Here is yet another small example of why the U.S. taxpayer won through the TARP deal, despite what all the naysayers will say about ‘main street vs. wall street’. For those too busy to open, the Treasury announced a $12 billion profit after selling their remaining stake in Citigroup. This is becoming a regular occurrence; GM, Citi and next year AIG. Absolutely brilliant.
http://www.reuters.com/article/idUSTRE6B55KP20101207
Tuesday, December 7, 2010
Sunday, October 17, 2010
Week 21 - Gold
These days, i get a lot of questions about gold. There are those who wonder why it's doing so well and others who don't care and just want to know how to own it. We are reading more in the news and hearing more on the radio that gold is hitting new all-time highs each week. Normally, these types of conditions would lead me to believe that we are in a 'gold bubble' and that gold is overvalued at these levels. However there are still those that think gold can go higher.
In my opinion, the value of gold is affected by many factors, so I will try to explain a few of them as well as I can.
Supply & Demand
Economics 101, as they say. This is the simple theory that the price of something can increase if more people want to buy it, or if less of it is available for sale. It is difficult to predict supply (we have no idea how much gold is still in the ground) but most believe that because of the rapid economic growth in China and India, there are many more people wanting to buy gold than there used to be. Should this increased level of demand cause gold to increase from $200/oz to $1350/oz today? Again, difficult to say. That is some increase, though. There's an expression that might relate to this massive level of demand; that the Stone Age didn't end because we ran out of stones - things come along that might be viewed as better than gold or at least an effective replacement. This might not be likely with gold though because of its historical significance as the precious metal.
Gold as a currency
Many moons ago, gold was used as the standard for valuing one country's currency. That country might hold a level of gold in their reserves, which would serve to give their dollar (or pound, franc, etc) some value. The United States did this until the '70s I believe, but then declared that they were no longer going to relate the value of their currency to their gold reserves, which would allow the price of gold to appreciate or depreciate in U.S. dollar terms. Today, the U.S. dollar itself is known mostly as the world's 'reserve currency'; a country would value its currency vs. the U.S. dollar. Gold is also valued in U.S. dollars but with the tremendous fiscal deficits south of the border, many are wondering if gold itself is the only safe 'currency' to hold. Ironically, people have been saying this for years but in 2008 during the global economic meltdown, gold dropped in value significantly as investors rushed to convert their holdings into U.S. treasury bills (short term bonds); a telling sign as to where people still believe their money will be the safest. Still, many believe this story is far from over as nothing seems to be getting done about economic health south of the border. If things get bad enough in the States that their dollar depreciates rapidly, then many believe gold will still be looked upon as the 'new' safe haven.
Gold as a store of value - a safe haven?
That's where things get tricky. Right now many believe that governments around the world are struggling to keep the value of their currency low versus the U.S. dollar. America wants their dollar value down as much as possible because of how many foreign governments are holding U.S. dollar denominated debt. Why not just turn the money-printing presses on at home to make it easier to pay those governments off? That's pretty much what the U.S. has been doing and is also what China has been doing for years, to keep them in a competitive advantage as an exporting nation. In this case, one would think that gold, being priced in U.S. dollars, would stand to benefit.
I believe that like any currency, gold has to have a level of trust behind it. I don't want to hold my wealth in some measurement that has the potential to decline significantly in terms of my purchasing power. If it's going to cost me 400 oz of gold to buy a nice house today (about $520,000 CAN), then I don't want to risk the value of gold depreciating because people don't think it's worth that much. With paper currency, the health of the government and the level of inflation is really what helps maintain a reasonably consistent level of value. In Canada, we have a very healthy economy and therefore a strong dollar, relatively speaking.
Conclusion
I have a difficult time valuing gold for these reasons. Gold isn't a company. It can't win new contracts or increase productivity in the plant to help its stock price climb. The value of gold is based only on external factors that in my mind are extremely difficult to predict; currency movements, future supply and demand, U.S. economic health to name a few.
I have always kept my clients out of gold when they ask for my advice. So far, it has been an opportunity lost. But I'd rather look at it as a risk that I am not taking. There are other ways to store value that I view as safer today, in my opinion.
Week 20 - More on Stocks
It's been more difficult than I thought, coming up with things to write about. If you have any suggestions, feel free to pass them on.
Because of my general belief that stocks will yield the highest returns over time, I wanted to focus more on some ways that we can take advantage of this, and some ways that I don't think add value.
Buy & Hold
We remember the AIC ads from the late '90s which urged us to 'Buy, Hold & Prosper'. This is an age-old investment philosophy which focuses on the idea of buying stock in a number of companies and then pretty much just holding them for a very long time. Originally, I was a bit of a non-believer. However, more and more of my older clients would buy stocks back in the day and actually receive the certificates in the mail, which they usually stored in safety deposit boxes. Most of them never really cared what the market did; they just figured that they'd buy some stock in whatever company looked interesting when they had some spare cash. Now - say 25 years later - they deliver the shares which (so far, without exception) have substantially increased in total value. This doesn't mean all the shares are worth more but the ones that are have usually increased by a far greater amount than the bad ones have fallen.
I can't tell you how many times this has happened. The theory (whether these investors really knew they were doing this or not) was that over time, companies would either prosper or fail but the net result would be a gain. If you bought 10 stocks in the 1980s and even 2 of them were Canadian banks, then today, you probably have increased the value of your portfolio by about five times, even if a few of those other 8 stocks went bankrupt.
I don't think this is a bad investment strategy. It is certainly low cost, since once you own the stocks, you don't pay any fees. I think in general, people watch the market too much and it is too easy to buy and sell their stocks because of some external factor. It actually leads most people to stop buying stocks all together because they have no faith in the returns of equity markets. Actually, over the past 50 years, stocks in Canada have been far and away the best place to invest.
We don't see this result over the short term, however. All we hear about is how much debt the world has or what countries are still in recessions, etc. We end up just buying more house than we probably should and investing all our spare cash in paying down our mortgage. It isn't a bad strategy because if things get really bad, you can just live in your investment (unless your mortgage is a little too high - see the U.S. subprime crisis). We don't have a screen that tells us what our house is worth every day and we can't buy and sell houses by the touch of a button. So we naively think that real estate is a better performing investment. I suppose the next 50 years could be different than the last 50 years but I doubt it.
Buy and hold is advice that I think more equity fund managers should take themselves. As a portfolio manager myself, I feel the pressure of being compared to benchmark indices on a monthly or quarterly basis. It's totally counterproductive though because when I start buying stock in a company, I don't do it with the idea that I'm only going to hold it for a few months - exactly the same as when I'd buy a house. And yet, every month I want to see how my clients' portfolios performed against the index, instead of just sitting back and watching my portfolios grow, focusing on our country's best managed companies.
The polar opposite of buy-and-hold is day trading. The epitome of this is the commercial with the little baby who has opened up his online trading account so he can buy and sell stocks on a daily basis, trying to eke out a paper thin profit which he hopes will add up over time. In my mind, the ad represents kids who are putting a little money in an account to try and make it grow overnight. It is so much like gambling in this way because the only people that end up making money on this system with any guarantee are the brokerages that take a commission every time these kids do a trade. Want my advice? Focus more on finishing university, getting a real job and making actual money which you can invest properly.
The end message is probably that regardless of what side of the desk we sit on (investor or advisor/PM), we should probably watch markets less. They are great at giving us a meaningless number of what our companies are worth, when we have no near-term plans of selling.
Friday, September 17, 2010
Week 19 - A sentimental favourite
There is a funny thing to consider when buying stocks, or when looking at the performance of a company's stock price, relative to the amount of money they earn: investor sentiment.
Take, for example, the results of one of Canada's (and for that matter, North America's) most well-known technology companies. Although the numbers were up nicely and ahead of the average analyst expectations, investors continue to hate on the company because of one metric: North American subscriber growth. Never mind the fact that this company has grown sales overseas by massive amounts, nor that they still have an incredible amount of upside in some of these markets. All people can focus on is how their devices are selling relative to the competition here at home.
The result of this is that you can buy this company with a stellar growth rate for less than 10 x trailing earnings. You would have to pay double these amounts to buy stock in Apple.
Why?
Investor sentiment. It's actually a beautiful thing if you like buying great companies at low prices. All you have to do is be willing to buy when others are selling and hold until those sellers turn into buyers again. That's when money is made.
If you already hold a company that gets negative press, then you need to have the conviction to follow your strategy, even when news might not be so good. In the end, it pays off.
Happy investing.
P.S. I never said anything about 52 CONSECUTIVE weeks, did I? And yes, I had a great summer, thank you very much!
Take, for example, the results of one of Canada's (and for that matter, North America's) most well-known technology companies. Although the numbers were up nicely and ahead of the average analyst expectations, investors continue to hate on the company because of one metric: North American subscriber growth. Never mind the fact that this company has grown sales overseas by massive amounts, nor that they still have an incredible amount of upside in some of these markets. All people can focus on is how their devices are selling relative to the competition here at home.
The result of this is that you can buy this company with a stellar growth rate for less than 10 x trailing earnings. You would have to pay double these amounts to buy stock in Apple.
Why?
Investor sentiment. It's actually a beautiful thing if you like buying great companies at low prices. All you have to do is be willing to buy when others are selling and hold until those sellers turn into buyers again. That's when money is made.
If you already hold a company that gets negative press, then you need to have the conviction to follow your strategy, even when news might not be so good. In the end, it pays off.
Happy investing.
P.S. I never said anything about 52 CONSECUTIVE weeks, did I? And yes, I had a great summer, thank you very much!
Tuesday, June 15, 2010
Week 18 - The BP Oil Leak
I know this is a huge cop-out for a blog post but honestly, if you have any interest in the actual workings of the BP oil leak and what they have been trying to do to prevent it, this article is for you. It is a great summary (including diagrams!!) that explains most of what has happened thus far. Enjoy.
http://news.bbc.co.uk/2/hi/world/us_and_canada/10317116.stm
Cheers.
http://news.bbc.co.uk/2/hi/world/us_and_canada/10317116.stm
Cheers.
Monday, June 7, 2010
Week 17 - Foreign Currency
You know when you travel to another country and you have to get money exchanged? There are a few different ways of doing this. You can do it at the airport, a foreign currency exchange desk or a local bank. This post will be short and sweet but is meant to alert you of how costly it can be to use a couple of these different services.
The key term here is something called 'spread'. Spread is the difference between what someone will buy your Canadian dollars for and what they will sell those dollars for to someone else. Today, the Candian dollar is trading at about $0.95 US. If you go to a bank though, you won't get $0.95 US for every Canadian dollar you give them; you will more likely get $0.935 or something close to that, with the bank taking the difference. Alternatively, if you had US dollars, you wouldn't be able to buy $1 Canadian with $0.95 US at the bank. It might take $0.965. So, what the bank will buy Canadian dollars for is $0.935 US and what they will sell them for is $0.965. That difference of $.03 is the spread.
As with any service, the more competition there is, the better your rates/prices are going to be (the tighter the spreads). This is why the best place to get your money changed is at your local bank branch. They know you can easily visit the competition, so they will be sure to give you something pretty close to 'market rates' ($0.95 in this example).
If you go to the airport, sometimes the spreads will be as much as 10% difference. In this example, the airport desk might only give you $0.90 for your Canadian dollars while selling those Canadian dollars at close to par ($1 US). Can you say 'rip-off'?
If you think the airport is the worst place to change money though, you are wrong. Try visiting some foreign countries (the fact that I was in Italy a few weeks ago is the inspiration for this post) and getting money exchanged at a local 'convenience store'. They would sell me Euros for $1.45 Canadian but they would only buy my extra Euros for $1.19 Canadian! That's a 26 cent spread! Insane.
The moral of the story is to make sure you get all the money you need before you leave home, either from your local bank branch or a major foreign currency trading centre. If you forget, make sure to go somewhere where the spread they are offering is fairly tight. Don't be the sucker that is paying a 10% premium for your money. You may as well light it on fire.
Cheers.
The key term here is something called 'spread'. Spread is the difference between what someone will buy your Canadian dollars for and what they will sell those dollars for to someone else. Today, the Candian dollar is trading at about $0.95 US. If you go to a bank though, you won't get $0.95 US for every Canadian dollar you give them; you will more likely get $0.935 or something close to that, with the bank taking the difference. Alternatively, if you had US dollars, you wouldn't be able to buy $1 Canadian with $0.95 US at the bank. It might take $0.965. So, what the bank will buy Canadian dollars for is $0.935 US and what they will sell them for is $0.965. That difference of $.03 is the spread.
As with any service, the more competition there is, the better your rates/prices are going to be (the tighter the spreads). This is why the best place to get your money changed is at your local bank branch. They know you can easily visit the competition, so they will be sure to give you something pretty close to 'market rates' ($0.95 in this example).
If you go to the airport, sometimes the spreads will be as much as 10% difference. In this example, the airport desk might only give you $0.90 for your Canadian dollars while selling those Canadian dollars at close to par ($1 US). Can you say 'rip-off'?
If you think the airport is the worst place to change money though, you are wrong. Try visiting some foreign countries (the fact that I was in Italy a few weeks ago is the inspiration for this post) and getting money exchanged at a local 'convenience store'. They would sell me Euros for $1.45 Canadian but they would only buy my extra Euros for $1.19 Canadian! That's a 26 cent spread! Insane.
The moral of the story is to make sure you get all the money you need before you leave home, either from your local bank branch or a major foreign currency trading centre. If you forget, make sure to go somewhere where the spread they are offering is fairly tight. Don't be the sucker that is paying a 10% premium for your money. You may as well light it on fire.
