Since I’ve started trying to talk a bit more openly with people around me about money, I have been a bit surprised by how many people are keeping their savings in cash, using highly conservative investment strategies, or who have never even considered anything beyond mutual funds. Most of the people I talk to who do have investments don’t seem to know much about them, can’t explain why they chose them, and don’t really know what other options they have. So in this video, I wanted to share some high level information to help demystify your investment options.
This is going to be a high level overview of some of the main ways you could invest your money. We’re going to talk about bonds, GICs and term deposits, mutual funds, stocks, and then one subset of stocks called exchange traded funds. I’ll share a few details about each and let you know why you would or wouldn’t choose each option. I’ll preface this whole conversation by saying that for most people in pursuit of financial independence, bonds, GICs, and mutual funds are pretty unpopular options. The reason I’m covering them at all is because many people still seem to use them, even though they don’t offer many advantages, and because I think it’s sort of difficult to explain why I think ETF index funds are far superior without having a bit more conversation about the other options.
Let’s start with bonds, which are also referred to as fixed income investments. What are bonds? You can think of a bond as a loan that you’re making to a government or corporation. When governments or corporations need to raise money, they issue bonds with agreements to pay them back in full, with interest, and sometimes with additional money to account for inflation, by a certain date.
The term of a bond can be up to 30 years, but you can usually sell at any time. The value of bonds can change a little bit, mostly in relation to the interest rate environment, but overall they tend not to fluctuate very much. The longer your investment period, the higher you can expect the interest rate to be, but interest rates on bonds are low - most bonds issued by the Government of Canada, for example, pay an interest rate of less than 2%. So how do you buy and sell bonds? You can buy and sell bonds like you would stocks - through your brokerage account. You can buy bonds directly from the issuer or through your brokerage account, but you can also gain exposure through mutual funds or ETFs, which we’ll get into in a minute.
So, when would it make sense to buy bonds? Bonds don’t offer much in the way of growth potential, and depending on the specifics you could actually lose money to inflation over time, but they otherwise protect your principal investment. So if you can’t risk losing any of your initial investment, bonds could be an option, as long as you understand that very little risk also means very little reward. Ok, moving along to GICs, or guaranteed investment certificates, and term deposits. A GIC is basically a fixed term loan that you are providing to a financial institution. In return for loaning them your money for a certain guaranteed period of time, they’ll pay you a little more interest than they would on cash that you could decide to withdraw at any time. Fixed terms typically range from 3 months to 5 years. Although the basic idea behind GICs is that the loan period is fixed, there are also cashable GICs that you can withdraw at any time, but the interest rate paid on those is lower than others. So for your fixed term GICs, you can choose one with a simple interest rate, or, you can allow for some variability by letting the bank invest the money in the market while they have it.
This is less risky than investing it yourself, because GICs will always guarantee your principal investment and a minimum rate of return, but if the market does well, you have a chance to earn a little bit more on that investment. Even in the best case scenario though, the highest guaranteed return that I could find was 5%, where the lowest was around 1%. The best case scenario that I found was a GIC that would be invested in the market that offered a 5% guaranteed return with up to 25% returns if the market did well. Higher returns come from longer investment periods, non-cashable accounts, and larger investments. Unlike bonds, you don’t need a brokerage account to buy GICs, so you just need to set up your regular account for GICs. So, when would it makes sense to buy GICs? Like bonds, GICs are an option for protecting your principal investment and earning a little more than you would in a standard savings account, but this is still a very conservative investment vehicle.
Next up is mutual funds. If you head into your bank and ask a financial advisor about investing, chances are, they’ll point you in the direction of mutual funds. A lot of the time, advisors will receive a commission for selling you mutual funds, so they’re incentivized to tell you more about that than any other option. Let me know in the comments down below whether you’ve had this experience - was your first investment in a mutual fund because of recommendation from someone at the bank? And while you’re at it, if you’re enjoying this video, don’t forget to give me a thumbs up so I know to make more content just like this. So, a mutual funds is a collection of stocks and/or bonds. You can choose mutual funds that focus on a particular industry or geography, or even a particular asset class like a mutual fund that invests mostly in bonds, or mostly in very well established companies.
There are also very broad based mutual funds called index funds that are designed to hold a set of assets that is reflective of the entire market. Index mutual funds are set up to generate the same returns as the overall stock market - if the market returns 8%, the index mutual fund should too. One of the main downsides of mutual funds is that they have a fund manager whose job it is to regularly rebalance the holdings to try to get the total collection to perform as well as possible, although they rarely outperform the market. Because there is someone behind the scenes actively managing the fund, there is a fee associated with owning a mutual fund.
The fee, known as the ‘management expense ratio’, or MER, is generally between 0.5% and 2.5%. So even if your mutual fund returns 8%, the money you get out of it could be as low as 5.5%, after you’ve paid your fees. So, when does it make sense to buy mutual funds? In my opinion, almost never. If you’re comfortable investing in the market and going with an investment that doesn’t guarantee your principal, there are very similar options, that involve similar levels of risk and investment knowledge, but that will yield greater returns because they have lower fees. Finally, let’s talk about stocks. Stocks are a pretty far reaching category, but essentially when companies need to raise money they will sell of tiny pieces of the company in the form of shares, so when you own a share you actually own a tiny sliver of the company.
That entitles you to some of the company’s earnings, in proportion to the number of shares that you own. You can buy shares in nearly any type of company out there, but it can be very tricky to choose ones that are going to bring you good returns, and you can potentially lose money, which is why people new to investing might perceive investing in stocks as a pretty risky option.
Since investing in individual companies is a less popular approach for people pursuing financial independence, I’m going to focus on a particular subset instead - exchange traded funds, or ETFS. ETFs are a lot like mutual funds, but they’re traded through your brokerage account. There are a wide range of ETF options out there, but I want to zero in on index ETFs. Like index mutual funds, they’re designed to track all or part of the market. The biggest difference is that index ETFs are passively managed, which means that they don’t have someone playing around with the holdings all the time trying to get a better outcome. Because of that, their management expense ratios are much lower. Typically, less than 0.5%. The difference between a 0.5% fee and a 2.5% fee might not sound like a lot, but as your portfolio grows, it can actually make a really big difference. You can even choose index ETFs according to your level of risk - you can get funds that are invested 100% in stocks, 80% in stocks and 20% in bonds, 50% in stocks and 50% in bonds, or many other combinations.
So I’m going to stop there for today because index ETFs are the main type of investment you’ll hear promoted in the financial independence community and it’s a topic I want to dig much deeper into.
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Posted from my blog with SteemPress : http://iread4u.live/2019/04/15/how-not-to-invest-for-financial-independence/