Investing Demystified

We all realize that we need to save money to provide for college tuitions, retirement, and the many unforeseen needs that arise in our lives. Most of us realize that it isn’t enough to simply “save” our money, but rather it should actually grow over time. But exactly why, how and where to invest is the million dollar question.

The reason why we need our money to actually grow over time is simple – inflation. Inflation refers to the rise in the price level of goods and services over time. As good and services get more expensive, our purchasing power actually decreases. Put another way, for a given amount of currency, we will be able to purchases less in the future than we can today. Therefore, we need to earn a return on our savings just to maintain our current level of purchasing power.

So the question now becomes how and where to invest our money to earn an appropriate return. Many people think investing successfully is dependant upon having a thorough knowledge of the individual stocks, bonds and cash that make up investment portfolios. However, the real key isn’t having a detailed knowledge of these “asset classes”, but rather understanding how to appropriately diversify one’s wealth across them. This process of allocating one’s wealth to different types of asset classes is known as asset allocation.

Stocks (equities), bonds (fixed income investments), and cash are the most common asset classes to invest in. Stocks are simply shares of ownership in public companies. By owning shares an investor is entitled to their pro rata share of a corporation’s earnings - this is where a stock gets its value from. As a public company’s prospects improve and there is an expectation of higher earnings, this gets priced into the stock as investors bid up its price. Of course the opposite could occur as well; investors might begin selling off a stock if they expect future earnings to be poor (leading to a drop in the share price, all else equal).
Bonds are essentially loans taken on by corporations who need money. Instead of borrowing large sums of money from a bank, it is often more cost effective for them to do so by borrowing from public investors. When you buy a bond you “loan” the corporation some principal amount today for a fixed time period (let’s say $100 over 5 years for example). In return the corporation pays you semi-annual or annual interest payments along the way. Finally after the fixed time period is up (at maturity) the corporation pays you back the original ($100 in our example) principal you loaned.

Cash investments can include savings deposits, guaranteed investment certificates (GICs), money market funds or any other highly liquid short term investments. Cash investments have very low risk (volatility) associated with them, however, you guessed it – this low risk is accompanied by low returns.

Stock (equity) investment is most suited to investors who are willing to take higher risk in the hopes of higher returns. These investors typically have long time horizons over which they don’t forsee selling their investment. Bonds are best geared to investors seeking a fixed stream of income (remember a bond pays interest “coupons”), providing a lower return than stocks but with lower risk. Cash is typically used to fund obligations, buying opportunities and day to day spending requirements.
Deciding on how much to invest in each one of these 3 major asset classes and how much to keep in cash is a difficult decision, which completely depends on our individual life circumstances. This is where a financial planner may be useful for novice investors. A financial planner takes into account your ability and willingness to take risk, the expected time horizon over which you plan to invest, and the relevant tax consequences before helping you design an appropriate portfolio. In choosing an appropriate planner/advisor, always inquire about how they will be compensated as well as any fees that may be incurred in buying and selling the products they recommend.

Financial planners along with banks often offer mutual funds as a means to allow novice / passive investors with a means of investing. Mutual funds are simply “pools of money” that come from many different investors, which are invested in any combination of the major asset classes (stocks, bonds, or cash) by a professional fund manager. While it may sound like a great idea to have an “expert” decide on what to invest in for you, the benefit is often offset by the fees built into these funds. Mutual funds have MERs (management expense ratios) which typically range between 2% to 5% of the overall return of the fund. These MERs eat away at your overall return and often make investing through mutual funds a suboptimal choice.

Many intermediate investors prefer to both make the asset allocation decision and the decision on what specific stocks, bonds or mutual funds to invest in themselves. A commons means of doing this is through online brokerage accounts. TD Waterhouse, BMO Investorline, and RBC Action Direct are three of the many online brokerages which allow you to direct your own trades with the click of a mouse.

Regardless of how you do it, it is essential that everyone maintain a portfolio with the diversification and return potential necessary to suit their investment objectives. I would wish you luck in your investment endeavours, but with the right asset allocation strategy – you simply won’t need it.