Cheers.
Wednesday, May 5, 2010
Week 16 - Dividend Income
It's a two-post week this week. I have to admit; golf season has started so time in the office is a little more sacred, meaning I could slip out a half-hour early here and there for a 4:30pm tee time! That leaves less time for posting and more time for hitting balls into the woods.
I wanted to talk about stocks that pay dividends this week. I know there are a plethora of financial products out there that are great tools for diversification and give you exposure to different parts of the world. That said, we have some of the world's best companies right here in Canada and it is very possible to set up a portfolio of Canadian stocks that pay nice dividends. You can do this by paying an up-front brokerage commission too, which means no annual management fees. You just set it and forget it.
Let's first review what a dividend is: we will use the CIBC as an example. If you buy shares of CIBC, you will receive a dividend every three months. Right now, that dividend is set at $3.48 per year or $.87 each quarter. This $3.48 is a percentage of the profits that CIBC makes that they don't choose to reinvest into their business. They would rather pay out their shareholders and let them decide what to do with the money.
Now let's look at some ways we can take advantage of companies that pay dividends:
DRIPs
Many Canadian companies offer their shareholders the option to reinvest their paid out dividends, often at a discount to the market price of the shares. If you don't rely on the income stream from your dividends, then this is a great way to grow your savings. If you assume that a dividend is 5% of the company's stock price, as an example, then by reinvesting the dividends, you could add 50% over ten years, assuming ZERO growth from the shares themselves. As you can see, that's a great way to save money, without having to add more of your own funds to the pot. DRIP = Dividend ReInvestment Plan.
SWPs
Another route to take if you hold shares at a brokerage is taking your dividends each month and having them electronically transferred from your investment account to your bank account. This is very popular with retirees who would use their dividend income to live off. Usually twice a month, the dividends that have been paid into the account from the stocks, (or interest if they are bonds) are 'swept' out of the investment account and transferred to the bank account. It's that easy. SWP = Systematic Withdrawal Plan.
Piece of Mind
I think the nicest part about dividends is that they help ease the pain of bad markets. If you know you are going to collect your dividends every month or quarter, you are less likely to care what your stocks are doing. That can help you stay invested, when it might otherwise feel difficult. If you sell, then you don't get your dividends anymore and you might miss the upswing of the next good market.
Tax Treatment
Dividends are nice too because our government offers preferred tax treatment over regular income. This results in about half as much tax to pay on your dividend paying stocks, compared to your bonds. So if you have a stock that pays a dividend equal to 5 % of the share price, you'd have to find a bond that paid 7.5% interest to get the same after-tax income. With interest rates as low as they are today, 7.5% bonds are not easy to come by.
Hopefully you see how nice a portfolio of good dividend paying stocks can be, if managed properly. You just buy the stocks, make one or two changes a year and collect the dividends. Life is good. Have a great week.
I wanted to talk about stocks that pay dividends this week. I know there are a plethora of financial products out there that are great tools for diversification and give you exposure to different parts of the world. That said, we have some of the world's best companies right here in Canada and it is very possible to set up a portfolio of Canadian stocks that pay nice dividends. You can do this by paying an up-front brokerage commission too, which means no annual management fees. You just set it and forget it.
Let's first review what a dividend is: we will use the CIBC as an example. If you buy shares of CIBC, you will receive a dividend every three months. Right now, that dividend is set at $3.48 per year or $.87 each quarter. This $3.48 is a percentage of the profits that CIBC makes that they don't choose to reinvest into their business. They would rather pay out their shareholders and let them decide what to do with the money.
Now let's look at some ways we can take advantage of companies that pay dividends:
DRIPs
Many Canadian companies offer their shareholders the option to reinvest their paid out dividends, often at a discount to the market price of the shares. If you don't rely on the income stream from your dividends, then this is a great way to grow your savings. If you assume that a dividend is 5% of the company's stock price, as an example, then by reinvesting the dividends, you could add 50% over ten years, assuming ZERO growth from the shares themselves. As you can see, that's a great way to save money, without having to add more of your own funds to the pot. DRIP = Dividend ReInvestment Plan.
SWPs
Another route to take if you hold shares at a brokerage is taking your dividends each month and having them electronically transferred from your investment account to your bank account. This is very popular with retirees who would use their dividend income to live off. Usually twice a month, the dividends that have been paid into the account from the stocks, (or interest if they are bonds) are 'swept' out of the investment account and transferred to the bank account. It's that easy. SWP = Systematic Withdrawal Plan.
Piece of Mind
I think the nicest part about dividends is that they help ease the pain of bad markets. If you know you are going to collect your dividends every month or quarter, you are less likely to care what your stocks are doing. That can help you stay invested, when it might otherwise feel difficult. If you sell, then you don't get your dividends anymore and you might miss the upswing of the next good market.
Tax Treatment
Dividends are nice too because our government offers preferred tax treatment over regular income. This results in about half as much tax to pay on your dividend paying stocks, compared to your bonds. So if you have a stock that pays a dividend equal to 5 % of the share price, you'd have to find a bond that paid 7.5% interest to get the same after-tax income. With interest rates as low as they are today, 7.5% bonds are not easy to come by.
Hopefully you see how nice a portfolio of good dividend paying stocks can be, if managed properly. You just buy the stocks, make one or two changes a year and collect the dividends. Life is good. Have a great week.
Week 15 - Group RRSPs, etc.
I wanted to touch on the options that you might have for saving money at work. I don't think that enough people understand how good some companies can be at helping us save money.
If you work for a company, see if they have a profit sharing plan, a group savings plan, matching plan, etc. There could be an opportunity to make great returns on your investment dollars, regardless of how they actually are invested.
Take for example company X. I will use numbers that I know exist, so you can get a real idea of how some companies do things. Company X has a program where employees can set aside a certain dollar amount from their pay cheque, and X will add 50% to that dollar amount to a maximum of 6% of your pay, which is then invested in X's company stock. So let's say you make a good living - $100,000 per year and you set aside the maximum: 6%. That means you have saved $6,000 of your own money each year as a start. Now remember, X matches half that amount, which means you are now up to $9,000 at the end of the year. Think of this as a return on an investment. If you DON'T do this and choose instead to save money on your own, you would have to make a 50% return in one year to just match that plan!! No chance.
So let's say you work for the company for ten years and do the same thing every year. At the end of ten years, you would have $90,000 saved up, assuming zero growth in the company's stock price! But let's say your company X is a good quality company and the stock might actually grow over that time period, say 5% per year. At the end of year 10, you will now have more than $118,000 set aside. And this only cost you a total of $60,000. That means your annual rate of return on the portfolio is better than 11% per year. And that's if the stock only returns 5% and doesn't play a dividend!
The bottom line is that most companies have some kind of profit-sharing plan or group savings plan. You might have to keep your money there for a certain time period before you can access it but it's still well worth it. I would advise you to look into this before you consider doing any saving outside the company.
Often, the company isn't publicly traded so you can't buy stock in the company with your contributions. In this case, the company will outsource the money to external money managers, who can often do a better job than 5% per year. They are normally in the form of mutual funds though, so you will pay fees.
It's a small post this week because everyone's plan is different. Look into yours and spend some time on the phone with your HR department to see how your plan can benefit you.
If you work for a company, see if they have a profit sharing plan, a group savings plan, matching plan, etc. There could be an opportunity to make great returns on your investment dollars, regardless of how they actually are invested.
Take for example company X. I will use numbers that I know exist, so you can get a real idea of how some companies do things. Company X has a program where employees can set aside a certain dollar amount from their pay cheque, and X will add 50% to that dollar amount to a maximum of 6% of your pay, which is then invested in X's company stock. So let's say you make a good living - $100,000 per year and you set aside the maximum: 6%. That means you have saved $6,000 of your own money each year as a start. Now remember, X matches half that amount, which means you are now up to $9,000 at the end of the year. Think of this as a return on an investment. If you DON'T do this and choose instead to save money on your own, you would have to make a 50% return in one year to just match that plan!! No chance.
So let's say you work for the company for ten years and do the same thing every year. At the end of ten years, you would have $90,000 saved up, assuming zero growth in the company's stock price! But let's say your company X is a good quality company and the stock might actually grow over that time period, say 5% per year. At the end of year 10, you will now have more than $118,000 set aside. And this only cost you a total of $60,000. That means your annual rate of return on the portfolio is better than 11% per year. And that's if the stock only returns 5% and doesn't play a dividend!
The bottom line is that most companies have some kind of profit-sharing plan or group savings plan. You might have to keep your money there for a certain time period before you can access it but it's still well worth it. I would advise you to look into this before you consider doing any saving outside the company.
Often, the company isn't publicly traded so you can't buy stock in the company with your contributions. In this case, the company will outsource the money to external money managers, who can often do a better job than 5% per year. They are normally in the form of mutual funds though, so you will pay fees.
It's a small post this week because everyone's plan is different. Look into yours and spend some time on the phone with your HR department to see how your plan can benefit you.
Wednesday, April 21, 2010
Week 14 - Current Thoughts
Here are a couple of current thoughts that you might be having. I actually took this from a letter to clients recently. Enjoy.
Interest Rates
Hopefully we are seeing the world’s major economies emerge from the depths of recession. Some are doing it faster than others but data from all over the world seems fairly positive. Whenever this happens we turn our attention to interest rates, which are still near all-time lows. If our economy strengthens, then it should follow that inflation becomes a concern and hence interest rates will rise. I think this is the case, although I don’t think it will happen as rapidly as some might expect. In my opinion, you might see our central bank raise rates by 1% or so over the next year but that might be about it, for a few reasons:
1) The U.S. dollar. Because our largest trading partner is directly south of us, we do not want to have a dollar that is worth much more than theirs. They will pay for things we make in U.S. dollars, while we make them by paying for the materials in Canadian dollars. I would expect our government to be cautious when considering further rate hikes.
2) Our economy. I don’t think it’s as strong as one might be led to believe by the data. In the U.S., you could look back as far as 10 years before seeing any kind of meaningful economic growth. Before this recession, Americans were refinancing their homes based on higher property values and spending this ‘found money’ on ‘stuff’, like TVs and cars. Any job growth from this housing bubble was unsustainable, as we later found out and now the unemployment rate is at about 9.5% in America. Before then, it was the internet bubble. During this time, it was not uncommon for stocks to trade at enormous premiums, which again tricked the investor into thinking they were worth more than they really were. Prices were based on future promise, rather than current fundamentals. In either case, jobs were created based on unsustainable market conditions. For that reason, I don’t think we will see any meaningful job creation (and hence economic growth) in America until they can find a sustainable source of employment. They have been losing jobs for years to overseas competition and real replacement hasn’t happened. As Canadians, we should prepare ourselves for a decreased demand from the US, and hence a decreased level of job creation as well.
The moral of the story is that we are probably in for an extended period of relatively low interest rates. I wouldn’t be rushing out to lock in your mortgage today; I think you might be safe with that sweet variable rate for the time being. Don’t quote me on it though – my crystal ball has been known to falter, from time to time.
Sovereign Debt
This is the other topic that most of us have heard about in the last few months. Many European nations have been struggling with the recovery, having to implement stimulus packages for their economies that they really couldn’t afford. We need to think about countries the same way we think about companies – they have revenue (taxes) and expenses. If the expenses outnumber the revenues, then they will eventually be in trouble and need external support. This is nothing new, as it has happened all over the world throughout history.
What worries us is something called ‘contagion’. This term suggests that if one country defaults on their debt, then other countries that hold the first country’s debt could also default. This could be the case with Greece, Portugal and others but my thought is that we learn from our mistakes. I would be shocked to see anything meaningful come out of this situation, other than a big bailout from either the other members of the European Union or the International Monetary Fund. Either way, none of my clients are holding Greek bonds, so we really don’t have much to worry about. Even our international equity mutual funds would have zero exposure to Greek debt (although I’m sure a couple of them wouldn’t mind doing a little bargain hunting).
Income Trust Conversion
As you probably have heard, by the end of this year all income trusts must start paying corporate income tax, thanks to Jim Flaherty back in 2006. Because of this, many of us have been wondering what is going to happen to our beloved income generating investments. Here’s a very short answer that many people don’t seem to be considering:
“Income trusts are going to pay corporate income tax at the end of this year”.
That’s it. Nothing else about their business models have changed. Yes, they are going to convert to regular corporations for the most part. All else being equal, they could reduce their distributions by the exact percentage of tax that they now have to pay. In many cases, this could result in a stock that still pays a very handsome dividend, which is much more favourable from our tax perspective. Instead of ignoring the income trust universe, we have actually been trying to look at good examples of trusts that would make great companies, paying handsome dividends. I wrote about this last May, when we first started the process of identifying these trusts. Since April 1st, 2009, the income trust total return index is up more than 60%. I don’t think we’re in for another similar 12-month return but I do think there are great investment opportunities in this space.
That's all I have for now. I hope you enjoyed the column. It was a bit more technical than some others I have written. Have a great week.
Interest Rates
Hopefully we are seeing the world’s major economies emerge from the depths of recession. Some are doing it faster than others but data from all over the world seems fairly positive. Whenever this happens we turn our attention to interest rates, which are still near all-time lows. If our economy strengthens, then it should follow that inflation becomes a concern and hence interest rates will rise. I think this is the case, although I don’t think it will happen as rapidly as some might expect. In my opinion, you might see our central bank raise rates by 1% or so over the next year but that might be about it, for a few reasons:
1) The U.S. dollar. Because our largest trading partner is directly south of us, we do not want to have a dollar that is worth much more than theirs. They will pay for things we make in U.S. dollars, while we make them by paying for the materials in Canadian dollars. I would expect our government to be cautious when considering further rate hikes.
