Taking Financial Ownership

The investing 101 checklist

By Danielle Alexandria

I designed the Investing 101 Checklist as a complement to The Empowered Woman’s Guide to Investing:

The Empowered Woman’s Guide to Investing Part 1 – Investing 101

The Empowered Woman’s Guide to Investing Part 2 – Taking action to begin investing

Below you’ll find simple explanations of many common investing terms. This list should only be considered as a reference base for you to continue learning. Check out the Resources section in Part 1 for some great places to do just that.

Financial concept Explanation
Investing

The act of placing your money into a financial product so that it can create more money for you. In other words, put your money to work so you don’t have to!

Compounding

Money magically grows itself over time when you re-invest your returns. Also calculated by the nifty and simple “rule of 72” (easily found online…give it a google!) which tells you how long it takes for an investment to double depending on the rate of return. Theoretically, the more time you have, the more money you’ll have because you can take on greater risk and there are more years for your investments to compound themselves.

Risk vs. reward

How much potential fluctuation and/or loss you’re willing to accept in return for potential or in some cases, guaranteed gain. In general, the riskier the investment, the higher the return. For example, “cash” products are often guaranteed, so you receive a much lower reward. Bonds are moderate, and stocks are riskiest. You need to take some risk in order to create money. If you don’t take on any risk, you’d actually end up losing money over time because everything costs more in the future (this is called inflation.)

Volatility

Asset values fluctuate constantly in response to changing supply and demand on the open market – millions of shares can trade hands in a day. Volatility is not the same as loss. As long as you “hold” the investment – meaning you don’t sell when it’s below the original value you paid for it, it’s not a loss.

Generally speaking, the more risk, the higher degree of volatility. Therefore volatility is required in order to create money.

In the short term, volatility can be distracting and lead to fear-based decisions. It’s important to know that over the long term (hello principle #2!), volatility creates a trendline that generally goes up.

If you can’t stand the thought of your investment dipping into negative territory on paper/screen, then you may need to reduce your risk level to invest in products with less fluctuation.

Risk tolerance

A combination of your age, goals, and how much risk you’re able to take and still feel comfortable emotionally.

Typically your risk tolerance is classified into one of the following categories, which determines your portfolio:

1) Conservative (very little – more cash products and bonds)

2) Balanced (moderate – typically around half stocks and half bonds)

3) Growth (more than half stocks)

4) Aggressive (high concentration in stocks)

Returns (also interest, gains, or dividends)

The monetary reward you receive for taking investment risk. It can be in the form of interest payments, an increase in the asset value itself, or a combination. For example, Apple shares could increase 5% this year, and pay a dividend of 1%, for a total return of 6%. Typically interest refers to money paid by bonds or cash products, while dividends refer to stocks, and returns is the total return.

Here’s how the risk tolerance categories have returned annually on average historically over many years:

1) conservative: 1-3%

2) balanced: 4-5%

3) growth: 6-8%

4) aggressive: 8%+

Diversification

The art of putting your eggs in many baskets to spread that risk across different investment products, industries, and countries. Because the world is vulnerable to change, the more you diversify, the less you are “exposed” to any one area if it suffers an economic crash, natural disaster, company scandal, or some other unpredictable event. ‘Peer’ companies, meaning companies sharing a sector are highly influenced by each other despite big differences in management style, policies, and products. This is because they share a similar economic profile. If one company suffers a devastating blow, it will pull down the stock value of its peers. Diversification protects your investments.

Cash Products

Cash products are issued by either governments or banks, and often pay a guaranteed interest rate for a specific length of investment. You can invest anywhere from a few days to several years. They are considered conservative on risk level and therefore offer a low rate of return.

Bonds (also called fixed income)

Bonds are issued by either governments or corporations and rated according to risk. In exchange for investing your funds, you receive a certain interest rate (called a coupon) which is paid annually. Bonds are different to stocks, in that you do not own the company. They are issued to raise money so act more like loans. Bonds typically return less than stocks, but also drop less during a crash.  Therefore a combination of bonds and stocks is usually recommended to smooth out your returns and lower your overall risk.

Asset Allocation

The plan that specifies how/where your money will be invested in different financial products.

The Stock market

The sum total of all companies globally which issue shares. They’re typically organized digitally by country on ‘indexes’ or ‘stock exchanges’.

Over 150+ years, the stock market as a whole has returned ~8% when averaged out annually on a historical basis, which is very good. Yet individually, it could return +20% in a stellar year, or -35% in a recession. The economy always follows cycles, so these numbers are bound to occur a few times in your lifetime. This makes the stock market riskier in the short term because you have less time to recover from a potential crash. It’s a good rule of thumb to leave your money invested at least 5 years for any risky investment (this includes all stocks and stock funds), because most losses recover by then. The more time you have, the more these fluctuations even out and you approach that 8% average (see volatility).

Stocks/shares/securities

In exchange for your money, you literally own a piece of a company. You usually get voting rights on things like director compensation and mergers and acquisitions, and the company has a host of legal responsibilities to you as a shareholder. You can buy as little as 1 share online, with just a few clicks. Each transaction (buying or selling) usually costs anywhere from $6 – $15, depending on the platform you use. If you buy and sell a stock, which is what you must do to receive a profit, you have to subtract these costs. This is yet another incentive to leave your money invested in good quality funds or securities for the long term – it reduces your costs.

Funds

Buying stocks can be risky and expensive. Funds provide a diversified and economical alternative by enabling you to invest in fractional ownership of many individual stocks or bonds in one offering.

Broadly speaking, there are two types of funds, mutual funds and exchange traded funds. Both can be either passive or active. See below for all of these descriptions.

A huge variety of funds are available, including industry sector, country, continent, dividend paying stocks, socially responsible organizations, large stocks, small stocks, bonds…you name it!

