INVESTING FOR BEGINNERS PART 2 – ETFs, STOCKS & BONDS, MUTUAL FUNDS

 

Below you’ll learn about the six most common investments to hold in your accounts. Remember that your RRSP, TFSA, and taxable accounts are like offices. They are empty rooms that are filled with things that generate profit. Money in the account is like your employees, and the investments you buy are like jobs for your employees. I’ve listed them in order of my recommendations with some basic information on how to evaluate each of them. But first some important terminology:

  • Management Expense Ratio (MER) – The percentage of the fund that will be deducted annually to cover fund expenses (Normally salaries for fund managers, exchange fees, and bank overhead costs).
  • Commission – Nearly every time you buy or sell a stock your brokerage will charge a commission (normally $5-$10, but many ETFs are commission free!)
  • Brokerage – This is referring to the company that will host your investment account.
  • Fund – A collection of different stocks presented in a single package (that you can buy)

 

1. EXCHANGE TRADED FUNDS (ETFs) AKA INDEX FUNDS

 

A good match for: Someone who wants to take an active role in their investments, but not too active.

Typical MERs: 0.05% – 0.75% (FYI that’s low)

An ETF is an index fund.

An index fund is a fund that tracks an index.

And index is a measure of the weighted average share price of all companies within a specified group.

For example: The S&P 500 index tracks the top 500 companies traded on the US stock markets. Therefore owning an S&P 500 index fund will be like owning stock in every one of those 500 companies. Talk about diversification!

ETFs are possibly the cheapest way to diversify since many brokerages will let you buy them commission free (compared to $5-$10 per stock trade). ETFs will typically have a theme, for example FTSE Canada All Cap Index ETF (VCN) is like buying the entire Canadian stock market. Some ETFs track a specific industry, and some track geographic areas like iShares MSCI Europe IMI Index ETF

Why are ETFs called Exchange Traded Funds? Because they are purchase on stock exchanges just like you would buy any other stock.

ETFs are my favourite thing right now and they should be yours too. They are simple to buy, inexpensive, and generally low risk. You’ll never lose all your money unless the entire index goes broke. And if that happens you’ll be too busy with the apocalypse to care about your investments.

Check out my other page for information on how to judge them: How to Judge ETFs

 


2. ACTUAL INDEX FUNDS

 

A good match for: Someone who doesn’t want to be actively involved in their investments, doesn’t need an advisor (i.e. can use google), and wants to minimize fees.

Typical MER: 0.5% – 1.07%

All ETFs are index funds but not all index funds are ETFs. The difference is that index funds are sold directly by banks instead of through a stock exchange. You’ll need to open an account with one of the main Canadian index fund suppliers:

I have not tried any of these myself, but if I wasn’t buying ETFs I’d be invested with Tangerine. Their Balanced Growth fund has averaged 10% over the past 5 years and 5% since its inception in January of 2008. That’s no guarantee of future performance, but I’d trust Tangerine with my money.

Advantages compared to ETFs

  • Automatic funding – You can set up automatic transfers from your chequing to investment account and have complete set-and-forget investing! Perfect for the lazy investor.
  • Idiot proof diversification – At Tangerine you can buy a single fund and be properly diversified. Avoid decision anxiety when presented with literally hundreds of ETFs to choose from.

Disadvantages compared to ETFs

  • Higher fees – 1.07% MER is pretty high compared to 0.11% with an ETF like VCN. That’s nearly 10x higher fees with Tangerine.
  • Less control – So you noticed oil stocks are at record lows? with ETFs you could buy an energy index, but now you are stuck with your single fund from Tangerine.

 


3. STOCKS

 

A good match for: Someone willing and able to study hard for the chance of the highest rewards, and more importantly able to emotionally handle the biggest losses. Also someone who has a lot of money to invest and can afford to be properly diversified.

 

Typical MER: Nope, no MER, but you will have higher commission fees ($5-$10 per trade)

 

Everyone wants to be the hero of their own story and picking stocks is the way to do it. For me ETFs were a gateway drug to the hardcore world of stocks. There are thousands of resources out there on how to pick stocks so I’m not going to go into it here. Well, to be honest….. every time I buy individual stocks they seem to immediately drop in value so I don’t have good advice!

So my advice for picking stocks is that there are three general strategies. Value, Growth, and Income.

  • Value stocks are “under-the-radar” stocks that have yet to be “discovered” by the greater investing community and thus you can buy them for less than their intrinsic worth. This is what Warren Buffett does.
  • Growth stocks are companies that have lots of room to grow in the future. An example might be a restaurant that is very popular and is starting to open franchises all over the country.
  • Income stocks are dividend paying stocks. They are established companies with little room to grow and so they pay out most of their profits to shareholders through dividends. You could be that shareholder!

Speaking of dividends, have you heard of dividends yet? A dividend is a cash payout to shareholders a few times a year as a way of attracting more shareholders and keeping the stock price high. Dividend are normally between 1% and 5% of the share price. Example: you own 1000 shares of Company A which is trading at $1 per share (you own $1000 worth of shares). They pay an annual dividend of $0.04 per share (which is 4%), so you get $40 a year.