2) Our economy. I don’t think it’s as strong as one might be led to believe by the data. In the U.S., you could look back as far as 10 years before seeing any kind of meaningful economic growth. Before this recession, Americans were refinancing their homes based on higher property values and spending this ‘found money’ on ‘stuff’, like TVs and cars. Any job growth from this housing bubble was unsustainable, as we later found out and now the unemployment rate is at about 9.5% in America. Before then, it was the internet bubble. During this time, it was not uncommon for stocks to trade at enormous premiums, which again tricked the investor into thinking they were worth more than they really were. Prices were based on future promise, rather than current fundamentals. In either case, jobs were created based on unsustainable market conditions. For that reason, I don’t think we will see any meaningful job creation (and hence economic growth) in America until they can find a sustainable source of employment. They have been losing jobs for years to overseas competition and real replacement hasn’t happened. As Canadians, we should prepare ourselves for a decreased demand from the US, and hence a decreased level of job creation as well.
The moral of the story is that we are probably in for an extended period of relatively low interest rates. I wouldn’t be rushing out to lock in your mortgage today; I think you might be safe with that sweet variable rate for the time being. Don’t quote me on it though – my crystal ball has been known to falter, from time to time.
Sovereign Debt
This is the other topic that most of us have heard about in the last few months. Many European nations have been struggling with the recovery, having to implement stimulus packages for their economies that they really couldn’t afford. We need to think about countries the same way we think about companies – they have revenue (taxes) and expenses. If the expenses outnumber the revenues, then they will eventually be in trouble and need external support. This is nothing new, as it has happened all over the world throughout history.
What worries us is something called ‘contagion’. This term suggests that if one country defaults on their debt, then other countries that hold the first country’s debt could also default. This could be the case with Greece, Portugal and others but my thought is that we learn from our mistakes. I would be shocked to see anything meaningful come out of this situation, other than a big bailout from either the other members of the European Union or the International Monetary Fund. Either way, none of my clients are holding Greek bonds, so we really don’t have much to worry about. Even our international equity mutual funds would have zero exposure to Greek debt (although I’m sure a couple of them wouldn’t mind doing a little bargain hunting).
Income Trust Conversion
As you probably have heard, by the end of this year all income trusts must start paying corporate income tax, thanks to Jim Flaherty back in 2006. Because of this, many of us have been wondering what is going to happen to our beloved income generating investments. Here’s a very short answer that many people don’t seem to be considering:
“Income trusts are going to pay corporate income tax at the end of this year”.
That’s it. Nothing else about their business models have changed. Yes, they are going to convert to regular corporations for the most part. All else being equal, they could reduce their distributions by the exact percentage of tax that they now have to pay. In many cases, this could result in a stock that still pays a very handsome dividend, which is much more favourable from our tax perspective. Instead of ignoring the income trust universe, we have actually been trying to look at good examples of trusts that would make great companies, paying handsome dividends. I wrote about this last May, when we first started the process of identifying these trusts. Since April 1st, 2009, the income trust total return index is up more than 60%. I don’t think we’re in for another similar 12-month return but I do think there are great investment opportunities in this space.
That's all I have for now. I hope you enjoyed the column. It was a bit more technical than some others I have written. Have a great week.
Tuesday, April 13, 2010
Week 13 - Tax
It must be that time of year. Every day, I am getting at least a couple of emails from local accountants, asking for tax information for our mutual clients. Adjusted Costs of stock that was sold, dividend information on stock or income trust positions. It keeps us (mostly my assistant) busy.
The accountants are working day and night because literally every Canadian investor gets these summaries within at most 60 days of when their return is due at the end of April. I am notorious for collecting all my receipts, tax slips, forms, etc and just putting an elastic band around it and handing it off! I even apologized to my accountant this year because he had to email me; turns out I was missing about 4 things that he needed. Awesome.
It brings me to the point of this article; the importance of an accountant. Yes, I called the post 'tax' because that's a subject that affects us all (along with death, the only two things in life that are certain) so I wanted to make sure people read on. It would be pretty hypocritical of me to do anything other than recommend that everyone uses an accountant. And I understand that some of our tax situations are simpler than others. But I would strongly urge you consider hiring an accountant to do your taxes.
If your return is really that simple, then this will cost you very little. But in the long run, your accountant can likely save you hundreds, if not thousands of dollars. They live and breathe tax. They know all the things that you should be looking out for on your return. They are up to date on the changes that happen every year in our tax system. They wear golf shirts to work, so you know they're not distracted by uncomfortable suits (not that I should talk).Seriously though, consider what you have to lose.
For most of us (unless we own a business), our tax situation will be for ourselves and our spouses. A good accountant can process this type of return for as little as a few hundred dollars. But what if you miss one of the valuable credits by filing your own return? What if you bought your first home in 2009 and didn't know that you could claim the one-time-only first time home buyers credit of $5,000? Or what if you had major losses on your investment portfolio in 2008 (not that I or any of my clients did... yeah RIGHT)? Would you have known that you can carry back those capital losses to the beginning of 2005 and use them to reclaim any capital gains tax you might have paid in those years? These are just a few ways that accountants can make us (or save us) money.
Unfortunately, there is no benchmark for accountants to measure themselves against. I guess that's why the exams to become a Chartered Accountant are some of the most difficult exams there are.
Our tax system in this country is generally fair, as I think I've talked about before. It rewards entrepreneurs and researchers. It is fair to those who do not earn a monster pay cheque. It even allows us to save money tax-free for retirement. There are ways that we can save a lot of tax by being smart. I would urge you to think about using an accountant to make sure you have all your bases covered.
Where can you find one? I think the best way is to ask people you know and trust. Who do they use? Are they happy? If so, are their accountants accepting new clients? To me, a good referral is the best way to go.
With my soapbox speech out of the way, I will leave you with some things to consider when you get your return ready this year (to hopefully drop off to your accountant);
We talked about the first time home buyers credit. Don't forget that freebie.
Home renovation tax credits. I think we can claim up to $10,000 worth of home renovations this year. There is a form to fill out. Your accountant will have it or you can find it on the CRA website.
Capital Losses. This is where we use losses from this year against gains from previous years. This form is called a T1-A form. You can also carry forward capital losses from past years against gains from this year.
RRSP vs. TFSA. Make sure you consider which vehicle makes the most sense to contribute to. Your accountant can offer advice here too.
Professional fees. If you did decide to use an accountant or you pay investment management fees on your stock portfolio (not including mutual fund fees), then you can claim these against your income.
Those are just a few of the ways that our government is fair about us getting our hard-earned tax dollars back. Consult with your accountant to make sure you are doing all you can.
Thanks again for reading. To all you accountants out there, happy tax season. Santa comes on May 1st.
The accountants are working day and night because literally every Canadian investor gets these summaries within at most 60 days of when their return is due at the end of April. I am notorious for collecting all my receipts, tax slips, forms, etc and just putting an elastic band around it and handing it off! I even apologized to my accountant this year because he had to email me; turns out I was missing about 4 things that he needed. Awesome.
It brings me to the point of this article; the importance of an accountant. Yes, I called the post 'tax' because that's a subject that affects us all (along with death, the only two things in life that are certain) so I wanted to make sure people read on. It would be pretty hypocritical of me to do anything other than recommend that everyone uses an accountant. And I understand that some of our tax situations are simpler than others. But I would strongly urge you consider hiring an accountant to do your taxes.
If your return is really that simple, then this will cost you very little. But in the long run, your accountant can likely save you hundreds, if not thousands of dollars. They live and breathe tax. They know all the things that you should be looking out for on your return. They are up to date on the changes that happen every year in our tax system. They wear golf shirts to work, so you know they're not distracted by uncomfortable suits (not that I should talk).Seriously though, consider what you have to lose.
For most of us (unless we own a business), our tax situation will be for ourselves and our spouses. A good accountant can process this type of return for as little as a few hundred dollars. But what if you miss one of the valuable credits by filing your own return? What if you bought your first home in 2009 and didn't know that you could claim the one-time-only first time home buyers credit of $5,000? Or what if you had major losses on your investment portfolio in 2008 (not that I or any of my clients did... yeah RIGHT)? Would you have known that you can carry back those capital losses to the beginning of 2005 and use them to reclaim any capital gains tax you might have paid in those years? These are just a few ways that accountants can make us (or save us) money.
Unfortunately, there is no benchmark for accountants to measure themselves against. I guess that's why the exams to become a Chartered Accountant are some of the most difficult exams there are.
Our tax system in this country is generally fair, as I think I've talked about before. It rewards entrepreneurs and researchers. It is fair to those who do not earn a monster pay cheque. It even allows us to save money tax-free for retirement. There are ways that we can save a lot of tax by being smart. I would urge you to think about using an accountant to make sure you have all your bases covered.
Where can you find one? I think the best way is to ask people you know and trust. Who do they use? Are they happy? If so, are their accountants accepting new clients? To me, a good referral is the best way to go.
With my soapbox speech out of the way, I will leave you with some things to consider when you get your return ready this year (to hopefully drop off to your accountant);
We talked about the first time home buyers credit. Don't forget that freebie.
Home renovation tax credits. I think we can claim up to $10,000 worth of home renovations this year. There is a form to fill out. Your accountant will have it or you can find it on the CRA website.
Capital Losses. This is where we use losses from this year against gains from previous years. This form is called a T1-A form. You can also carry forward capital losses from past years against gains from this year.
RRSP vs. TFSA. Make sure you consider which vehicle makes the most sense to contribute to. Your accountant can offer advice here too.
Professional fees. If you did decide to use an accountant or you pay investment management fees on your stock portfolio (not including mutual fund fees), then you can claim these against your income.
Those are just a few of the ways that our government is fair about us getting our hard-earned tax dollars back. Consult with your accountant to make sure you are doing all you can.
Thanks again for reading. To all you accountants out there, happy tax season. Santa comes on May 1st.
Monday, April 5, 2010
Week 12 - Charity
I have to admit, this post is 50% financial and 50% opinion so bear with me.
As Canadians, if we take the time to step back from our daily grind and think about the rest of the world, we realize how good we have it. We have a stable government, no domestic wars, one of the most stable financial systems in the world and a relatively healthy economy. We don't pay for health care (whether you agree with the system or not) and we have a public pension plan. Overall, I think Canada is one of the greatest places in the world to live.
I think for these reasons, we are spoiled for the most part. We make good money as a nation. What we once considered luxuries are now parts of most people's daily living (computers, cell phones, flat-screen TVs, etc.). We spend tens of thousands of dollars on things that will one day be worthless, such as cars, boats, TVs, cell phones and video games.
With all this in mind, in my opinion, we have to start doing more to consider those around us (or far away from us) that are much less fortunate. If you haven't started already, then start thinking about making donations to one or more charities. Maybe your cause is something to do with people, animals or the environment. Either way, there are many excellent organizations that depend on the private sector (you and I) for funding.
The nice thing about charity is that it is totally voluntary and arbitrary. Maybe you grew up playing a sport that you now love. If you love it that much, maybe you should consider giving to an organization that would assist other kids to play your sport that couldn't otherwise afford it. Maybe a hospital or clinic was helpful during a time of need, or maybe you lost someone to a disease. You could contribute to that clinic or to the foundation that raises money for research into a cure for that disease. Maybe you grew up outside camping or hiking with family and you want to see some part of that nature preserved for future generations to enjoy it the same way. All of these are great reasons to contribute.
Tax Benefits
In Canada, our government has set it up so that we receive receipts for charitable donations that we make. According to Canada Revenue Agency, "In 2007, the first $200 you donate is eligible for a federal tax credit of 15% of the donation amount. After the first $200, the federal tax credit increases to 29% of the amount over $200. Generally, you can claim all or part of this amount up to a limit of 75% of your net income. For gifts of certified cultural property or ecologically sensitive land, you may be able to claim up to 100% of your net income."Also, if we have a capital gain on something, we can donate that thing (stock, bond, etc.) to charity and get a receipt for the entire amount, without having to pay the capital gains tax.
Here is an example: You bought 1,000 shares of Suncor at $10/share. Today, they are worth $35/share ($35,000).
Option 1 - sell them and keep the money. You realize a gain of ($35-$10) $25/share, or $25,000 in total. You have to pay tax on that amount (1/2 your normal tax rate), say $10,000. that leaves you with $25,000 in total, or a $15,000 after-tax profit.
Option 2 - donate the shares to a registered Canadian charity. That would yield us $11,122 in tax back, or a profit on our original investment of $1,122. AND our charity would have a $35,000 donation!
Donor Recognition
Many charities have ways of recognizing donors, or you can make a donation as an anonymous individual. It is totally up to you. You might be tempted to keep your donation anonymous, if you aren't the type to boast about money. While that's okay, I think sometimes by showing others how you contributed to a certain organization, it could spur them on to increase their level of contribution. In the end, donor recognition might be better for the charity itself!
Personal or Family Foundations
In Canada, there is also the option of setting up your own foundation (this probably doesn't make sense unless you have more than $50,000 to donate, as it can be costly) and can then direct a fixed % portion of the funds to charities of your choice each year. That way, your foundation will remain long after you are gone and you can leave someone in charge of naming the charities that will receive your donations. The benefit of doing this is that you get the tax back when you contribute to your foundation, without having to allocate all the funds to specific charities right away.
As I mentioned, I think every Canadian should be making some sort of charitable contribution in some way. It might be only a tiny % of your annual salary that comes right off your paycheque but it is still meaningful. If every Canadian even donated $10 per year to various charities, that would be more than $300 million that would be raised! It all helps.
