be paid out of the $525 or might have to share that with his or here employer.)
However, imagine that after 30 years you have managed to accumulate $200,000 in mutual funds. Now those 2.5% fees amount to $5,000 per year or probably more than you can save in a year. Certainly at that point there are better alternatives than mutual funds unless you are particularly “wedded” to your financial advisor.
My point is that you should not worry much about the fee on mutual funds when you are first starting out. What you should worry about is investing a reasonable amount each month.
“Graduating” from Mutual Funds to Exchange Traded Funds and to Individual Stocks and Bonds
A small percentage of investors will make stock picking something of a hobby and or obsession. They will want to get out of mutual funds and into picking their own stocks as soon as possible. These investors should open a self-directed investment account. All of the major banks offer self-directed accounts through their discount brokerage arms. The trading fees are about $30 for each buy or sell of a stock (the dollar amount traded does not matter). If the investment account or even the sum of all investment accounts in the same household is over about $100,000 then the trading fees may drop to about $10 per trade. In most cases it will not make sense to open a self-directed account unless the amount is invested is about $20,000 or higher. However, in theory if you initially only wanted to own one stock you could start with as little as $3,000 or so in a self-directed account. Again, this self-directed approach is only for people who want to pick their own stocks.
Self-directed investors tend to pick up ideas for investments by watching investment television shows, reading the financial pages and sometimes by purchasing investment newsletters. Also the discount brokerages provide a huge amount of investment ideas on their Web Sites.
The majority of investors may never have the time or inclination to select their own stocks or make their own trades online. Also they may fear the risk that they will make sub-standard returns. These investors may feel most comfortable with continued use of a financial advisor. Obtaining personalized financial advice on which stocks to buy usually requires a full service broker. Due to the fees involved this may require a larger investment amount such as at least $200,000. The use of a full service broker will allow you to be invested in individual stocks and bonds as well as Exchange Traded Funds. Below a total family invested amount of about $200,000 it way be more cost effective to stay with a mutual fund advisor (this assumes you are notwilling to be a self-directed investor). For larger amounts such as $500,000 it may be cost effective to use the services of an an Investment Counsel. These firms will invest your money on a discretionary basis. (They don’t have to call and get your permission every time they trade your account).
There are certainly many other ways to invest money. The categories above are the mainstream categories that I am most familiar with.
How do RRSPs, RESPs and Tax Free Savings Accounts Fit into the picture?
In Canada there are several tax-advantaged ways to invest. These are special accounts that your financial advisor, bank or broker must “register” with the government. In each case only limited amounts of money can be invested each year.
What follows is a very brief and simplified description of the three most commonly used tax-advantaged plans. This is not meant to be a detailed description of these plans and all their rules. For the full details talk to your financial advisor or bank branch staff. There are also other tax-advantaged plans that may apply to some people such as disabled persons.
Finding the money to contribute to these various plans is easier said than done. I recognize it can be very frustrating to those on tight budgets to be hear about all the tax savings that some people are getting. And down right maddening to be lectured about not contributing to these plans – when your budget may simply not allow it. (Adequately feeding, clothing and housing the family today will always trump saving for tomorrow). So please don’t take the following as being lectures. I know these plans are simply not affordable to everyone.
A Registered Retirement Savings Plan (RRSP) Account provides for an income tax deduction when you put money into it. The amount you may contribute is limited, as of 2010, to no more that 18% of earned income to a maximum of $22,000 per year. And, if applicable, this maximum is reduced by the “value” (called the Pension Adjustment) of contributions that you and your employer make to your registered pension plan. Money is allowed to grow tax free inside this plan. When money is withdrawn it is taxed. This can prove very advantageous when your tax rate in retirement is lower than when you contributed. It can be very advantageous when money can be left in it to compound and grow tax free for many years and decades. Money that you were allowed to contribute to an RRSP but which you did not contribute may be carried forward indefinitely and contributed in a future year. The down-side to this is that for every year of delay you lose the growth that you might have obtained.
With a Registered Education Savings Plan (RESP) the government adds 20% to your contribution to a maximum of $500 per year. This means you can contribute $2500 per year per child to receive the maximum grant amount. The funds then grow tax free. If the funds are spent on your child’s education after high school then the growth and the grants are taxed in the child’s hands (presumably at a low rate of tax). Your original contributions when removed and spent on the child’s education are not taxed at all since that is a return of your own money. There is a limited amount of ability to “catch-up”. I understand you can obtain a grant of $1000 per year per child if you start late and then contribute $5000 per year. The best scenario, if affordable, is probably to set up the plan and begin contributing the year the child is born. The downside of delaying is that you may never be able to catch up fully on the missed grant money and you lose years of tax-deferred growth.
With a Tax Free Savings Account, each Canadian, aged 18 and over, can contribute (as of 2010) up to $5000 per year. There is no tax deduction and no grant money. However no income is payable on the earnings in these plans – ever. It’s your own legalized tax haven! Any money removed from the plan can be returned to the plan, but only in the following calendar year. Any unused contributions can be carried forward indefinitely starting with 2008, the year these plans came into effect. The disadvantage of carrying forward amounts is the loss of the opportunity to invest sooner on a tax free basis.
Under government rules, each of the three plans above allows the funds in the plan to potentially be invested in a varity of things including a simple savings account, a bank guaranteed certificate of deposit (GIC), mutual funds and individual stocks and bonds. However your ability to invest in different things may be limited by the financial institution that provides your plan. Your financial institution may not allow your plan(s) to be invested in individual stocks and bonds unless you set up a self-directed plan or you deal with a full service broker at the bank. If you deal with a mutual fund advisor at either a bank or an organization like Investors Group they are often not licensed to allow you to invest in individual stocks and bonds or even Exchange Traded Funds. You can, if you wish, start these plans with mutual fund investments and later perhaps “graduate” to investing in Exchange Traded Funds and/or individual stocks and bonds.
Each of the three plans above has the benefit of reducing income taxes paid. And the RESP has the added advantage of receiving grant money.
Perhaps the biggest advantage of these plans is that they provide a strong incentive for us to save and invest money.
Is now a good time to Invest in Stocks?
I have recently updated a number of important articles that look at whether stocks are a good investment or not.
During the last 6 weeks or so, I also emailed links to the articles below to those on the list for this free newsletter. For convenience, here once again are those links
“Time in The Market” shows what happened to investments that have been in the market for 1 year, 2 years, 3 years etc. all the way back to 85 years in the market. See
An article on the historical performance of stocks:
Historical results for 30-year savings periods, 100% equities versus the balanced approach:
Historical results for 30-year retirement periods, 100% equities versus the balanced approach:
Are Stocks Riskier than bonds?
Asset Performance – Stocks, Bonds, Cash and Gold
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