Can you imagine anything better than studying calculus in the summer? I bet you can. But I found myself doing exactly that, late in my high school days, in a nerdy effort to graduate a semester early.
Aside from picking up an infinitesimal amount of calculus, I met a fellow keener in class who had the investing bug. He rattled on and on about odd things called mutual funds and how you could make a potload of money from them. Naturally enough, I promptly forgot about funds for about a decade while exploring calculus a bit more. But I rediscovered them after I had amassed just over $10,000 by playing the part of Beaker to a series of lovable Dr. Honeydews in a variety of laboratories.
At the time, I felt that $10,000 was a tidy sum for a young fellow—enough to think about alternates to a bank account anyway. So after some pondering, I moved my grubstake into mutual funds. If only I knew then what I know now. But you can profit from my experience. Here’s what I’d tell a younger me about investing, if I had the chance.
The importance of fees
To begin with, there are only a few things that you can really control when heading to the market to make your fortune. It is important to realize that the market is just there. It doesn’t care if you make or lose money—and there are many ways to lose money.
That’s why you should launch your offensive for profits from a secure foundation. Instead of immediately seeking the very best opportunities, it can pay to aim to limit your losses. And it shouldn’t come as a surprise that fees are an important source of such losses. To make money from a small base it helps to be thrifty because many financial institutions seem to prey on the middle class and poor these days.
To highlight how important keeping costs down can be, let’s look at the miracle of compounded interest. The notion is simple. If you can grow your money—even at a low rate—over a long period, then you too can be rich as Croesus. More concretely, if you grow your $10,000 nest egg at 4% a year over 30 years, you’d have just over $32,400. Both higher rates of return and longer investment periods would improve your results considerably.
But unfortunately, all too many investors don’t realize that their funds charge annual fees—and the effect of those fees compounds too. A fund’s fee will rarely be highlighted as part of a sales pitch, but you can spot it in the fund’s prospectus, or you can look it up in your fund’s fact sheet online. It’s called a management expense ratio, or MER. Usually, if fees are mentioned, they’ll probably be referred to in some diminutive fashion. Something like: “It’s only 2%, just think about how much money you’ll make.”
It’s true that 2% doesn’t sound like a lot, but let’s say that you hold a mutual fund for 30 years and it earns 4% a year, on average, before fees. That means that almost half of all of your growth will be snatched back from you in fees. As a result, your $10,000 would grow to about $18,100, which is a good deal less than $32,400. That’s why it’s well worth your time to keep an eye on costs—after all, annual fund fees in Canada are often in the 2% to 3% range.
Three enemies of growth
Taxes are another bane to investors. Despite the government’s desperate need to fund new $400-million hockey arenas in Quebec and G8 gazebos in Ontario’s cottage country, I suggest structuring your affairs so as to minimise taxes as far as is both sensible and legal. For most people, the best way to pay less tax over the long run is to hold investments inside a Tax-Free Savings Account (TFSA) or an RRSP. Outside tax-sheltered accounts, taxes can act a bit like a 2% to 3% annual fee on stock returns over the very long term. Interest income from bonds and GICs is taxed at an even higher rate.
I hate to bring it up, but next I must address an even more insidious way that you can lose your hard-earned savings. It is called inflation. That’s the tendency of money to lose purchasing power over time and it is generally caused by the government printing too much currency. Inflation is the reason why ice cream cones cost 10 cents in the distant past whereas now they cost $3. These days inflation is running at 3.1% annually, which means that even if you avoid the risks of the market by stashing your cash under your mattress, you’re still losing 3.1% of your money’s value every year.
There’s one more threat to your growing portfolio: Your own behaviour. Specifically, it’s the tendency we have to buy high and sell low. Most people can sit in a savings account and sleep well at night. But they seem to lose their heads in the stock markets and it’s easy to see why. The markets gyrate and plunge frequently. In early 2009 many investors woke up to discover that their portfolios were only half as big as they were a couple of years earlier. Problem is, very few investors seem to dive in and actually buy low during such downturns. More commonly purchases are made after a good rally, and investments are sold after a big decline. As a result, history has shown that investors lose—very roughly—2% a year over the long term due to such behaviour.
So let’s do a rough summary: Fund fees might reduce your returns by 2.5% a year, taxes another 1%, say inflation nibbles off 3%, and bad timing another 2%. Gulp! Unless your money is earning an annual return of more than 7.5%, your savings could actually be shrinking. How can you avoid this nasty fate? By minimizing taxes, fees and bad timing.
So where should you invest? I’ve already suggested making use of TFSAs and RRSPs to reduce taxes, but what about fees and bad timing? The solution for the vast majority of investors is the humble low-fee balanced fund. It’s the unsung star of the investment world.
Balanced funds are a one-stop shopping experience for portfolios, and they hold a diversified selection of both stocks and bonds. Usually such funds invest about 60% in stocks and 40% in bonds, or equal amounts in both stocks and bonds.
Because balanced funds contain a big dollop of bonds, their returns tend to be much less volatile than those of stock funds. As a result, it is usually much easier to sleep well at night. You might lose a bit during market crashes, but the declines will be more palatable that those from stocks alone. History has shown that most investors handle balanced funds relatively well and don’t suffer too much from the buy-high, sell-low syndrome. That helps to minimize your losses from bad investing behaviour.
Even better, if you look for them, you can find excellent low-fee balanced funds in Canada. Because I know many people like to deal with their bank, I’ve picked a solid low-fee balanced fund for each of the big banks in 8 great funds to stash $10,000 in. I also included a couple of excellent funds from Calgary-based Mawer Investment Management. You can get both Mawer funds with a $5,000 initial investment through a discount broker, or wait until you have $50,000 and invest directly with Mawer to avoid the brokerage fees.