Understanding when something is risky is just as important as figuring out how profitable it will be. What would you do if you had to choose between A) climbing a rusty 8th floor balcony railing in your slippers to get a candid photo of your “chesty” next door neighbor or B) learning how to use the internet and just googling “chesty next door neighbor” (Don’t google it at work). Unfortunately, assessing investment risks is never this simple.
Increases in return = increases in risk. More often than not, the better the ROI the more risk is involved. For example, you can potentially make more money investing in sexy penny stocks than boring government bonds. On the flip-side, penny stocks are more likely to declare bankruptcy, governments rarely go bankrupt (please ignore Argentina, Iceland, etc). To simplify, equity (stocks) is associated with higher risk while fixed income (bonds) is considered to be a lower risk investment.
Should you go balls out, invest in tech stocks and become a millionaire in a few years? Or, should you diligently put money into safe bets, knowing that these will steadily fund your retirement? It depends on your personality but it also greatly depends on your age. Age determines risk tolerance. All things being equal, the younger you are the more risk you can tolerate. When you’re in your 20’s, it’s much easier to lose everything, move back into your parent’s basement and curse the stock market to hell. At 65, rebuilding your entire net-worth while wearing soiled Depends® is an adventure none of us should embark on.
It’s important to keep risk assessment in mind when choosing various investments. A useful guideline is to subtract your age from 100 to arrive at the equity portion of your portfolio. As you get older and hair migrates from your head to the rest of your body, you should shift investments from equity to fixed income. A 20 year-old should have an 80-20 mix of stocks to bonds, when they turn 45 they should aim for a 55-45 breakdown, by the time they are 100 the stock market should be the last thing on their mind.
***If you like bungee jumping, sky-diving or cliff jumping, feel free to change the above rule and subtract your age from 110.
Nothing warms the cockles of my heart more than being guaranteed something. When I buy a laptop I like to pay a little extra for a guarantee. Usually what’s guaranteed is that two years down the road I get to endlessly haggle over who’s responsibility it is to fix a broken part. When I’m driving my car I have a big smile on my face because I know that I pay a fortune each month for a guarantee. If I get into an accident, I am guaranteed to be drawn into a lengthy legal battle over what my insurance is covering. Even death’s guarantee can be cheated with some stem cells. Luckily for my cockles, the world of finances has concrete guarantees, such as the Guaranteed Investment Certificate (GIC). Also know as Certificate of Deposit (CD) in the United States.
GICs are products offered by your local bank in order to “encourage” you to invest. Bankers aren’t entirely delusional, they understand that sooner or later people will wise up to the fact that high-interest bank accounts are slowly draining away at their savings. So for those smarty pants, GICs offer a better return than a savings account. There’s a variety of GIC options out there but they all boil down to the same principal. When investing in a GIC, you lock up your money for a specific time period. The return will depend on your initial investment and how long you are willing to let the bank hold it. For a 5-year GIC, you will get a return every single year but it will be greatest for the 5th year. Withdrawing the money earlier will incur a penalty and likely wipe out any gains.
Here are some Canadian GIC comparisons: http://www.redflagdeals.com/features/canadian-mortgage-gic-rrsp-savings-rate-comparison/canadian-gic-rates-annual/
Here are some American CD comparisons: http://cdrates.bankaholic.com/
The bad news for the consumer is that GICs barely beat the returns of a savings account. Even here it seems guarantees aren’t all they’re hyped up to be. Why should you use GICs? If you have the risk-tolerance of a retired librarian, keep your kids in a giant bubble or wear a bulletproof vest while shopping for sofas, then this option is for you. Similarly, if you want to keep a certain amount of money safe (down-payment on a house) you can stuff it into GIC until you are ready to use it. Just remember to load your GICs into a TFSA because any return earned on them will be taxed.
And for God’s sake let the kids out to play!
What’s the point of saving money? Being debt-free is nice and it’s always rewarding to see a growing number on your ATM receipt. What’s the point of spending money? Getting to drive stupidly fast cars, having breakfast on an enameled lava counter-top and wearing a Gucci jockstrap (yet it’s still uncomfortable). Unless you have a juicy inheritance coming your way, keep driving that KIA, eat breakfast off those disposable plastic plates (which you keep reusing) and kiss that jockstrap goodbye (not literally I hope). Mo’ money can only be made from an an initial investment (savings), which then begets Mo’ money and after that you might start seeing Mo’ problems.
