Let’s review a few key definitions before we get started:
Invest: What does it mean to invest? It means to buy an asset from which you expect a benefit or return in the future. That return can be in the form of a capital gain or in the form of income from interest or dividends.
Rate of return: The rate of return is calculated over a specified time period (usually a year) and expressed as a percentage of the total investment.
Capital gain: A capital gain is the increase in value of a capital asset (stock, bond, real estate) from the purchase price. The gain is only taxed when the asset is sold. In Canada, 50% of the capital gain is taxable which means that 50% is tax free.
Interest: Interest is the income earned on borrowed money or debt, typically bonds and GIC’s. It is usually expressed as an annual percentage rate or rate of return. Interest is treated as regular income for tax purposes and is taxed at your marginal tax rate. They are considered a fixed income asset.
Dividend: A payment from a company’s after-tax income to its shareholders. Dividends are decided by a company’s board of directors and are paid per share. Dividends are usually paid in cash or in shares of stock. For tax purposes in Canada, dividends are grossed up and then a special tax credit is applied to them. As a result, dividends are taxed more favourably than interest income.
Principal: The amount of money you put into an investment.
Mutual Funds: A mutual fund is an investment that is managed by a professional fund manager. The investment itself is made up of a portfolio of stocks, bonds, money market instruments and other assets. There are a large group of people that are investors and their money is pooled together to invest in the underlying assets. Each investor owns shares of the mutual fund, however, investing in a mutual fund is different than stocks. Investors do not get voting rights and each share of the fund represents investments in many different assets. Click here for a more detailed discussion about mutual funds
Inflation: The rate at which prices are rising for a “fixed basket” of goods. It is also a measure of how the purchasing power of a currency is falling. This means that it takes more money to buy the same basket of goods and services. Inflation is measured as an annual percentage change. The basket of goods that is measured includes food, shelter, furniture, clothing and transportation.
A key part of measuirng your investment success is to measure the “real” rate of return on your investments.
This is the rate of return after taxes are paid and minus inflation. It’s not enough for your investments to just increase in dollar value if inflation (the cost of future expenses) is increasing at a faster rate.
TYPES OF ASSETS OR INVESTMENTS
Cash and cash equivalents
Cash assets have the least amount of risk and therefore have the lowest rates of return. They include:
Savings accounts
Treasury bills (T-bills) – These are short-term debt instruments that are backed and guaranteed by the federal Government of Canada (provinces also back t-bills). T-bills have maturity dates of 30 days to a year. The minimum amount you can invest is $5,000. Since they are backed by the government, T-bills are considered risk-free. They are easy to buy and sell.
Money market funds - mutual funds that invest in short-term bonds and T-bills. They are not as safe as cash but generally have a slightly higher rate of return.
Fixed Income Investments
These assets are also called debt instruments or obligations. They generally pay interest on a fixed schedule or regular intervals such as monthly or yearly. The amount of the payments can vary. Fixed income investments include:
Bonds – an asset where you loan money to a company or government for a stated time period. They agree to pay you interest on a regular basis. They also agree to pay you back the principal on a set date, called the maturity. A bond is usually guaranteed by another asset. This means the asset can be sold to pay the bondholders if necessary.
Term Deposits and Guaranteed Investment Certificates (GIC’s) – guarantees the original amount invested plus pays interest. You can buy them at financial institutions such as banks, trust companies and credit unions. Your money is locked-in and you can’t redeem it or cash it until the maturity date. Term deposits sometimes offer you the option of cashing it in before it matures but with a lower interest rate.
Bond funds – a mutual fund that invests in bonds and other debt instruments. These funds are usually low-risk.
Debentures – similar to bonds in that the company you lend the money to agrees to pay you interest and the principal at a certain date. Unlike bonds, however, they are not backed by another asset therefore they are more risky than bonds. They are backed only be the credit rating and reputation of the issuer.
Stripped Bonds and Coupons – A stripped bond has had its interest payments (coupons) and principal repayment stripped or broken into two pieces and sold separately. You buy the bond at a discounted value with the promise of being paid the principal or “at par” amount.
Mortgages – private mortgages are available as well as funds that invest in pools of residential and commercial mortgages.
Equity investments
Equities represent ownership in a company. They produce both capital gains and dividends. Equities are more risky than fixed income investments. Equity investments include:
Common shares – this type of shares entitles the owner to share in the success of the company. If the company does well and the shares increase in value the owner will have capital gains and the board of directors can decide to pay out dividends on the shares. Common shares also have voting rights. These shares are more risky because if the company doesn’t do well the shares may go down in value and there may be no dividends paid. They are also paid out last in the event of liquidation.
