Investing: How to make your money make money

 

Hello,

Welcome to the third session of the MoneySmart Bootcamp. Last time we talked about debt. Now let’s look at how to make money with your extra money – otherwise known as investing.

Before we dive in, let me emphasize an important point: Investing isn’t some kind of “advanced” or “optional” part of managing your money. Unless you’re independently wealthy or have a plush employer pension, you need to make your hard-earned money generate more money to one day be able to retire or even partially step back from the daily grind.

There are many ways to invest, but here I’ll talk about investing in the financial markets. The good news is there are simple, low-maintenance and low-cost ways to grow your money through investing. But you do need to learn some basics. Here’s a little guide to get you started.

Compound interest is now your friend

Interest piling on interest is a dreadful thing when you’re in debt. But when you’re an investor it becomes the engine that turbocharges your gains. Here’s a quick refresher:

• Imagine that, instead of borrowing the $10,000 we talked about in last week’s newsletter, you’re now investing that money at a 5 per cent annual interest rate. At the end of Year One, you’d have earned $500 in interest. You’ll now have $10,500, which will grow by another 5 per cent, or $525, by the end of Year Two. You’ll start Year Three with $11,025 ($10,500 + $525), which will grow by another 5 per cent, or $551.25, for a total yield on your investment, after three years, of $1,576.25. The math is the same if you owned $10,000 worth of a financial asset whose value increases by 5 per cent a year.
• Over long periods of time, the power of compounding gains becomes really impressive. That $10,000? With annual returns of 5 per cent, over 30 years it would turn into more than $43,000.

Stocks, bonds and other useful lingo

Buying financial investments is one way in which you can get your money to earn compound returns (although those returns are rarely guaranteed – that would be too easy). Here are some of the main types of investments:

• Stocks. Buy one and you become the owner of a tiny share of a company (think: Apple or RBC). That’s why stocks are also called “shares.” Companies issue shares to raise money they can use to expand their business, and investors trade those stocks in the stock market. Some stocks also come with dividends, an amount companies distribute to their shareholders out of their earnings on a regular basis. Stock prices are typically volatile, rising or falling (or a bit of both) over short periods of time. History, however, shows that over the long term, the stock market trends up.
• Bonds. Buy one and you become a lender. Both companies and governments use bonds to borrow funds. In return, they pay you a set interest, usually once or twice a year, until maturity, when you get all your money back. You can also try to sell your bond in the financial market at a gain, somewhat like a stock.
• Mutual funds. You can purchase units of a mutual fund. This allows you to gain exposure to a broad basket of investments without buying and holding those investments on your own, which would be unaffordable for many of us. You may also want to diversify across investment types, for example, holding a mix of stocks and bonds.
• Exchange-traded funds (ETFs). Also a collection of investments, but unlike a mutual fund, an ETF trades on the stock exchange. You can buy shares of it (also called units), just like you would any other stock.
• Guaranteed investment certificates (GICs). You lend money to the bank and in turn get a – you guessed it – guaranteed rate of return. Many GICs pay you an interest rate, but, unlike with a savings account, you have to park the money at the bank for a set period of time (usually the longer the term, the higher the interest rate). There are also cashable or redeemable GICs, but they typically come with lower rates.

Investing risk and how to manage it

Why can’t we all finance our retirement by stashing our savings in GICs? Unfortunately, lower-risk investments also typically come with lower returns. This is also the reason that stocks, whose prices are notoriously volatile, generally have higher expected returns compared with bonds, whose prices don’t fluctuate quite so much. But that doesn’t mean you need to play roulette with your life’s savings. Here are ways to manage the risk you take on when you invest in the financial market:

• Put your eggs in many baskets. What happens if you put all your money in one company’s stock and that company goes belly up? You get my point. One way to manage your risk is to spread your money across many different companies, industries and even countries. That is where mutual funds and ETFs come in handy: They allow you to gain exposure to a broad basket of investments without buying and holding those investments directly, which would be unaffordable for many of us. You may also want to diversify across investment types, for example, holding a mix of stocks and bonds.
• Play the long game. The stock market goes up and down, but, historically, it has followed an overall upward trajectory over long periods of time. The longer you can keep your money invested, the better your chances of riding out short-term drops and benefit from long-term growth. An example: When the market crashed in the financial crisis of 2007-08, it took five years to climb back to where it was.

A common piece of advice is to put money in the stock market only if you can leave your money invested for a minimum of five years. More conservative advisers often recommend having a time-horizon of at least 10 years. If you’re saving up for a shorter-term goal such as a wedding or a down payment, a GIC or a savings account with a competitive interest rate can be good options.

• Choose the ride you can stick with. Investing in financial markets is like riding a roller coaster where you can step on or off any time. Wouldn’t it be wonderful if you could catch the train on the way up and hop off just before it starts heading south? This – called “timing the market” – is what many investors try to do, and it almost never works. Instead, the key is to stay put and keep your cool. But not everyone can stomach wild ups and downs. Generally, investing only in stocks comes with higher expected returns but also makes for a bumpier ride. Adding some bonds to your portfolio usually helps to smooth out both the highs and the lows.

Low-cost investing for busy people

Beyond what you invest in, you should also think about where you’re holding your investments and how much you’re paying to invest. Taxes and investing fees can make a huge difference to your bottom line when you stay invested for a long time.

• Taxes. Luckily, so-called registered accounts, such as tax-free savings accounts (TFSAs) and registered retirement savings accounts (RRSPs), allow you to invest tax-free or defer taxes.
• Fees. Companies that help you invest in the markets will charge you for it, and how much you pay makes a big difference to your long-term returns.

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Yes, but what about crypto?

Here’s what everyone agrees on: Cryptocurrencies are extremely volatile. On the thrill scale: If stocks are a roller coaster, crypto is skydiving. And digital coins haven’t been around for long, so there’s no historical evidence that their value trends up over longer periods of time, as is the case with stocks. If you really want this speculative investment in your portfolio, the advisers I’ve spoken to recommend limiting it to 5 per cent of your investments or less.

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