Give it some thought. I am certain that you can find something worthwhile of a few pennies of your hard-earned dollars.
As Canadians, if we take the time to step back from our daily grind and think about the rest of the world, we realize how good we have it. We have a stable government, no domestic wars, one of the most stable financial systems in the world and a relatively healthy economy. We don't pay for health care (whether you agree with the system or not) and we have a public pension plan. Overall, I think Canada is one of the greatest places in the world to live.
I think for these reasons, we are spoiled for the most part. We make good money as a nation. What we once considered luxuries are now parts of most people's daily living (computers, cell phones, flat-screen TVs, etc.). We spend tens of thousands of dollars on things that will one day be worthless, such as cars, boats, TVs, cell phones and video games.
With all this in mind, in my opinion, we have to start doing more to consider those around us (or far away from us) that are much less fortunate. If you haven't started already, then start thinking about making donations to one or more charities. Maybe your cause is something to do with people, animals or the environment. Either way, there are many excellent organizations that depend on the private sector (you and I) for funding.
The nice thing about charity is that it is totally voluntary and arbitrary. Maybe you grew up playing a sport that you now love. If you love it that much, maybe you should consider giving to an organization that would assist other kids to play your sport that couldn't otherwise afford it. Maybe a hospital or clinic was helpful during a time of need, or maybe you lost someone to a disease. You could contribute to that clinic or to the foundation that raises money for research into a cure for that disease. Maybe you grew up outside camping or hiking with family and you want to see some part of that nature preserved for future generations to enjoy it the same way. All of these are great reasons to contribute.
Tax Benefits
In Canada, our government has set it up so that we receive receipts for charitable donations that we make. According to Canada Revenue Agency, "In 2007, the first $200 you donate is eligible for a federal tax credit of 15% of the donation amount. After the first $200, the federal tax credit increases to 29% of the amount over $200. Generally, you can claim all or part of this amount up to a limit of 75% of your net income. For gifts of certified cultural property or ecologically sensitive land, you may be able to claim up to 100% of your net income."Also, if we have a capital gain on something, we can donate that thing (stock, bond, etc.) to charity and get a receipt for the entire amount, without having to pay the capital gains tax.
Here is an example: You bought 1,000 shares of Suncor at $10/share. Today, they are worth $35/share ($35,000).
Option 1 - sell them and keep the money. You realize a gain of ($35-$10) $25/share, or $25,000 in total. You have to pay tax on that amount (1/2 your normal tax rate), say $10,000. that leaves you with $25,000 in total, or a $15,000 after-tax profit.
Option 2 - donate the shares to a registered Canadian charity. That would yield us $11,122 in tax back, or a profit on our original investment of $1,122. AND our charity would have a $35,000 donation!
Donor Recognition
Many charities have ways of recognizing donors, or you can make a donation as an anonymous individual. It is totally up to you. You might be tempted to keep your donation anonymous, if you aren't the type to boast about money. While that's okay, I think sometimes by showing others how you contributed to a certain organization, it could spur them on to increase their level of contribution. In the end, donor recognition might be better for the charity itself!
Personal or Family Foundations
In Canada, there is also the option of setting up your own foundation (this probably doesn't make sense unless you have more than $50,000 to donate, as it can be costly) and can then direct a fixed % portion of the funds to charities of your choice each year. That way, your foundation will remain long after you are gone and you can leave someone in charge of naming the charities that will receive your donations. The benefit of doing this is that you get the tax back when you contribute to your foundation, without having to allocate all the funds to specific charities right away.
As I mentioned, I think every Canadian should be making some sort of charitable contribution in some way. It might be only a tiny % of your annual salary that comes right off your paycheque but it is still meaningful. If every Canadian even donated $10 per year to various charities, that would be more than $300 million that would be raised! It all helps.
Give it some thought. I am certain that you can find something worthwhile of a few pennies of your hard-earned dollars.
Tuesday, March 23, 2010
Week 11 - Insurance Pt. 1
A major part of a financial picture is insurance, whether it be on yourself, your car, your business or anything else. Almost anything is insurable and the scope of things we can insure has grown rapidly over the past 25 years. It is even possible, as a farmer or vintner, to buy insurance against poor weather conditions! For the sake of the blog, however, I'll try to limit the insurance discussion to things that Canadians might (or should) think about as they grow old.
I think the best way to view insurance of any kind is as a hedge, or a form of protection. Yes, it is possible that insurance could be looked on as an investment as well, depending on your definition. If you think of it though, insurance is a way of keeping the odds in your favour, at a price.
For this article, I will keep the discussion to life insurance only, of which there are two main types:
1) Term insurance. This is normally the least expensive type of insurance, meant to pay you if you die during a specific term. A good example of this would be someone who buys a policy that would expire when they retire. If they were 40 and planned to retire when they were 60, then they would buy 20-year term insurance. That way, if they died unexpectedly during their 'earning' years (while their family depends on having an income), their loved ones would have something to help them get by until retirement. Because the odds of us dieing (touch wood) are much lower before we retire, this type of insurance is normally very cheap. With any term insurance policy, it expires at the end of the term with no value. It is possible to renew a policy, however, for another term. You might do this to avoid having to go through another medical examination (normally a requirement to get life insurance in the first place).
2) Whole Life or permanent insurance. As the name suggests, this policy is good for your whole life, meaning that your beneficiaries get paid when you die, regardless of the timing of your death. In my opinion, this type of insurance is good for protecting an asset that might otherwise be difficult to keep if you die. For some families, their cottage is a very important part of their lives and may have been in the family for multiple generations. The problem then becomes the tax that is going to be owed when the parents die and the kids inherit the place. By estimating the amount of tax we might have to pay on the cottage when it gets passed to the next generation (there is no tax to leave something to your spouse), we could buy a Whole Life insurance policy for that amount. Then the beneficiaries would have the money set aside to pay the tax on the cottage and keep the legacy alive. The best way to think of permanent insurance is that it is there to take care of a permanent problem, normally tax-related, that isn't likely to go away. There are types of permanent insurance that have an investment component as well (Universal Life) but I think that gets a bit complicated for today.
When should I buy insurance?
All situations are different of course but there are a few instances where I think insurance is a must. Remember, insurance is a hedge. It is meant to be there in case we die so that our loved ones can continue to lead as normal a life as possible. That's why in my opinion, the first time we should really think about insurance is when we have kids. Should anything happen to us, we would like our kids to have exactly the upbringing we had imagined for them. Insurance makes this possible.
I mentioned the cottage example. The same would apply for a second house, farm house or anything that you would like kept in the family but don't have the cash available to pay the capital gains tax.
There is the business example as well. If you owned a business with a partner and your partner died, would you have the money available to buy out their portion or would you want to risk being in business with someone new that you might not know? Or even worse, your partner's heirs have no interest in maintaining the business, you don't find a buyer and have to wind up the whole thing. You and your business partner can buy insurance on each other's lives to protect against this scenario.
Insurance as an investment
Insurance comes at a cost. Many people choose to avoid buying insurance for this reason - they would rather invest their savings themselves in order to leave something for their heirs. I don't have a problem with this logic, unless you die unexpectedly. Then you will need that money right away, leaving it no time to grow through investment. That's why I think it makes sense to look at insurance as an investment.
Let's say you want a Whole Life policy that has a death benefit of $1 million and you are 50 years old. The insurance company has looked at the results of your medical and deemed that to insure you for this policy, it will cost you $25,000/year over the next ten years, or $200,000 today to pay it in full (these are total ballpark numbers, by the way), if you prefer to get it over with. The insurance company is betting that you will live until the average life expectancy; let's say 85 years old. If you do, this policy would be in force for 35 years. That means if you invested the $200,000 yourself over 35 years, the rate of return to get it to $1 million would be about 4.7%; not a bad risk-free rate of return, but we could probably do better.
However, if something happened unexpectedly and you got hit by a bus one year after the policy went in force, you just invested $200,000 to get $1,000,000 in a year. That's a 400% return on your investment. THAT is the benefit of insurance. If you had chosen to invest the money yourself and got even 8%, you would have all of $216,000 when your heirs needed it.
A counter-argument might be that as we get older, our tax liability on something like a cottage would increase. So if anything happened to us earlier, we would pay less tax. That's a fair point. But keep in mind that an insurance policy is risk-free, as long as you make your payments (called premiums), regardless of what happens in the stock market, bond market, etc.
In conclusion, when thinking about insurance, think about the need and try to match the policy. If you need insurance only for while you're working, then buy it for only that long. Yes, the policy will expire worthless but guess what? That means you're still alive. Maybe it's a small price to pay to have the piece of mind that your heirs will be taken care of.
If the math works for you, then why take the chance?
Cheers.
I think the best way to view insurance of any kind is as a hedge, or a form of protection. Yes, it is possible that insurance could be looked on as an investment as well, depending on your definition. If you think of it though, insurance is a way of keeping the odds in your favour, at a price.
For this article, I will keep the discussion to life insurance only, of which there are two main types:
1) Term insurance. This is normally the least expensive type of insurance, meant to pay you if you die during a specific term. A good example of this would be someone who buys a policy that would expire when they retire. If they were 40 and planned to retire when they were 60, then they would buy 20-year term insurance. That way, if they died unexpectedly during their 'earning' years (while their family depends on having an income), their loved ones would have something to help them get by until retirement. Because the odds of us dieing (touch wood) are much lower before we retire, this type of insurance is normally very cheap. With any term insurance policy, it expires at the end of the term with no value. It is possible to renew a policy, however, for another term. You might do this to avoid having to go through another medical examination (normally a requirement to get life insurance in the first place).
2) Whole Life or permanent insurance. As the name suggests, this policy is good for your whole life, meaning that your beneficiaries get paid when you die, regardless of the timing of your death. In my opinion, this type of insurance is good for protecting an asset that might otherwise be difficult to keep if you die. For some families, their cottage is a very important part of their lives and may have been in the family for multiple generations. The problem then becomes the tax that is going to be owed when the parents die and the kids inherit the place. By estimating the amount of tax we might have to pay on the cottage when it gets passed to the next generation (there is no tax to leave something to your spouse), we could buy a Whole Life insurance policy for that amount. Then the beneficiaries would have the money set aside to pay the tax on the cottage and keep the legacy alive. The best way to think of permanent insurance is that it is there to take care of a permanent problem, normally tax-related, that isn't likely to go away. There are types of permanent insurance that have an investment component as well (Universal Life) but I think that gets a bit complicated for today.
When should I buy insurance?
All situations are different of course but there are a few instances where I think insurance is a must. Remember, insurance is a hedge. It is meant to be there in case we die so that our loved ones can continue to lead as normal a life as possible. That's why in my opinion, the first time we should really think about insurance is when we have kids. Should anything happen to us, we would like our kids to have exactly the upbringing we had imagined for them. Insurance makes this possible.
I mentioned the cottage example. The same would apply for a second house, farm house or anything that you would like kept in the family but don't have the cash available to pay the capital gains tax.
There is the business example as well. If you owned a business with a partner and your partner died, would you have the money available to buy out their portion or would you want to risk being in business with someone new that you might not know? Or even worse, your partner's heirs have no interest in maintaining the business, you don't find a buyer and have to wind up the whole thing. You and your business partner can buy insurance on each other's lives to protect against this scenario.
Insurance as an investment
Insurance comes at a cost. Many people choose to avoid buying insurance for this reason - they would rather invest their savings themselves in order to leave something for their heirs. I don't have a problem with this logic, unless you die unexpectedly. Then you will need that money right away, leaving it no time to grow through investment. That's why I think it makes sense to look at insurance as an investment.
Let's say you want a Whole Life policy that has a death benefit of $1 million and you are 50 years old. The insurance company has looked at the results of your medical and deemed that to insure you for this policy, it will cost you $25,000/year over the next ten years, or $200,000 today to pay it in full (these are total ballpark numbers, by the way), if you prefer to get it over with. The insurance company is betting that you will live until the average life expectancy; let's say 85 years old. If you do, this policy would be in force for 35 years. That means if you invested the $200,000 yourself over 35 years, the rate of return to get it to $1 million would be about 4.7%; not a bad risk-free rate of return, but we could probably do better.
However, if something happened unexpectedly and you got hit by a bus one year after the policy went in force, you just invested $200,000 to get $1,000,000 in a year. That's a 400% return on your investment. THAT is the benefit of insurance. If you had chosen to invest the money yourself and got even 8%, you would have all of $216,000 when your heirs needed it.
A counter-argument might be that as we get older, our tax liability on something like a cottage would increase. So if anything happened to us earlier, we would pay less tax. That's a fair point. But keep in mind that an insurance policy is risk-free, as long as you make your payments (called premiums), regardless of what happens in the stock market, bond market, etc.
In conclusion, when thinking about insurance, think about the need and try to match the policy. If you need insurance only for while you're working, then buy it for only that long. Yes, the policy will expire worthless but guess what? That means you're still alive. Maybe it's a small price to pay to have the piece of mind that your heirs will be taken care of.
If the math works for you, then why take the chance?
Cheers.
Thursday, March 11, 2010
Week 10 - Mortgage Payments or RRSP Contributions?
Many of us don't earn enough money in a single year to both maximize our RRSP contributions and maximize the amount that we can pay down our mortgage without penalty. So, each year we are faced with the choice of which vehicle to tackle.
In my mind, there are two ways of looking at this question.