Preferred shares – these shares are safer investments than common shares. Preferred shares have a set value (par) for future redemption and do not have any capital appreciation. They do, however, have a set dividend unlike common shares. Their dividends must be paid before any common share dividends can be paid. Preferred shares do not have any voting rights.
Real estate investments
These include rental properties. Don’t forget that the capital gain on your principal residence is tax free in Canada.
Physical assets
art
gold and silver
jewellery
collectibles
antiques
YOUR INVESTOR PROFILE
What kind of investor are you? Do you have short-term or long-term goals? Are you uncomfortable with some risk? Do you prefer to use managed funds or are you a hands-on investor? All of these questions help build your investor profile.
Your investor profile will help you determine your ideal asset mix. It will help you make wise investment choices for your portfolio. Keep in mind, your investor profile can change over time so you should review it regularly to make sure you have the ideal asset mix.
Any discussion about your investor profile should include a detailed discussion about risk and how much you are comfortable with. The time spent on your investor profile really won’t be worth it if you’re not honest with yourself about your comfort level around risk. One of the goals of careful investing is to be able to sleep at night and not be stressed about where your money is.
Each asset is assigned to an asset class. The asset classes are: equities or stocks, fixed income or bonds, cash and cash equivalents, and, real estate. You are said to be diversifying your portfolio when you carry investments that are a mix of the asset classes.
The right asset mix will help you:
get the income and growth you need to reach your goals
get the right balance between your comfort level with risk, or your tolerance for risk, and the rate of return you want from your investments
get your money when you need it in the short and long term
Your investor profile is a good starting point to finding your asset mix. Your asset mix or asset allocation is considered to be one of the most important decisions you can make as an investor. Spend some time on it.
Your asset mix will change over time. You will likely want to adjust your asset mix as your financial needs and goals change.
Notes:
Fixed Income: This part of your portfolio should be about the same as your age. For example, if you are 40 years old, you should have about 40 percent of your portfolio in fixed income investments. Of course, this number will be fine-tuned to each investor’s tolerance to risk and their goals.
The closer you are to retirement the less risk you should be taking.
If you’re a big saver you can take on more risk. If you lose on your investments you will be able to make up those losses quickly because of your high savings rate.
In general, the more aggressive you are as an investor the more you will have invested in riskier investments such as stocks.
You will want to adjust your asset mix according to economic conditions: when the economy enters a recession, you may want to reduce the amount you have in the stock market. And, at the end of a recession, during the recovery period, you may want to buy more equities.
You’re in your 20’s and are just joining the work force full time: You probably don’t have a lot of savings and may be re-paying student debt. Since you will be investing for a long period of time you may be willing to take risks with long-term investments.
You’re in your 30’s or 40’s and have been working for several years: You may be more established in a career and are likely earning more income. You may have a mortgage, you may be saving for a child’s education and for retirement. At this point, you may want more of a mix of higher and lower risk investments.
You’re approaching retirement: This is when you start investing in lower-risk investments to protect your principal and all the income you have earned on those investments. At this point, you also need to think about investments that provide steady income like interest and dividends.
ASSESS YOUR CURRENT SITUATION
Gather all your bank and investment statements, including any registered accounts such as RRSP’s, RRIF’s and locked-in pension accounts.
Make a list of each asset within these accounts and note whether they are a fixed-income asset, an equity asset, real estate, etc.
Total all of the assets.
Total each of the asset types (ie. fixed income, equity, etc.) and divide each of them by your total assets. This will give you the perecentage of your total assets that you hold in each asset type and thus your current asset mix.
IDENTIFY PROBLEMS AND OPPORTUNITIES
Risk, risk, risk, risk, risk!!!
The most common complaint about investing is the level of risk involved. It can be uncomfortable to not know if you’re going to lose money or how much you may lose.
Compare your current investment mix with your benchmark investment mix.
You don’t want to make drastic changes all at once. You may face unnecessary fees for redemptions or you may face capital losses.
Make changes to your asset mix when assets mature and are to be renewed, and, with any additional savings.
MONITOR YOUR SITUATION PERIODICALLY
Monitor your investor profile:
Whenever your personal and/or financial situation changes. For example, new job or loss of income, having children, getting older, etc.
It’s also a good idea to review it on an annual basis just to make sure you keep your goals aligned.
