Monday, July 8, 2019
Clearing up Investment Confusion
One of the most common points of uncertainty I encounter with my clients is Investments. The truth is, most people have no clue what’s going on. If you are one of them, don’t be mad and please do not be offended. I am here to tell you that it doesn’t have to be that complex and it certainly shouldn’t be confusing. I am of the ilk that believes when someone makes something confusing, they are usually trying to hide something. In the investment industry that usually means they are trying to hide that they really don’t know what they are talking about or that they don’t want you to know what they get paid. I want to take this post to clear up some of the most common confusing investment topics I have encountered as an advisor. Let’s get this right once and for all.
What is an investment?
Investopedia describes an investment as, “An asset or item acquired with the goal of generating income or appreciation.” What is an asset? Well, an asset is anything of value, or worth. Assets can include physical items like a car, a home, gold, art or many other things. An asset can also be intangible items such as cash, stocks, bonds, and various other items. The goal of generating income or appreciation means you buy the asset, and then you want it to either grow in value, ie. you now have more value than when you started, or it generates income, meaning it pays you simply for owning it. Most of us can understand what an investment is, but then the question becomes, what is a good investment? That is the tougher question to answer. Logically, an investment that generates a larger return, or more income, would be a better investment. Therein lies the problem and this is where people get confused. What generates larger returns? The answer is riskier investments. Can I receive large returns with no risk? The answer is no. I will go a bit deeper into this as we go on.
One common thing I hear quite often is, “I am invested in RRSP’s.” (Registered Retirement Savings Plan here in Canada, 401K in the States). You are not investing in RRSP’s, you are investing WITH RRSP’s, or an RRSP. Here is the difference. Where you choose to put the money that you invest with is what is known as the vehicle. You need to think of the vehicle as to the “bucket” that holds your money. Different vehicles have different features. The BIG defining factor is TAX. Where you put your money always has tax implications. An RRSP is taxed differently than a TFSA, (Tax-Free Savings Account, or Roth IRA in the States). If you simply buy 1 share of 1 stock outside of these vehicles, that is taxed differently too. The RRSP is the vehicle, what’s inside it is the investment. Whatever you put inside it, is what you are invested in. If you choose to put that 1 share of a stock in an RRSP, you are invested in that company and you are investing with or within an RRSP.
Investing with: Registered Retirement Savings Plan (RRSP)
Investment in: 1 share of Amazon
An RRSP will not generate you any income or appreciation. The share of Amazon is what has the potential for growth.
Vehicles (Investing WITH):
Registered Retirement Savings Plan (RRSP), 401K in America
Tax-Free Savings Account (TFSA), Roth IRA in America
Registered Education Savings Plan (RESP), 529 Plan in America
Registered Disability Savings Plan (RDSP)
Non-Registered Investments, any investment outside of government investment vehicles
Investments (Investing IN):
Stocks, Google, Amazon, TD Bank, GE, etc.
Bonds, an entity (Country, jurisdiction, company) raises money and pays it back with interest to the bondholder
GIC’s, money held for a duration and then paid back guaranteed with interest
Mutual Funds, a pool of money invested by a fund manager who chooses what to invest in
Index Funds, an investment that mimics the movement of a stock market, ie. Dow Jones, Toronto Stock Exchange, S and P 500
Many, many, many more
I hope this clears this up a bit. “I own an RRSP and it is invested in Mutual Funds.”
What is a Mutual Fund?
I bring up this topic because it is the most common investment type utilized by investors today. NerdWallet describes a mutual fund as:
“A mutual fund pools money from different investors in order to invest in a large group of assets (also known as securities) such as stocks and bonds. Professionals manage the holdings that make up the fund’s portfolio; investors buy shares that rise or fall in value based on the performance of the fund’s underlying securities.”