1) Rates. If we think about each vehicle as an investment, by paying down our mortgage, we are saving the interest that we would have had to pay on that amount of money. So if your mortgage rate is 4%, then you are effectively getting a 4% return on your investment, since if you didn't pay it down, that's how much you'd have to pay each year. The question therefore becomes whether or not you can get a better rate of return by contributing to your RRSP. I might go a step further and suggest that the expected return from your RRSP better be pretty close to 'risk-free', since your mortgage rate isn't likely to go down from today's levels. What I mean by risk-free is that you can choose to buy stocks with your contribution but if your stocks go down, then you were better off paying down your mortgage. If you bought a bond that pays 5.5%, then you are better off doing that, since your mortgage rate is 1.5% less than that. So by this criteria alone, as long as we can get a higher low-risk rate of return in our RRSP, we are better off doing that.
2) Tax Deduction. Because mortgage payments are made with after-tax dollars, we know we are going to be immediately ahead by making an RRSP contribution, since we get the tax refund. By this logic alone, we might want to consider an RRSP contribution instead of a mortgage lump-sum payment. I will offer this argument, however. Remember that RRSP contribution room doesn't go away; we can always use it later in life. If we are only earning $50,000 per year now, we aren't even really getting that high a percentage of our tax back, compared to earning $100,000 down the road. So, it might make more sense to pay down the mortgage today while you are in a lower tax bracket and save your RRSP contributions for later in life when you are making the big bucks. If you don't see your salary increasing much from today's levels, you should probably contribute now, while you can.
Unless...
3) Sleep-at-night factor. Sometimes in life, we do things that may not make the most financial sense but they allow us to sleep better at night. For many people, this means paying down debt as quickly as possible. I could show you all the arguments in the world where RRSP contributions would make more sense than lump-sum mortgage payments but if you are someone who hates having debt, it's going to go in one ear and out the other. And you know what? There is absolutely nothing wrong with that. Regardless of our financial situation, the most important thing is being able to sleep comfortably with as little stress on our mind as possible. And with money being the number one reason people get divorced, we can see why the sleep-at-night factor might be the most important factor of all. Not to mention, mortgage rates rise. We never know how what rate we'll be able to get when we go to refinance down the road. Being able to refinance at a higher rate is less of a big deal, if we aren't needing as much money.
It was a relatively short post this week but this is one of the more common questions I get from people in this situation. I think I outlined the three most important variables, in my opinion.
What would I do? Well, it just so happens that I am completely debt-free and my RRSP is totally maxed out, so luckily, I don't have to make that decision ever again.
PFFFFFFFFFFFFFFFFFFFFFFFFFF!!!!!!
Seriously now? I try and do a bit of both. I like the idea of getting some tax back each spring and also reducing the amount of money we owe on our mortgage. Sometimes, the best strategy is to pay down your mortgage with your tax refund, killing two birds with one stone.
My last piece of advice on this is to speak to an accountant. They have no bias either way and will be able to offer their educated opinion for you as it applies to your own situation. Then you will have a better understanding when it comes time to make the decision.
Thanks for reading my blog.
In my mind, there are two ways of looking at this question.
1) Rates. If we think about each vehicle as an investment, by paying down our mortgage, we are saving the interest that we would have had to pay on that amount of money. So if your mortgage rate is 4%, then you are effectively getting a 4% return on your investment, since if you didn't pay it down, that's how much you'd have to pay each year. The question therefore becomes whether or not you can get a better rate of return by contributing to your RRSP. I might go a step further and suggest that the expected return from your RRSP better be pretty close to 'risk-free', since your mortgage rate isn't likely to go down from today's levels. What I mean by risk-free is that you can choose to buy stocks with your contribution but if your stocks go down, then you were better off paying down your mortgage. If you bought a bond that pays 5.5%, then you are better off doing that, since your mortgage rate is 1.5% less than that. So by this criteria alone, as long as we can get a higher low-risk rate of return in our RRSP, we are better off doing that.
2) Tax Deduction. Because mortgage payments are made with after-tax dollars, we know we are going to be immediately ahead by making an RRSP contribution, since we get the tax refund. By this logic alone, we might want to consider an RRSP contribution instead of a mortgage lump-sum payment. I will offer this argument, however. Remember that RRSP contribution room doesn't go away; we can always use it later in life. If we are only earning $50,000 per year now, we aren't even really getting that high a percentage of our tax back, compared to earning $100,000 down the road. So, it might make more sense to pay down the mortgage today while you are in a lower tax bracket and save your RRSP contributions for later in life when you are making the big bucks. If you don't see your salary increasing much from today's levels, you should probably contribute now, while you can.
Unless...
3) Sleep-at-night factor. Sometimes in life, we do things that may not make the most financial sense but they allow us to sleep better at night. For many people, this means paying down debt as quickly as possible. I could show you all the arguments in the world where RRSP contributions would make more sense than lump-sum mortgage payments but if you are someone who hates having debt, it's going to go in one ear and out the other. And you know what? There is absolutely nothing wrong with that. Regardless of our financial situation, the most important thing is being able to sleep comfortably with as little stress on our mind as possible. And with money being the number one reason people get divorced, we can see why the sleep-at-night factor might be the most important factor of all. Not to mention, mortgage rates rise. We never know how what rate we'll be able to get when we go to refinance down the road. Being able to refinance at a higher rate is less of a big deal, if we aren't needing as much money.
It was a relatively short post this week but this is one of the more common questions I get from people in this situation. I think I outlined the three most important variables, in my opinion.
What would I do? Well, it just so happens that I am completely debt-free and my RRSP is totally maxed out, so luckily, I don't have to make that decision ever again.
PFFFFFFFFFFFFFFFFFFFFFFFFFF!!!!!!
Seriously now? I try and do a bit of both. I like the idea of getting some tax back each spring and also reducing the amount of money we owe on our mortgage. Sometimes, the best strategy is to pay down your mortgage with your tax refund, killing two birds with one stone.
My last piece of advice on this is to speak to an accountant. They have no bias either way and will be able to offer their educated opinion for you as it applies to your own situation. Then you will have a better understanding when it comes time to make the decision.
Thanks for reading my blog.
Wednesday, March 3, 2010
Week 9 - Basic Financial Planning
I'm going to spend a few posts outlining my opinions about financial planning and what we should all be doing on a day-to-day basis. There are many different reasons to do a financial plan but the goal of all of it is to get an idea of what is happenning with our money, both now and years from now.
On a whole, I'm not entirely a fan of spending a lot of time with financial projections. I agree, they can paint a useful picture but I'm not sure they should be relied upon. What I would say, however, is that any time you want to use financial projections, make them as conservative as possible. The last thing you want to do is find out that you don't have enough money because your investments didn't grow at the expected 8% per year. I'm not saying 8% as a long-term return objective isn't reasonable but would you bet your life savings on it? I'm not sure I would.
I'm going to try my first attachment in this post as well, so you can get an idea of what my financial plan would look like. Yes, it's simple. It should be. I am going assume that my investments grow by 5% per year because that's the level of income I can get right now, without assuming too much risk. No, government bonds don't pay it but good corporate bonds and preferred shares do. I'm turning 32 this year so I'll actually have all my money in stocks anyway, but I'm still gonna stick with my 5% long-term return forecast. Most of my clients have been able to maintain this average over the past ten years (even despite what happened in the past few years) so I'm comfortable with that going forward.
In my opinion, you need two things for your plan;
1) A good income statement. This should tell you exactly what all of your sources of income are in a year (after tax), and what all of your expenses are as well (this should also be an after-deduction number, for those of us lucky enough to write off certain things against our income). If you're not exactly sure what your tax rate is, here is a quick and easy calculator to give you a ballpark amount. http://lsminsurance.ca/calculators/canada/income-tax (no idea how I got the thing to properly link this time).
I can't get a file to link, so here's an example of an income statement:
This paints a picture. For this example, the family only has $1,000 worth of credit card debt but is still paying $180 of interest per year. My advice on this issue could not be clearer: do not have ONE CENT of credit card debt. I understand that debt is a part of life but look at that interest rate! Be sure to pay off your credit card at all times and if you need to carry some debt, use a line of credit. The rates are much lower. Assuming the above rates, on $10,000 of credit card debt, you are paying $1,800 of interest each year. Move that debt over to your line of credit and your interest payments drop to $350. That's a $1,450 savings just for being smart.
My only other thought here is the car. They are a depreciating asset (they go down in value over time), which means that we should look at our cars as an asset as well as an expense, even if we don't have any car payments to make. Because eventually, our cars break down and we will need a new one. We might as well plan for this over time, especially if we are thinking about retiring. That's why I've put it in as a loss, using 20% as my depreciation rate. In theory, if I drove new cars each year and made no money on my investments, my balance sheet would deteriorate because of the depreciation. The moral of the story is to keep this in mind when checking out cars; don't spend what you consider to be a lot of money on something that will eventually be worthless.
In Retirement
When you retire, my advice would be to have no debt. You want to be getting paid in your retirement and not worrying about paying anyone else. Your 'rates' column should be working for you as much as possible.
Also, when you retire, you will add your retirement income to your income statement. It might come from a pension or from your Registered accounts. Either way, it is what is replacing your employment income.
Wondering about how much you will need to retire? Look at how much you are spending each year right now, compared to how much your investments could make you, assuming 5%. If your investments can make you enough today (including pension income, etc.) that you could live off the income without touching the capital, then you can probably start thinking about it! Congratulations. Your income statement is in the black and your balance sheet isn't shrinking! You are looking good for retirement. You might even gross up your retirement spending by some amount, because you'll have a lot more free time for trips, golf, etc. Just keep this in mind when planning.
If you don't have enough money to live off of yet, you will need to keep working or adjust your spending habits. My advice would be to do the latter before you retire, just to make sure you are being realistic at whatever spending limits you are setting for yourself.
That's it for now. Please feel free to fire me any questions on this. If you want, I can also send you the spreadsheet. Excel is a handy tool for this type of thing and is surprisingly easy to use.
Cheers.
On a whole, I'm not entirely a fan of spending a lot of time with financial projections. I agree, they can paint a useful picture but I'm not sure they should be relied upon. What I would say, however, is that any time you want to use financial projections, make them as conservative as possible. The last thing you want to do is find out that you don't have enough money because your investments didn't grow at the expected 8% per year. I'm not saying 8% as a long-term return objective isn't reasonable but would you bet your life savings on it? I'm not sure I would.
I'm going to try my first attachment in this post as well, so you can get an idea of what my financial plan would look like. Yes, it's simple. It should be. I am going assume that my investments grow by 5% per year because that's the level of income I can get right now, without assuming too much risk. No, government bonds don't pay it but good corporate bonds and preferred shares do. I'm turning 32 this year so I'll actually have all my money in stocks anyway, but I'm still gonna stick with my 5% long-term return forecast. Most of my clients have been able to maintain this average over the past ten years (even despite what happened in the past few years) so I'm comfortable with that going forward.
In my opinion, you need two things for your plan;
1) A good income statement. This should tell you exactly what all of your sources of income are in a year (after tax), and what all of your expenses are as well (this should also be an after-deduction number, for those of us lucky enough to write off certain things against our income). If you're not exactly sure what your tax rate is, here is a quick and easy calculator to give you a ballpark amount. http://lsminsurance.ca/calculators/canada/income-tax (no idea how I got the thing to properly link this time).
I can't get a file to link, so here's an example of an income statement:
I've got my income sources and then my expenses. If I subtract the expenses from the income, that's what's left over for either saving or spending. If you do this exercise and you find that you are spending more than you are saving already, then it's time to make some lifestyle changes. Be sure to include everything you can think of. You're only cheating yourself if you leave out certain expenses. A good way to get an idea is to check your past few months worth of credit card bills or bank statements. They will quickly give you an accurate picture of what you're spending your money on.
2) A good balance sheet. This should show you what you own (assets) and what you owe (liabilities). Subtract your liabilities from your assets and you get your net worth. Hint: if your net worth is a negative number, you need to keep working. Here is a very basic balance sheet:
As you can see, this family has a nice cushion. They do have some debt but they also have some good assets, which gives them a net worth of $429,000 (assets minus liabilities).
You'd be surprised how you'll feel about your financial picture once you do these two exercises. Then, if you're feeling confident with excel, you can actually add another column so that you can include the interest rates that you are either earning from your assets or owing from your liabilities.
This paints a picture. For this example, the family only has $1,000 worth of credit card debt but is still paying $180 of interest per year. My advice on this issue could not be clearer: do not have ONE CENT of credit card debt. I understand that debt is a part of life but look at that interest rate! Be sure to pay off your credit card at all times and if you need to carry some debt, use a line of credit. The rates are much lower. Assuming the above rates, on $10,000 of credit card debt, you are paying $1,800 of interest each year. Move that debt over to your line of credit and your interest payments drop to $350. That's a $1,450 savings just for being smart.
My only other thought here is the car. They are a depreciating asset (they go down in value over time), which means that we should look at our cars as an asset as well as an expense, even if we don't have any car payments to make. Because eventually, our cars break down and we will need a new one. We might as well plan for this over time, especially if we are thinking about retiring. That's why I've put it in as a loss, using 20% as my depreciation rate. In theory, if I drove new cars each year and made no money on my investments, my balance sheet would deteriorate because of the depreciation. The moral of the story is to keep this in mind when checking out cars; don't spend what you consider to be a lot of money on something that will eventually be worthless.
In Retirement
When you retire, my advice would be to have no debt. You want to be getting paid in your retirement and not worrying about paying anyone else. Your 'rates' column should be working for you as much as possible.
Also, when you retire, you will add your retirement income to your income statement. It might come from a pension or from your Registered accounts. Either way, it is what is replacing your employment income.