This means funds themselves can range from lower to higher risk. For example a global bond fund would be moderate risk, but a fund focused on stocks in the tech sector only, or say India, would be higher risk. Why? Your eggs are concentrated in less baskets, and riskier assets. They also tend to have higher fees, because once you start to specialize you move from passive to active. It’s important to note that you would still be able to own these companies by applying a passive index investing approach, and because you would own smaller amounts of them (smaller amounts of every company in a large fund), you would have less risk.

Active investing

Active investing is based on ‘stock-picking’ – the attempt to predict individual top stock performers using computer algorithms, economic analysis, and bright mathematical minds. The goal is to ‘beat the index’, which we know historically is 8% a year. These funds often focus on an exciting sector or style of investing, so they’re quite specialized, and therefore, higher risk because all the eggs are only in a few baskets.

Active is just that; once a stock is included in the fund, they’re continually monitored and sold off in case they don’t actually perform. All the trading back and forth adds costs on top of expensive salaries and company marketing budgets. Therefore your fees are much higher to pay for this (see fees and MER).

You might be thinking well this sounds great! I should do active investing! Well, not so fast. It is infinitely riskier, expensive, and the truth is, they are only predictions. No one has a crystal ball. There’s also plenty of evidence to prove them wrong: historically, 96% of the time active managed funds do not beat index funds! (Source: Money: Master the Game, Tony Robbins, 2014)

Anytime you see a TV personality excitedly presenting their top picks, this is active investing. Buyer beware; sensationalism sells news.

Passive investing (index investing)

An index simply means a stock exchange, for example the New York Stock Exchange or the Toronto Stock Exchange. Each exchange has listings of hundreds or thousands of individual companies.

Since we know stocks historically have averaged 8% a year overall, we don’t have to try and figure out which ones will perform well. Passive index investing involves buying one or more exchange traded funds (ETFs) that replicate an index. This removes the need to understand and even monitor the intricacies of the stock market or economy. We are aiming for the long term, averaged-out 8% that comes with decades of investing. Index funds typically have the lowest fees of all funds.

Because this strategy literally is passive, there’s no need to hire anyone to try and figure out this year’s winners. We aren’t paying for fancy computer algorithms, expensive staff, or company marketing budgets. That means we aren’t charged high fees, so more of the return goes to our pockets. Speaking of returns, they are what that particular index did that year, minus your small fee. This is why investing can be boring, slow, and simple. And effective.

Mutual Funds

A ‘basket’ of stocks or bonds compiled into a fund offering sold in units by banks/financial institutions. They are typically offered by financial advisors or financial planners. Rather than purchasing online directly, banks or advisors transact the buying and selling on your behalf. Mutual funds may have additional, unique fees in addition to ETFs, partially for advisor compensation.

Canada is known for having the highest mutual fund fees in the developed world, so it’s very important to ask a lot of questions if one is recommended to you. See part 2 of this article series for specific questions you can use.

Exchange Traded Funds (ETF)

Look very much like mutual funds in both structure and asset offerings but are bought and sold just like stocks online. They are typically used by DIY investors and robo-advisors (see article 2 in this series for definitions) in a passive investing strategy, although there are also active ETFs. Fees are typically lower than mutual funds across the board, which means your gains may be higher.

Fees

Fees are how much you pay to the investment company for the ability to own their product, whether or not your investment performs well. Ouch!

This section, in combination with MER are the two most important items on this chart because fees have the potential to make the biggest impact on your results (see below). They can be confusing so take your time understanding them.

Not all investments have fees. Stocks only have trading fees when you buy and sell them.

Mutual funds and exchange traded funds have several fees. The MER – “Management Expense Ratio” is the total fee and the figure to pay attention to (see below). Because ETFs are traded on exchanges just like stocks, they also have trading fees, although there’s a growing movement by many platforms to waive them. Mutual funds do not have trading fees as they are not processed on exchanges.

Remember – in general, as a fund moves from passive to active, the fees increase.

If you work with an advisor, they may charge additional fees to manage your portfolio. It’s important to clarify how they are compensated.

Management Expense Ratio (MER)

The MER is the total percentage of all fees for either a mutual fund or exchange traded fund. It covers all expenses related to running the fund including salaries, administration and marketing.

Did you know that in Canada the average mutual fund MER is 2.14%?

While this might not seem that high, let’s compare it to a common 0.2% passive index ETF fee.

We’ll use a hypothetical scenario of a $100K initial investment with a $5K annual contribution at a 5% moderate rate of return.

After 25 years, you would pay $182,909.94 to the mutual fund in fees alone vs. only $14,457.94 to the ETF. This is a whopping 92% more for the same results. That means when you retire, you’d have almost $200K less in your account because of fees. Over a person’s financial lifetime, these decisions can easily make a 5-6 figure difference!

Tax

Depending which account you hold your investments in, different tax rates/tax advantaged benefits apply. Most Western nations have retirement accounts which shield your investments from tax until you retire. By then you’ll likely be in a lower tax bracket, so when you withdraw your funds, you’ll pay less income tax than during your working years.

In Canada, we have the RRSP – Registered Retirement Savings Plan. We also have the TFSA – Tax Free Savings Account. Each offers different advantages. In the financial world, ‘registered’ means tax-advantaged.

Tax will greatly affect your returns, so it’s in your best interest (and legal right) to reduce it as much as possible. Tax can be quite complicated. This is where a good accountant or certified financial planner can really help.

The views and opinions expressed in this checklist are those of the contributor and do not necessarily reflect those of Equitable Bank. Any information provided is for information purposes only and Equitable Bank makes no representations as to the validity, accuracy, completeness or suitability of any content. You should seek the advice of a qualified professional or undertake your own research before making financial decisions.

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