 

Picking stocks can be a lot of fun if you do proper research and make good choices. When I say research I mean it. You’ll have to learn how to read balance sheets and financial reports to properly judge the value of a company. Personally I decided that the massive time commitment wasn’t worth the ultimate risk. And I didn’t want to blindly follow the recommendations of others.

 

Of course there’s always the option to blindly pick stocks. This is called SPECULATION and is akin to gambling. It’s a great way to lose lots of money really quickly! Did I mention that there are thousands of people in the world that have been studying stocks for decades and have access to supercomputer algorithms? It’s best to accept that you aren’t going to find the miracle stock that will make you an overnight millionaire. When your friend tells you how much he made off of Tesla stock or whatever, he is not mentioning the other ten stocks that lost him way more money. I learned this the hard way. Stick to ETFs.

My last comment on picking stocks comes from A Random Walk Down Wall Street:

 

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts


4. BONDS

 

A good match for: Conservative people, and those looking to diversify.

Typical MER: Like stocks they have no MER, unless it’s a bond ETF, in which case 0.05%-0.75%

What’s a bond? It’s essentially a loan where you are the lender! The come in short and long term and can be issued by governments or private companies. They have a maturation date and a yield, which can sometimes change over time. Bonds are not exclusive to any one person and can be traded, thus their value will go up and down much like stocks.

How to use them: Bonds are like a safety net to protect you against market crashes. Their prices aren’t as volatile as stocks meaning there’s less risk associated with them. But with less risk comes less reward. They grow slowly compare to stocks and if you are under 30 you should avoid making them a large part of your portfolio. A good bond strategy? Make them 10-20% of your portfolio, and when the inevitable stock market crash comes you can sell them all and buy stocks instead. And yes there are many bond ETFs!

Learn more about bonds at my other post: EVERYTHING YOU NEED TO KNOW ABOUT BONDS

 


5. MUTUAL FUNDS

 

A good match for: The laziest of the lazy. Someone who isn’t willing to put any time towards financial literacy and is fine having other people manage their money for a high price.

 

Typical MER: 2% – 3% ADDITIONALLY some funds have load charges, which are 1-6% when you buy or sell.

 

I would wager that at some point in your life someone has told you to buy mutual funds, or maybe you own them right now. Mutual funds continue to be extremely popular, mostly due to the ignorance of the general public. Mutual funds and index funds are similar, they own a variety of different stocks that follow an index. The difference is that mutual funds are ACTIVELY managed and index funds are PASSIVELY managed. So a mutual fund has a guy behind the scenes buying and selling the stocks within the fund to try and maximize the return. This sounds really appealing to most investors, a professional must be good at what he does right? Wrong. Statistics show that roughly 80% of mutual funds under perform compared to a similar index fund.

I go into this more detail on this page.

Mutual fund do have a few advantages. If you are investing a small amount (<$5000) then commission fees and brokerage fees for ETFs are comparatively high. Mutual fund fees may be lower. And for dividend reinvesting, mutual funds allow you to buy fractional shares, meaning you can own 10.4 shares, instead of 10 or 11 if it were an ETF or stock. Those small fractional shares can add up.

DO NOT UNDERESTIMATE THE HIGH MER. 2-3% doesn’t sound like much, but it is MASSIVE. Everyone underestimates that tiny percentage. 3% per year over 30 years can reduce your retirement nest egg by 50%. How about over 40 years? 70% less. Really. I mean it. Compound interest is an incredible thing. Do the math. OK fine I did it for you on my other page.

 


6. CASH

 

“Hey! This isn’t something you can buy! What gives?” Holding cash is not necessarily a bad thing. Sure, you are losing purchasing power from inflation, but what if the market drops 10% in one day? And you are reasonably confident it will rebound entirely within 3 days? (Like it did with Brexit) Normal funding of your investment account from your bank account can take 3 days. Had you kept cash you could have capitalized on the market yo-yo! Consider cash part of your diversification.

 


There you have it! This isn’t a complete list, but I believe these are the most common investments. Investors Away!

 

 

More terminology:

  • Bull Market – Referring to a stock market that is increasing in value. Stocks are generally going up!
  • Bear Market – Referring to a stock market that is decreasing in value or staying stagnant. Stocks are generally going down or not moving. You could also call this a recession
  • Timing the Market– An attempt to buy high and sell low. Easy to say, really difficult to execute.
  • Day Trader – Someone who buys and sells stocks multiple times during one day in an attempt to profit.
  • Passive Investor – Someone who buys and holds stocks over a long time period.
  • Asset Allocation – The ratio of each investment type that you own. Can be broken down by geographic location (30% Canadian funds, 70% International), or investment type (70% stocks, 30% bonds), or industry (60% Financials, 30% Consumer Staples, 10% Energy).
  • Stock/Share – A unit of ownership of a company
  • Dividend – A cash payout of a company’s profit to its shareholders based on a dollar value per share of ownership.
  • REIT – Real Estate Investment Trust – An investment in a company that owns real estate and earns money through rent
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