Wondering about how much you will need to retire? Look at how much you are spending each year right now, compared to how much your investments could make you, assuming 5%. If your investments can make you enough today (including pension income, etc.) that you could live off the income without touching the capital, then you can probably start thinking about it! Congratulations. Your income statement is in the black and your balance sheet isn't shrinking! You are looking good for retirement. You might even gross up your retirement spending by some amount, because you'll have a lot more free time for trips, golf, etc. Just keep this in mind when planning.
If you don't have enough money to live off of yet, you will need to keep working or adjust your spending habits. My advice would be to do the latter before you retire, just to make sure you are being realistic at whatever spending limits you are setting for yourself.
That's it for now. Please feel free to fire me any questions on this. If you want, I can also send you the spreadsheet. Excel is a handy tool for this type of thing and is surprisingly easy to use.
Cheers.
Saturday, February 20, 2010
Week 8 - RRSPs Part 3
This is going to be a two-post week. I don't know if I'm alone on this one but the Family Day short week kind of threw me off. That, and I think I've watched about a hundred hours of the Olympics. I go to bed and all I think of is the speed skating oval or the downhill race course. It's like when you play too much Tetris and then all you see is the little blocks falling when you're trying to fall asleep. Maybe that's a bit sad, huh? A little FYI about the Canadian team thus far: we have approximately twenty 4th or 5th place finishes; so close and yet, so far... Anyway, my apologies for all of you who are hanging off my every word each week. After all, we know what a riveting topic personal finance can be, right?
This will be the third and final installment on RRSPs, meant to be short and sweet. We've looked at the benefits of contributing to a RRSP, as well as a few different ideas as to what we could do with our contributions. Now we'll look at a few final details around these accounts, in chronological order.
First we open the account, then we contribute each year, hopefully growing our accounts over time to be used for retirement. But there are a few other ways we can use our RRSPs before we retire.
1) First Time Home Buyers Plan. Basically, we are allowed to take money out of our RRSPs to buy our first home. It is a tax-free, interest-free loan that we make to ourselves. We take out the money for our down payment (up to a $25,000 maximum) and then we have 15 years to pay that loan back. Here's a good website for all the details of this option: http://www.taxtips.ca/rrsp/homebuyersplan.htm
2) Education. If, down the road, you decide to get back learning but need an investment in yourself to get going, then you might be able to use your RRSP to help fund your education. Like the home buyers plan, you have to repay the money, albeit within ten years of withdrawal. Here is the link for more information: http://www.canlearn.ca/eng/lifelong/llp.shtml
After deciding whether or not to use these options, it's the waiting game. We can take money out of our RRSP whenever we want, although we have to pay income tax on the money when we do it. So unless you aren't paying much tax and need the money desperately, it probably makes sense to let the fund grow until we have to withdraw them in retirement.
Conversion to a RRIF
Unfortunately, even if we don't need the money, we can't keep letting our RRSPs grow indefinitely. In the year we turn 71, we have to convert our RRSPs to Registered Retirement Income Funds (RRIFs). The following year, we will then be required to take out our first annual RRIF payment. This payment is a percentage of the total value of the RRIF, as of December 31st of the previous year. For example, if you turned 71 last year and on December 31st, your RRIF was worth $500,000, then you would use that number to calculate the amount you are required to take out this year. The following link is the percentage table that you use to determine your RRIF payment: http://www.ecgi.ca/rif_schedule.html
As you can see, you can convert your RRSP to a RRIF before age 71, but you need to do it by age 71.
Beneficiaries of your RRIF
A nice feature of any registered account is that you can name a beneficiary that will inherit your account if you die. This way, your account doesn't get left to your estate, which would have left it open to probate fees. Be sure to name a beneficiary on your account when you open it, as long as it's a registered account (RRSP, TFSA, etc). If your spouse is your beneficiary, he or she does not have to pay tax on the account either, when you die; another benefit of the RRSP. However, if you are leaving your RRSP or RRIF to your kids or anyone else, they will have to include that account as income for the year you pass away. Still, they will not have to pay probate fees.
Be sure to keep your beneficiary updated, too. From time to time, family situations change and I suspect you wouldn't necessarily want your ex to still be the beneficiary of your RRSP if you die. If you did, that's your business. Just make sure it's updated if you have a change in your life.
Hopefully, this begins to summarize registered accounts and how they can help us save for retirement. They are useful accounts and as I've mentioned previously, I think they are the only truly effective way to defer income tax. I admit this is just my opinion but I'll stick with it for now. Don't forget to contribute and when you do, you can celebrate with a pint a few weeks later on St. Patrick's Day; one of my favourite days of the year and I'm not even Irish!
Thanks for reading. Now that the RRSP deadline is nearly in our rear-view mirrors, I will switch it up for the next post and talk more about financial planning. Again, this is a topic that requires much attention and detail so it will just be an overview. I will start by trying to explain the difficulty in predicting our future needs and why it might just be better to focus on what we are capable of saving today. More on this in a few days.
Cheers.
Wednesday, February 10, 2010
Week 7 - RRSPs Part 2
I'm settled in. It's Wednesday night. There's a Raptor game on TV, which is going well. Life's good! Then, someone comes in and wants to watch Cougar Town. Time to post week 7.
Last week, I talked about the benefits of RRSP contributions and went over some strategies to maximize your total return down the road. We looked at the power of compounding rates of return, while being able to defer the taxes until we actually need the money.
This week, I wanted to go over a couple of ideas for how your RRSP could be set up, if you are someone that hasn't found the right advisor to work with yet.
We talked about mutual funds already, which are great investment vehicles if you don't have the expertise to pick stocks. I actually prefer picking stocks - I like the research, following my picks, making changes and trying to maximize returns for me and my clients. I would recommend that my clients do the same, or at least let me do it for them! I truly believe that I can achieve better returns this way, if for no other reason than the fees aren't nearly as much when you buy and sell stocks directly.
If you haven't found the right person to work with yet but still need some advice as to how to set up your RRSP, consider this step by step mutual fund strategy:
1) Look for 4 mutual funds, one in each of the following asset categories;
a) Canadian Equity
b) Canadian Bond/Income
c) Global Equity
d) Emerging Markets Equity
When considering your options, look for funds with good long-term returns (see if their 5-year return is good enough to get a 5-star rating) and look for fund managers that have been working on the fund for a long time.
2) Divide your RRSP equally among the 4 funds.
3) Each year, when you make your new RRSP contribution, add to the funds so that they rebalance back to their 25% weight per fund. Make sense?
Essentially, you are adding to the funds that have underperformed, while taking away (or not adding new money) from the funds that have outperformed. It's an easy way of staying disciplined, even if it's been a bad market for one of the areas. It takes the emotion out of having to make the picks yourself. I'd say this is a great strategy for anyone more than 10 years away from retirement.
----
If you are closer than 10 years to retirement, congratulations! That said, it probably doesn't make sense to have 75% of your money invested in equity funds (which could decline in value and leave you needing to wait longer for retirement), especially since most mutual funds don't pay a consistent income. With stocks, you can sometimes keep a high weighting because they often pay dividends that will help support your retirement lifestyle, while still offering the potential for future growth. It's different for everyone, depending on your personal situation.
If you aren't in stocks and want a simple rule, consider the old adage that you should always have your the same percentage as your age invested in bonds. So, if you are 50 years old, then you should be 50% invested in bonds or other fixed income investments. As you get older, you can shift more money into bonds to preserve your capital and increase your income. The only problem with this is that right now, bonds pay a very low income. If you were invested in 10-year bonds right now, your average annual return would probably be about 4%. Yes, some bonds pay better rates but aren't of the same quality as the ones that pay lower rates. You want higher returns? Be prepared to take on more risk. Either way, it's a good starting point for someone looking for very basic guidance on setting up an RRSP asset allocation. Just remember the part about rebalancing every year.
Some of you probably have more than 4 funds in your portfolio already. You don't need them. Just pick 4 funds that have good track records. Between all 4 funds, you will likely have about 200 stocks and bonds, which is more than enough diversification. The only reason you should ever switch out of one of the funds completely is if the manager changes. In that case, all bets on past performance are off.
With a stock portfolio, I would only have up to about 20 stocks and then add bonds as needed. I think this is enough diversification, provided my clients are prepared for the ups and downs of owning stocks.
Another thing to consider is that if you have an RRSP and a non-registered account, keep the stocks in the non-registered account and keep the bonds in the RRSP. The interest created by the bonds is taxed at regular income levels, while dividends and capital gains are taxed at approximately half that rate.
The bottom line is that investments in an RRSP are probably a lot easier than many people would have you believe. I think that if you follow that simple formula, you will be satisfied over the long term. You will also be able to brag to your friends that you actually had the balls to add to your equity funds in years like we had in 2008 and 2009, which is a move that would have nicely paid off if you had done so.
Thanks again for reading. Next week, I will continue with RRSPs for those of you who are left wanting more.
Cheers.
Monday, February 1, 2010
Week 6 - RRSPs Part 1
It's been six weeks and I'm still going strong, despite having to try to explain stocks and bonds using one column each. They are tough columns to write without becoming really boring after a while. Also, finance isn't really something that I can use pictures to describe so the blogs tend to be quite the run-on at times. I'll work at making things break down a bit more by using more point-form. I'll maybe even put a swear word in here and there to keep you on your toes. I also wanted to say thanks for all the great feedback I've been getting on this thing! It's great to hear that people are getting something out of it. The idea is to help so I'm glad it's working.
So this is pretty much the apex of the blog for the Canadian investor; the RRSP Articles! The deadline is exactly a month away as of this entry, so we need to start thinking about what the best strategy is for the RRSP. I'm going to try and spread it out over a few weeks, so we can look at the different features of the RRSP and what the most appropriate investments are for them.
Let's look first at a few points about RRSPs:
- Think of an RRSP as a piggy bank that we put money into. Once the money is in the piggy bank, we can use it to buy investments such as stocks, bonds, GICs and mutual funds, which remain in the piggy bank until we sell them and transfer out the cash again. We do not buy RRSPs; we open them (they are accounts) and then we contribute to them!
- When we put money into an RRSP, we can claim that contribution against any earned income from that calendar year. For example, if your income was $60,000 and you put $10,000 into your RRSP, then your taxable income goes down to $50,000. If you already had the tax taken off of your pay cheque, then you would receive the tax back that would have paid on the last $10,000 of your earned income.
- Here are the marginal tax brackets for Canadians for 2009;
http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html
You may want to think about contributing the right amount to lower your taxable income into the next lowest bracket, rather than making large lump sums all in the same year. More on this later.
- Everyone has a limit to the amount they can contribute to an RRSP in a given year. For the 2009 tax year, that limit is $21,000. If you don't use all of your contribution room, then it carries forward to the following year and gets added to that year's new amount. Also, if you had additional contribution room from past years, then this would be added to your 2009 contribution limit.
- The limit is lowered if you contribute to a registered pension (teachers, nurses, etc.), as registered pension contributions count toward your RRSP contributions.
- You can find your 2009 contribution limit on your Notice of Assessment that you would have received when you filed your 2008 tax return.
- Most of our RRSPs are self-directed, that is, ultimately we decide what the investments are that will be bought in our own accounts.
- If we want to take the money out of our RRSP, that amount gets added to our taxable income for the calendar year in which we take it and we pay tax on it. Also note that if we take money out of our RRSP, we cannot put it back, unless we have additional contribution room. Moral of the story: try to avoid taking money out of your RRSP for as long as you can or at least until you reach a point where you aren't working any more, so your taxable income would otherwise be very low.
- Any investment income, dividends, capital gains is sheltered from tax once it is inside the RRSP. This, in my opinion, is what makes it such an effective investment tool. It, along with the TFSA are the only truly effective tax shelters, in my opinion. There are others but they always seem to come with strings attached.
Let's look at an example of the power of not having to pay tax on your investment gains:
If you had a $10,000 bond that paid you 10% per year which you reinvested into similar bonds, then without paying tax, you would double your money in 7.2 years, to $20,000.
However, if you had to pay tax on your interest income, your annual interest would drop from 10% to 6% (assuming a 40% tax rate). The amount of time it would take for your money to double to $20,000 would skyrocket to 12 years.
By that time, your $10,000 in an RRSP would be worth more than $31,000.
You might be thinking "yeah but what about when I actually want to spend it? I'll pay 40% tax and only have like $18,000." True, but that assumes you just blew the $4,000 tax refund you would have received for contributing to your RRSP in the first place!! If you had invested that amount as well at the taxable rate (assume 6%, as above), then you would be left with a total of about $26,000!! That's a full $6,000 more than if you never contributed in the first place. Ah, the power of the RRSP.
Here's a sweet strategy: Contribute to your RRSP (if you can max it out, all the better) and then with the tax refund you will likely get, contribute up to $5,000 of that amount to your TFSA!!! If you do both those things, you are on your way to success, because that means a huge portion of your invested assets are growing TAX-FREE. Then next year if you can't max out your contributions from your employment income, take the money that is in your TFSA and move it into your RRSP to make up the difference. Then, when you get the refund, put it back into your TFSA. Lather, rinse, repeat.
If you did this just once like the above example with $10,000, you would have $31,000 in your RRSP and $12,500 in your TFSA after the same 12 years. If you wanted all that money at once, you'd still have more than $30,000 after tax, since you don't pay tax to take money out of your TFSA. That compares to having just $20,000 if you kept letting the tax man take his cut each year.
The only trouble with my example is finding good bonds that pay 10%. This ain't 1984, people. If you don't get that joke, then ask your parents how they liked refinancing their mortgages in the early 1980's. In those years, you could actually find government bonds that paid about 15-20% per year, or close to it. Mortgage rates were similar.