The basic way to earn steady cheddar is also the most sombering because of the pathetic returns. A high-interest savings account will immediately pay you a monthly sum just for being a good boy/girl and putting away money for a rainy day. The vig on these cash cows? As of today, 2%. Here is the proof: http://www.redflagdeals.com/financial/savings-accounts. Nevertheless, anything is better than nothing, things could be worse, right? And they are, for two very simple reasons. Inflation and taxes. Historically, the inflation rate is right around 3.25%, which means money is slowly losing value even if it is sitting in a savings account. Luckily if you’ve managed to beat the inflation rate and get a measly cash return, you actually get taxed on it! After all your hard work the government wants a piece of the action, it’s no wonder people are more interested in spending then savings.
I can’t help you with inflation because I don’t control the monetary policy. But, there’s a good way to avoid tax on savings and keep the mounties away from your pockets. A tax free savings account (TFSA) works the same as a savings account, except you do not have to pay taxes on any of the money earned. The account was invented in 2009 and since its inception Canadians are allowed to deposit up to $5,000 a year into it. If you open an account today, you will have a limit of $20,000 to deposit until the end of the year. This account is ideal for anyone starting to save. If miraculously you earn $1,000,000 from your initial deposit, you won’t pay a single cent upon withdrawing the cash. This is one of the few “breaks” we get, take full advantage of it and put all your savings into it. Next time you go to a cocktail party, tell the gal next to you that you’re working on topping up your TFSA for the year…stand back and prepare to get lucky!
Isn’t it strange that every car in a used car dealership looks like an amazing deal? Why is it each time you speak with a mortgage broker there is “no better time to buy”? How come after a year of going to your chiropractor, there is still a slight misalignment that requires 12 extra bi-weekly visits? I don’t know, seems legit to me (I’m seeing Dr. Silverstein tomorrow). Anyways, for no apparent reason today’s post will be about critical thinking.
Critical thinking (or the ability to separate fact from fiction) is a fundamental skill that extends to all aspects of life. If there is one thing the world is lacking, its people who use personal research to make up their minds about important issues. For example, I don’t need to watch a 12 minute video to realize that things are bad in Africa. I KNOW things are bad (that’s why I vacation elsewhere) but how is sending $30 to an unproven charity going to help?
Don’t make any financial decisions until you have considered all of the alternatives and consulted multiple professionals (or blogs). Don’t be shy about asking how much commission these “advisors” will earn from playing around with your money. Don’t sign anything without consulting a lawyer first. Above all seek transparency, accountability and a sexy smile.
Seek a fee-based financial advisor who will charge you an initial fee for setting up a portfolio, provide tax shelter advice and give you the option of coming back annually to rebalanced your portfolio. Run-of-the-mill advisors will try and push products that pay them the highest commission, your needs for steady returns will be a secondary concern. View advisors as booty calls; when you need some advice, call them up, do the deed and be out the door before they can say “mutual fund”. Don’t stick around to cuddle, it ain’t worth it.
So lets recap: you’ve got a fresh budget, expenses are being tracked online, spending limits are set and there’s a few extra benjamins winking at you with each paycheck. It’s about time to consider investing. Don’t let the cheddar sit idly in the bank, put it to work.
A good starting point in choosing an investment avenue is to consider Return On Investment (ROI). This is a handy yardstick that sums up how efficient (profitable) an investment will be. The formula is straightforward:
ROI = (money being made – money being spent) / total money invested
Multiply the ROI by 100 and you will get a percentage, obviously the higher the ROI the better the investment but there are some exceptions. ROIs do not reflect how much risk is involved and they do not take into account how much work is required. For example, investing $10,000 in a conservative diversified portfolio may only produce an ROI of 5%-10%. That’s as vanilla as Martha Stewart baking an apple pie. Buying a rental property, taking on a mortgage and finding a tenant could produce a much higher ROI. In this case you get to live out your fantasy of being a superintendent! Smuggling cocaine from Columbia and pushing it onto the mean streets of Toronto could net an insane ROI. This last case takes into account your willingness to spend the twilight years of your life sharing a cell with “Big Tyrese”.
The goal is to find that sweet spot. Consider how much effort you are willing to put in and how much risk you can tolerate. There are more important things in life than making money efficiently. Sometimes it’s better to pick the lesser ROI, especially if it means not having to spend your evenings making shivs from toothbrushes and soap.