Let’s break that down. A mutual fund pools money. What that means is that you, me and everyone else who decides to invest in this fund, put all our money together. The reason why this is done is that it gives the fund manager more buying power, meaning they can buy more assets. Think of it as strength in numbers. He or she or they use that money to buy a large group of assets, known as securities, such as stock or bonds. The job of the manager is to take our money and buy shares of companies (stocks) or uses it to buy bonds (money repaid later with interest), or other investments that hopefully generate a profit. The manager of the fund chooses the investments to buy, based on their expertise, and it is their hope that the fund performs well. They have an underlying desire to succeed because if they do, more people will choose to invest their money with them. If that occurs, they receive bigger compensation, and the company they work for does as well. Their job is strictly performance-based, meaning if they perform poorly, they will not have a job for long.
Where mutual funds are beneficial is that they spread out the risk amongst many people, and many companies, simply by the action of pooling money. For instance, when you invest in a “Canadian Large Cap Dividend Fund,” you are essentially investing in the Canadian Economy. While that fund may have TD Bank within its holdings, it also has dozens of other companies. That means that no one particular company can bring that fund down. If you were to invest solely in TD Bank, you would feel every up and down of that stock, meaning if it did poorly that year, your whole investment would suffer. A mutual fund diversifies within itself, allowing the investor (you), more security.
Can I lose all my money?
I hear this question a lot. The answer to this question is maybe. It all depends on what you invest in. We have all heard the phrase, “High Risk, High Reward.” That’s what investing is all about. For instance, investing in one stock, say Amazon, is inherently riskier than investing in 10 stocks. Simply put, the odds of one company having a bad year or simply going out of business is more likely than 10 doing that. This means that if you invest in one company or one commodity, you have a greater chance of losing all your money than if you invested in a Mutual Fund, (dozens of stocks and/or bonds). For a Mutual Fund to lose all your money, let’s say the Canadian Large Cap Dividend Fund, every company within that fund would have to go bankrupt simultaneously. For that to happen, the Canadian Economy would have to collapse beyond repair. If that were to happen, we would be fighting over bread at the grocery store and investments would be the least of our worries. Even during the Great Depression, the overall market did not drop more than 25%, meaning balanced investors did not lose more than a quarter of their investments. The market eventually recovered, but it did take some time.
Can you lose money? Indeed, but the question then becomes, “What will cause me to lose money?” We have all heard this other phrase, “Buy low and sell high.” Sadly, most people do the opposite. When times are good, meaning the market is doing well, people tend to get involved, buying more investments. When times are not as good, meaning the markets are doing poorly, people tend to sell their investments and get out of the market, out of sheer fear of losing everything. This is how people lose money, they buy and sell at the wrong times. So, what is the right time? No one knows when the right time is. The strategy then becomes to buy and hold investments for long-term growth. This will allow you to weather bad markets and stay in during the good ones. Warren Buffett once said, “My favorite holding period is forever.” He also said, “If you don’t feel comfortable owning a stock for 10 years you shouldn’t own it for 10 minutes.”
What are my guarantees?
Again, with stocks and mutual funds, there are no guarantees. You only get guarantees with guaranteed investments, such as GIC’s. Anything with a guarantee attached to it doesn’t grow as much simply because of the guarantee. Essentially you pay for the guarantee with performance. Does that mean that guaranteed investments are a bad thing? Hell no! They are a great thing if you don’t like losses. They are a terrible thing if you are looking for amazing returns. Back to your guarantees. There are no guarantees in the stock market except for one thing. I guarantee that no one can predict which way the market will go. If someone tells you they can, run for the hills, because they are lying. What we do know is that the trend over the past 100 years is that the overall market goes up over time. It has averaged about an 8% return historically. That doesn’t mean there weren’t bad years or even terrible years. What it means is that when you invest in the market you are investing in the idea that businesses will attempt to grow and make profits. Apple isn’t in the iPhone game to lose money. Wal-Mart doesn’t open the doors everyday eying bankruptcy as a viable option. They hope to win and win big and if they do, you do.
Who gets paid?