I think I'll stop there for this week. It's quite a bit to digest. Please feel free to ask questions. There are no stupid questions; only stupid people. Just kidding. Email me if you don't feel like leaving a comment on here directly. If I get a chance, I'll answer it. If it's about what to buy with your contribution, hold that thought. I will touch more on that next week.
Adios!
Monday, January 25, 2010
Week 5 - Mutual Funds
So we have covered both sides of the ledger, between debt and equity (bonds and stocks). That said, as you may have guessed, buying individual stocks and bonds can take a lot of research, not to mention following your picks once you make them. It's not as big a deal on the bond side of things (they are more 'set it and forget it' if you buy good quality bonds) but stocks do require some degree of maintenance. We are often busy or just choose to do other things with our spare time than research our stock picks. Many investment advisors don't 'do' stocks for this reason; they would rather spend their time building their businesses or monitoring other aspects of their clients' financial situations, so they leave the stock and bond selection up to others; quite often, mutual funds.
Most of you probably own mutual funds but many may not know what they actually are. A mutual fund is like a pool of different investors' money that is then used to buy many different stocks or bonds, or sometimes other asset classes, like real estate holdings. It's easiest to follow a dollar invested to find out how they work.
1) You decide it's time to do some investing but don't have all that much money to buy a diversified portfolio of stocks and bonds. Let's say you're starting with $10,000. You take your money to a bank, and ask to open an investment account.
2) After meeting with an advisor, you decide that the best idea would be to buy units (they're called units, as opposed to stocks which are called shares) in a mutual fund. For the sake of the example, we will use one of Canada's oldest funds, the Mackenzie Ivy Canadian Equity fund.
3) Let's take a look at the name. Mackenzie is the company itself. It has employees that are in charge of buying and selling the investments for a wide array of mutual funds, one of which is your Ivy Canadian Equity fund. These employees are called fund managers. When you give your money to Mackenzie, you now own units in the fund and benefit (or suffer) from the manager's ability to pick stocks that go up (or down). In this case, as the name 'Canadian Equity' tells us, this fund invests only in equity (stocks) of Canadian companies. No bonds. The 'Ivy' part is just some word they decided to use for the name.
Here's a link to globefund.com which is a good enough site for checking out different mutual funds.
http://www.globefund.com/servlet/Page/document/v5/data/fund?style=na_eq&id=17974&gf_uid=globeandmail.gf.04382357814
What's most important with mutual funds if their ability to grow your money over time. The different funds and fund companies (e.g. Mackenzie, Fidelity, Templeton, Trimark to name a few of the bigger ones in Canada) are constantly being measured against one another for their performance. There are awards each year for which managers or companies returned the highest amount of money (or lost the least amount, as was certainly the case in 2008) for their unit-holders. The ironic thing about having annual awards is that any advisor will tell you that you should hold a fund for at least three years before you make any judgement on whether or not the money is being well-managed, but I digress.
Here are some key terms that you will come across when checking out different funds:
NAV - Stands for Net Asset Value, which is a technical term for the current price of your fund units. It is better defined as the total value of all the shares of all the companies in the fund, divided by the total number of units sold. The 'Net' means that the units are valued net of any fees that the company has taken for their services, which leads us to...
MER - Stands for Management Expense Ratio, which is another name for the fees you pay to own a fund. I will speak more on fees in another column. That said, a typical Canadian equity fund usually charges fees of around 2-2.5% per year. With the fees, the company pays its employees, including the manager who is making their picks. There are also trading costs for buying and selling the stocks, which this fee pays for. Lastly, often the advisor that recommended the fund to you will be compensated a portion of the annual fee, normally 0.5-1%.
FE, ISC, DSC - Some advisors will also charge an up-front (Front End or Initial Sales Charge) commission if you want to buy a fund, while others will sell funds with bank-end (Deferred Sales Charge) penalties (you pay if you sell the fund before a set time period lapses; generally 3 years or more). Advisors are compensated additional money by the fund company, depending on how long your funds are committed before you can sell them without penalty. It can be as much as 5%, which would be the penalty you would pay if you sold the fund in the first year. There are virtually limitless fee options for buying funds - be sure to have all the information on the fee structure before you buy.
Star Rating - some websites will use a star rating to measure funds for their performance over different time periods. The rating is based on how well the fund performed, relative to the other funds in the same asset class (i.e. Canadian Equity funds). If a fund has returned the highest percentage gain over a three year period compared to all other funds that invest the same way, then it is often garnered a 5-star rating. Buyer beware: sometimes ratings do not tell the whole story. Maybe the fund had a very high percentage of its holdings in oil stocks during a time period when the price of oil rose dramatically, which led to a 5-star rating. This could lead to a few bad years, if oil prices fall and the fund still has a big position in the sector. Try to buy funds that have good long-term track records with no change in management. A fund is only as good as the individual making the investment decisions. Otherwise it is just a name.
Here are some different types of funds that are commonly available for purchase:
Canadian Equity - invests in stocks of Canadian companies
Canadian Bond - invests in bonds of either Canadian companies or governments
Global - invests in stocks or bonds anywhere in the world
International - buys and sells stocks or bonds anywhere OUTSIDE North America
Emerging Markets - invests in countries that are developing. The four most common are the BRIC nations; Brazil, Russia, India and China
There really are no limits as to what kind of mutual funds could be launched. If some manager thinks that the prospects for investment in Germany are going to be massively successful over the next few years, he or she may launch a German Equity fund to take advantage. More likely however, he/she will launch a European Equity fund and concentrate the buying to German companies while the prospects are good. Then, if things work out in Germany, they can still look elsewhere in Europe for other good investments. Funds will also focus on different sectors. Back in the late 1990s, technology funds were started to invest only in 'high-tech' companies that were sure to change the world. Some of them did but most went bankrupt. When you buy a fund, you will get a document called a prospectus, which will outline the investment parameters for the fund; locations, company size limits, etc.
In my opinion, the best way to buy mutual funds is to buy a few in different areas. Maybe buy one Canadian Equity, one International or Global equity and one bond fund. Then, each year, add to the one that did the worst (buy low) and trim from the one that did the best (sell high).
Mutual Funds in a Nutshell
Upside: Good way to own many stocks and access professional management, as well as gain access to other areas that are more difficult to research from home.
Downside: Fees can be high, managers can leave, performance not guaranteed.
As always, there is much more. But these things start looking like mini-novellas by the time I'm done writing them and I don't want to bore you. But on the other hand, it's your money! By taking the time to digest a bit of knowledge here and there, you will be much better off in the long run.
Please feel free to ask questions. Thanks, as always, for reading.
GW
Wednesday, January 20, 2010
Week 4 - Bonds
Last week, I tried to give a basic description of stocks, starting from the time they are created to the time they are then bought and sold on an exchange. This week, I will look at bonds in the same light. This should help you to understand the idea of a bond and why a company (or government) would issue one.
Think of bonds as loans. By this stage in my life, I know all too well what a loan is! My parents have loaned me many a dollar for a variety of different undertakings, most of them resulting in me spending (as opposed to investing) the money on dumb things and having to work to pay it back over time. Luckily for me, my parents didn't charge me any interest for borrowing their money or some of my loans could have been rather expensive propositions.
The easiest description of a bond would be to think of it as the I.O.U that I would have written my parents for their money. When a company needs money and doesn't have enough cash from the day-to-day business, they can write a giant I.O.U to whomever is willing to lend them the money. Let's take our baseball cap company from the previous post. Since we have been in the cap-making game for quite a while, we are looking to try something else with our business in order to grow it. We decide after doing some research that making T-shirts would be a good step forward. The problem is that we don't have enough cash to build the T-shirt factory or buy the equipment necessary to make the shirts themselves. We need a loan. For this example, let's assume that the bank will not loan us the money directly, so we have to issue a bond (write the big I.O.U.). We have to decide on how much money we are going to need and what rate of interest (the money that we have to pay our lenders each year for being nice enough to loan us the cash) we are willing to borrow at. If we make our interest rate too low, then nobody will want to buy our bond. If we make it too high, then of course everyone will want to buy our bond but it will cost us too much money in interest payments for the loan to be worthwhile. You wouldn't borrow money from a friend if they were going to charge you 20% interest each year, would you?? There are some factors that go into deciding how our bond interest rate will be set:
1) The Overnight Lending Rate (Bank Rate). This is the rate that we hear about on the news, that the government sets. It is the rate that one bank can lend to another overnight. The government looks at the health of our economy, amongst other factors, before setting the rate. Right now, since our economy is in such a fragile state, our bank rate is 0.25-0.5%. If times are good, there is the possibility of inflation, which would cause the government to raise the overnight rate, which makes borrowing money more costly, slowing business down somewhat. The trick is to not raise the rate too much, which would cause a recession, since lending would slow down too much. In the 1980s when inflation was a huge concern, the overnight rate got as high as 21%. Anyone trying to get a mortgage back then will remember these times all too well. I admit, this is a very simplified explanation of the overnight rate, but anyone who has a mortgage would know how the overnight rate can affect the rates they are charged. Simply put, the lower the bank rate, the lower we can set our bond rate and still have it be competitive. I'll say more on the bank rate another time.
2) Company Quality. As with any loan, you wouldn't want to lend money to a company that you didn't think could easily pay you back. If you did, then you would want a higher interest rate to compensate you for the extra risk you are taking with your money. This is a big part of how rates are set. If a company with a spotty track record of profits and losses tries to borrow money and sets a relatively low interest rate, nobody will lend them money by buying their bonds. As a rule, riskier companies need to pay higher rates of interest to get loans. There are companies such as Moodys or Standard & Poors whose job it is to rate other companies 'credit quality', or their ability to make good on their loans. It's the same for us if we go to the bank to get a loan but haven't been paying our other bills - makes it tough to get that loan.
3) Time. Just like a regular loan, a bond's interest rate will be higher, the longer the company needs the money for. If you are only borrowing funds for a year, you don't need to be paying too much interest. On the other hand, if you want to borrow funds for 30 years, this is much longer that you are asking me to have my funds tied up with you. Therefore, you will have to pay me more interest.
When we have these criteria set (the size of the bond and the interest rate, or coupon, we are prepared to pay) then we alert the public to see who wants our bond. If we've priced it right, then we should have no problem raising the money we need.
As we know, governments also issue bonds. In Canada, we have Government of Canada bonds (Canadas), Canada Savings Bonds (CSBs), Provincial Bonds, municipal bonds (munis) and also bonds for certain crown corporations, such as Canada Housing Trust. The government is issuing bonds for the same reasons that companies are; building roads, schools, hospitals and other types of public investment. They pay off the bonds through taxes, which is effectively the main income source for the government. We are lucky that our financial system is in such good shape (i.e. we have a good economy that generates lots of tax revenue and we don't have a lot of debt, relatively speaking), so that our government bonds are very safe. Other countries such as Iceland aren't so lucky. The entire country had to declare bankruptcy about a year ago. So indeed, different governments have different ratings on their bonds, depending on the health of their economy.
So let's say you like the idea of owning bonds. How does one buy them? There is a bond market, but not really a bond exchange, so to speak. Each bank will buy bonds and have an inventory of different bonds at any given time. To buy bonds, you have to phone up your banker or advisor and see what kind of bonds they have available. The advisor will ask you which ones you are looking for, so there are considerations to this question as well. To answer them, we have to understand how bonds move (and yes, they do move) in price. If you want to sell bonds, you sell them to your bank's bond department and they will give you a bid for that bond, similar to selling a stock but without the stock exchange. The price that they will give you is determined by a few factors:
Let's say you buy a 10-year Bank of Nova Scotia bond with a coupon of 5% (that means the bond will pay you 5 cents for every dollar they issue) and you buy it on the first day the Bank issues their bond, so you pay $100. You buy $100,000 of this bond, so each year, you get $5,000 in interest (hence the 5% coupon). All is good. However, here's the tricky part. Interest rates go up so 6 months down the road, the Bank of Nova Scotia issues another 10-year bond but this time, the coupon is 6%. What do you think happens to the price of your bond if everyone can get the same company bonds with a higher coupon? That's right. The price of your 5% bond goes down until the yield of your bond (the coupon divided into the market price) equals about 6%. The laws of supply and demand! Why would I want your 5% bond when I can get one that pays 6% from the same company? Odds are if you wanted to sell your bond before it matures (at the end of the 10-year period), you would only be able to get about 85 or 90 cents (or $90,000 of your original $100,000 investment) for your bond. Yes, if you hold your bond for the entire duration, you will likely get your full investment back. The moral of this story though is to not buy long duration (I'd say more than 6 or 7 years) bonds during times of very low interest rates because you know rates are going to rise and when they do, nobody is going to want your bond that has a low coupon. If you do, then be prepared to hold them to maturity if we get rate increases because of inflation.
It's a lot to digest, I know. Feel free to ask questions in the comment section and I will either email you or answer directly.
The other risk of buying bonds is the obvious one: bankruptcy. If the company doesn't have the money to pay you back, then you are out of luck. So think twice when looking at bonds with very high yields (over 10% these days) because odds are that something is not right.
What would I do right now for bonds?
1) Buy short to medium term bonds and be prepared to hold them to maturity. It may not happen this year but eventually, interest rates will rise.
2) Buy good quality. If you aren't comfortable with buying the stock of a company, don't buy the bonds. You can look at government bonds but the yields usually aren't that attractive, although they are normally very safe.
3) Diversify. Just like stocks, it's always good to own a few different bonds in case something unpredictable happens to one of yours. At least you would be insulated.
There is so much more I could tell you about bonds; the world's bond market makes the world's stock markets look tiny. Please feel free to answer questions about this - I'd welcome the dialogue.
Thanks for reading.
Think of bonds as loans. By this stage in my life, I know all too well what a loan is! My parents have loaned me many a dollar for a variety of different undertakings, most of them resulting in me spending (as opposed to investing) the money on dumb things and having to work to pay it back over time. Luckily for me, my parents didn't charge me any interest for borrowing their money or some of my loans could have been rather expensive propositions.
The easiest description of a bond would be to think of it as the I.O.U that I would have written my parents for their money. When a company needs money and doesn't have enough cash from the day-to-day business, they can write a giant I.O.U to whomever is willing to lend them the money. Let's take our baseball cap company from the previous post. Since we have been in the cap-making game for quite a while, we are looking to try something else with our business in order to grow it. We decide after doing some research that making T-shirts would be a good step forward. The problem is that we don't have enough cash to build the T-shirt factory or buy the equipment necessary to make the shirts themselves. We need a loan. For this example, let's assume that the bank will not loan us the money directly, so we have to issue a bond (write the big I.O.U.). We have to decide on how much money we are going to need and what rate of interest (the money that we have to pay our lenders each year for being nice enough to loan us the cash) we are willing to borrow at. If we make our interest rate too low, then nobody will want to buy our bond. If we make it too high, then of course everyone will want to buy our bond but it will cost us too much money in interest payments for the loan to be worthwhile. You wouldn't borrow money from a friend if they were going to charge you 20% interest each year, would you?? There are some factors that go into deciding how our bond interest rate will be set:
1) The Overnight Lending Rate (Bank Rate). This is the rate that we hear about on the news, that the government sets. It is the rate that one bank can lend to another overnight. The government looks at the health of our economy, amongst other factors, before setting the rate. Right now, since our economy is in such a fragile state, our bank rate is 0.25-0.5%. If times are good, there is the possibility of inflation, which would cause the government to raise the overnight rate, which makes borrowing money more costly, slowing business down somewhat. The trick is to not raise the rate too much, which would cause a recession, since lending would slow down too much. In the 1980s when inflation was a huge concern, the overnight rate got as high as 21%. Anyone trying to get a mortgage back then will remember these times all too well. I admit, this is a very simplified explanation of the overnight rate, but anyone who has a mortgage would know how the overnight rate can affect the rates they are charged. Simply put, the lower the bank rate, the lower we can set our bond rate and still have it be competitive. I'll say more on the bank rate another time.
2) Company Quality. As with any loan, you wouldn't want to lend money to a company that you didn't think could easily pay you back. If you did, then you would want a higher interest rate to compensate you for the extra risk you are taking with your money. This is a big part of how rates are set. If a company with a spotty track record of profits and losses tries to borrow money and sets a relatively low interest rate, nobody will lend them money by buying their bonds. As a rule, riskier companies need to pay higher rates of interest to get loans. There are companies such as Moodys or Standard & Poors whose job it is to rate other companies 'credit quality', or their ability to make good on their loans. It's the same for us if we go to the bank to get a loan but haven't been paying our other bills - makes it tough to get that loan.
3) Time. Just like a regular loan, a bond's interest rate will be higher, the longer the company needs the money for. If you are only borrowing funds for a year, you don't need to be paying too much interest. On the other hand, if you want to borrow funds for 30 years, this is much longer that you are asking me to have my funds tied up with you. Therefore, you will have to pay me more interest.
When we have these criteria set (the size of the bond and the interest rate, or coupon, we are prepared to pay) then we alert the public to see who wants our bond. If we've priced it right, then we should have no problem raising the money we need.
As we know, governments also issue bonds. In Canada, we have Government of Canada bonds (Canadas), Canada Savings Bonds (CSBs), Provincial Bonds, municipal bonds (munis) and also bonds for certain crown corporations, such as Canada Housing Trust. The government is issuing bonds for the same reasons that companies are; building roads, schools, hospitals and other types of public investment. They pay off the bonds through taxes, which is effectively the main income source for the government. We are lucky that our financial system is in such good shape (i.e. we have a good economy that generates lots of tax revenue and we don't have a lot of debt, relatively speaking), so that our government bonds are very safe. Other countries such as Iceland aren't so lucky. The entire country had to declare bankruptcy about a year ago. So indeed, different governments have different ratings on their bonds, depending on the health of their economy.
So let's say you like the idea of owning bonds. How does one buy them? There is a bond market, but not really a bond exchange, so to speak. Each bank will buy bonds and have an inventory of different bonds at any given time. To buy bonds, you have to phone up your banker or advisor and see what kind of bonds they have available. The advisor will ask you which ones you are looking for, so there are considerations to this question as well. To answer them, we have to understand how bonds move (and yes, they do move) in price. If you want to sell bonds, you sell them to your bank's bond department and they will give you a bid for that bond, similar to selling a stock but without the stock exchange. The price that they will give you is determined by a few factors:
Let's say you buy a 10-year Bank of Nova Scotia bond with a coupon of 5% (that means the bond will pay you 5 cents for every dollar they issue) and you buy it on the first day the Bank issues their bond, so you pay $100. You buy $100,000 of this bond, so each year, you get $5,000 in interest (hence the 5% coupon). All is good. However, here's the tricky part. Interest rates go up so 6 months down the road, the Bank of Nova Scotia issues another 10-year bond but this time, the coupon is 6%. What do you think happens to the price of your bond if everyone can get the same company bonds with a higher coupon? That's right. The price of your 5% bond goes down until the yield of your bond (the coupon divided into the market price) equals about 6%. The laws of supply and demand! Why would I want your 5% bond when I can get one that pays 6% from the same company? Odds are if you wanted to sell your bond before it matures (at the end of the 10-year period), you would only be able to get about 85 or 90 cents (or $90,000 of your original $100,000 investment) for your bond. Yes, if you hold your bond for the entire duration, you will likely get your full investment back. The moral of this story though is to not buy long duration (I'd say more than 6 or 7 years) bonds during times of very low interest rates because you know rates are going to rise and when they do, nobody is going to want your bond that has a low coupon. If you do, then be prepared to hold them to maturity if we get rate increases because of inflation.
It's a lot to digest, I know. Feel free to ask questions in the comment section and I will either email you or answer directly.
The other risk of buying bonds is the obvious one: bankruptcy. If the company doesn't have the money to pay you back, then you are out of luck. So think twice when looking at bonds with very high yields (over 10% these days) because odds are that something is not right.
What would I do right now for bonds?
1) Buy short to medium term bonds and be prepared to hold them to maturity. It may not happen this year but eventually, interest rates will rise.
2) Buy good quality. If you aren't comfortable with buying the stock of a company, don't buy the bonds. You can look at government bonds but the yields usually aren't that attractive, although they are normally very safe.
3) Diversify. Just like stocks, it's always good to own a few different bonds in case something unpredictable happens to one of yours. At least you would be insulated.
There is so much more I could tell you about bonds; the world's bond market makes the world's stock markets look tiny. Please feel free to answer questions about this - I'd welcome the dialogue.
Thanks for reading.
Saturday, January 9, 2010
Week 3 - Stocks
After last week's post about TFSAs, I thought I should start giving a few ideas for what we can buy in our investment accounts, whether they are TFSAs, RRSPs, non-registered accounts, etc. Since they are at the heart of investing in Canada, I think one of the first things to go over is exactly how public companies are structured at the most basic level; common stock. In the coming weeks, I will touch on other methods of investment, including bonds, mutual funds, etc.
Let's start by considering our own fictitious company. For simplicity's sake, let's say we make the world's best baseball caps and everyone wants them. We are able to make a profit of a hundred million dollars per year. We are on our way to success! Because there are only two of us that own the company (you and me), right now, there are two shares (yours and mine) and for this example, we will say that we are equal partners. The problem is that since our company is privately owned (by us), we don't really know how much our business is worth. We know how much profit we make each year ($50 million each) but that's about as far as it goes.
So, we decide that our cap-making enterprise is big enough that we should sell it. But instead of looking for one buyer (which would be difficult if our company is this big), we decide to take it public, which means splitting our shares into many smaller shares and selling them on a stock exchange. In Canada, we have two stock exchanges: the Toronto Stock Exchange (TSX) and the TSX Venture Exchange, which was formerly the Vancouver Stock Exchange. The Venture is normally reserved for much smaller, more speculative companies.
Since our company is fairly big, we are going to list our shares on the TSX to try and sell them. We decide for simplicity's sake that we are going to divide each of our two shares (yours and mine) into 50 million shares, for a total of 100 million shares. So now comes the tough part. How much do we sell our shares for? If you recall, our business earns $100 million per year in profit, which is $1 of profit per share, since we now have 100 million shares in total. I don't know about you, but I'm not ready to sell this money-making machine for $1 per share, since that means someone who buys it gets all their money back in the first year!!! No sir. We need to sell our business for a multiple of how much profit our business makes. Here comes the good part: on the TSX today, there are companies that sell for as much as 30 times their profit or more!! That means we could sell our 50 million shares each for $30/share or as much as $1.5 billion each in cash money!!! Oh baby!!! The problem is that 30 times profit (or earnings, as it is more commonly known) is expensive. I think to be safe, we will sell our shares at fifteen times earnings; a common multiple for Canadian companies. This means our shares are going to sell for $15 each. Still, this makes our company worth $1.5 billion in total, or $750 million to each of us. Not a bad take for ball caps.
So we go to the TSX to sell our shares at $15 each and people all over the world buy them at that price. People paid a Price/Earnings (PE) multiple of 15 for our company. They deposit cash into their RRSP, TFSA, etc and use that cash to buy our stock.
The good thing for our original buyers is that because our business is so successful and odds are we will earn even more money in the future for our caps, people are actually willing to pay $16 for our stock now! This is known as a bid; the price people are willing to buy our stock for. If you own stock in any company, you can sell it on the TSX at the bid price, provided there is a bid for as much stock as you want to sell.
So what if a friend of yours wasn't one of the people lucky enough to get our stock at the original $15 price but he still wants to buy it? He can go on the TSX and buy our stock at the lowest price that people are willing to sell it for. If you recall, people are already willing to buy our stock for $16 (bid) but if you want to buy it badly enough, you will have to pay what people are willing to SELL their stock for; the ask price, which is always higher than the bid.
For simplicity's sake, let's say the current ask price for our company is $17. If your friend buys stock at the ask price (or the offering price), then the last price our stock traded for was $17. Every stock has these three prices, while the market is open (9:30am until 4:00pm each weekday); the bid (what I could sell my stock at today if I had to), the ask (what I could buy the shares at today if I had to) and the last (what the last price the shares traded at was).
Ideally, we want to buy shares in companies that make a good profit each year, and have good potential to grow their profit in the future. That way, hopefully we can sell our shares for more than we bought them for, down the road. Make sense? You can try it. Here are some easy steps to look for a stock to buy.
1) Go to a financial website (www.google.com/finance is a great one)
2) Enter the name of the company you want to look up in the search bar. You will need to know the stock symbol to look up your company more easily in the future, or if you want to follow it on TV, etc. Stock symbols are normally one, two or three letters, and will sometimes have an exchange code on the end. As an example, Shoppers Drug Mart trades on the TSX. Its symbol is SC-T, or just SC, depending on the website.
3) Once you've found your company and know the symbol, click it and you will see a page that has a bunch of information on it, including names of guys that run the company, price information, and more. If the markets are open, you should see a big bold price, which is the LAST price that the shares traded for. You should also see a bid and ask price. If you look closely, you can also see the price/earnings multiple that these shares are trading for (normally P/E on the websites). That will show you how much you would have to pay for the shares, relative to how much profit they make.
If we are going to buy some stock, we probably want to buy stock in more than just one company, in case something bad happens to our company (new competition in the baseball cap market, fire at the factory, whatever). We want to own stock in many companies so we can try to insulate ourselves against these negative events. We also probably don't want to own stock in too many companies that do the same thing, because if something bad happens to one, it could affect the others. Just think if you owned a portfolio full of stock in US banks in 2008. You may have owned many different banks but they were all in trouble for the same reasons, so your portfolio would have taken a beating. Here are some guidelines for buying stocks, if that's the way you want to go with your investment dollars:
1) Buy stocks in companies that make money, as opposed to lose it. This seems obvious but wait until you see how many of the companies you know out there aren't making money. They could be victims of the poor economy, tough competition or bad management. There are also companies that are losing money today to do research or development to make a profit in the future. These aren't necessarily bad investments but are more risky, since there always is a chance that their work doesn't pay off.
2) Buy lots of different companies. As we talked about, this is called diversification. You will get different answers about what the right number of companies is to own. I think 15-25 is pretty sufficient. Any more than 25 and you're going to start owning too many companies that do the same thing. You would be over-diversified!
3) Take advantage of professional advice. Researching these companies takes a lot of time. A good financial advisor or portfolio manager will know which companies are good ones and be able to follow them once you have purchased the shares. Mutual funds are one way of doing this - we will come to that. Yes, it will cost you - we will come to that, too.
4) Don't fall in love with your stocks! Companies that are great today may not be great tomorrow. Be sure to keep informed about your stocks and how their businesses are progressing.
There is obviously a lot of information about stocks but hopefully you will be able to gain a simple understanding from this piece. I have 52 weeks to elaborate, so more information will follow, including tidbits on dividends, splits, bankruptcy and many other really stimulating topics, if you aren't already falling asleep! In my opinion, stocks are probably the best way to make money investing over the long term. It's picking the right ones that is the tricky part.
Thanks for reading. See you next week.
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