The short answer is everyone. Like I just mentioned, people aren’t in this business to not make money. There are several people in the chain of getting paid off your investment. The first is the Dealer or the company that houses your investment. This company performs the transactions, like buying your funds and setting up your investment. They are the name on your statement. Examples include your bank or investment company like the one I work for. There are thousands of people working at these companies that all make a salary and your investment helps pay for that. The next person getting paid is the fund company. This is the company that runs the fund you are invested in, remember our talk about mutual funds earlier? This company employs the fund manager who chooses the investments. That manager usually has a team helping him out, doing research and such. While there are usually fewer people to employ at the fund company, they still get a chunk of the money. The last person getting paid is the investment advisor or your personal contact. That is what I do for a living, along with other roles. This is the person who helps you choose the investment, pick the vehicle and follows up with you as time goes on, hopefully. They receive a percentage from your investment for simply bringing you to the dealer and fund company.
In this competitive environment, you, the client, are a very valuable commodity. It is your money that drives this whole industry. Therefore, dealers, fund companies and advisors are all looking to have you on their books. One of your questions should always be about fees. The average Mutual Fund Fee hovers anywhere from 1-3%, which does affect performance. What that means is that if you have 10K, you are paying $100-$300 a year for that investment. If you have $1,000,000 invested, you are paying 10K-30K a year in fees. You must determine if paying those types of fees is worth the performance and service you are receiving. Much like an advisor that can predict the market being faulty, any advisor that shies away from the fee conversation is usually up to something. Demand transparency.
Why is it so confusing?
It is confusing because people make it confusing. For me as an advisor, it is my job to take the often-complex world of investing and make it as simple as possible. For example, I watch BNN Bloomberg every day. That is our Canadian Financial News Channel. I watch it to get market updates and absorb the knowledge of what’s going on in the world of finance. Mainly I watch it to listen in as I get ready for work in the morning. Much like cable news channels and cable sports channels, the news they present is often of the sensational variety. They talk about what the hot stock is, or a looming great recession like in 2008, or what investors should fear. Why do they discuss this? The reason is simple, it gets people watching. The same reason the sports channel will have 5 guys around a table to discuss a Lebron James Instagram post or CNN will have the same discussing a Donald Trump tweet, these channels want people watching. What makes people tune in? Noise and lots of it. If BNN Bloomberg had 24 hours of news discuss long-term market returns and the benefits of a TFSA, no one would watch. It’s the same reason why my post entitled, “If you are excited for Black Friday, you’re an idiot,” was my most popular ever and my one entitled “5 Tax-Advantaged Investment Vehicles,” wasn’t. We like drama and we like excitement. I will repeat this to you, and I hope it sinks in: Anyone that takes something seemingly complex and makes it more confusing is usually up to something. My goal is to take something seemingly complex and make it simpler. That is why my site is called Budget Boss, not Individual Personal Finance Management for the Canadian Consumer.
Break it all Down
So, what did we learn?
An investment vehicle holds and investment. I am investing with an RRSP and it is invested in Mutual Funds.
A good approach to investing is Mutual Funds, as it spreads out the risk amongst many people, sectors, and companies.
You can lose all your money, but if you are invested properly, it is unlikely. That does not mean that on any given year you won’t lose some money. What it means is that being well-diversified and emotionally stable is important.
Fees are important, and everyone involved is getting paid. Are they the most important thing? No. I would rank performance and service over them in terms of importance. But you should know what you are paying, so seek out that information.
It is confusing because people make it that way. Confusion brings out our primal emotions like greed, fear, and anger. Your goal should be to learn as much as possible and the person managing your money should be there to facilitate your investment knowledge and growth. Otherwise, what’s the point of them? Like Dave Ramsey says, “Your Financial Advisor should have the heart of a teacher.”
I hope I was able to clear some of the air on investing. I know some of this must have flown right over some of your heads, but my goal is that we gather some of the basics. A knowledgeable investor is a profitable investor. The most important thing to ever know in the world of investing is yourself. Know that and you’ll always win.
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.” – Robert G. Allen
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