The most common types of investments
This is just going to be an introduction to the most common types of investment options you have. If you want to learn more, you can either google it, go to my website (although I will probably just direct you to other people) or visit the facebook group and see what others are saying.
Understanding your risk profile
Before we talk about the different investment options, it is important to have a basic understanding of your risk profile. According to Investopedia, a risk profile is an evaluation of an individual’s willingness to take risks. A risk profile is important for determining a proper asset allocation for a portfolio.
All the different types of investments will have different risks. What may be acceptable for me may not be for you.
Investment risk test
When working with a registered investment advisor in Canada, taking an investment risk test is a requirement. However, since we’re looking to do our own investing, we should still have a rough idea as to what our risk profile is.
If you google investment risk test, you will see many free tests you can take. To make it easier, I’ve listed a few risk tolerance quizes:
British Columbia Securities Commission’s investment risk test
Ontario Securities Commission’s risk profile quiz
Hopefully, you did the tests. Now, I suggest you take your results and be one level more conservative. Here’s the thing. At this point, you’re answering this logically. However, if it ever happens in real life, you’re now full of emotion. You worked months, years, and even decades to save that up. You have bills to pay. You have goals that you want to achieve.
Even though logically, you should not touch your investments (in fact, you should be buying), emotionally, you want out.
I’m speaking this from my own experience. I thought I’m able to handle risk, that I love risk, that I can stomach risk. However, that was no where near the case when I saw my investment accounts drop thousands minute by minute. I felt like puking. I was not able to think about anything else. All I could think of was to sell. To get out. I knew rationally that I should hold, or even buy more, my emotions won, and I lost thousands.
Anyway, now that you have a general sense fo your risk profile, let’s look at the most common types of investments and how they work.
In the simplest form, buying stock is buying a fraction of a company. Like 0.0000000001% of a company. But still a part of the company nonetheless. When you own a part of the company, you are entitled to that percentage of growth of the company. You are also entitled to any dividends that get paid out. A dividend is when the company decides to give back some of the money they’ve made to their shareholders (as opposed to using that money to continue to grow the business). If the company ever goes under, you will lose the money you’ve put into the stock, but no more than that (in the case that the company owes more money after going bankrupt).
If you’re interested in owning stocks, I would suggest starting with what they call blue chip companies. These are typically the largest companies, employing thousands of people and have services and products that are used by the general public (Think TD, Manulife, P&G etc). Because of that, they are stable and will not suddenly disappear. In fact a part of the reason why I’m able to have extra travel money is because I own some bank stocks with pay dividends every 3 months (quarterly). I also don’t have to worry about the stock going down 10% in one day as I am confident that they not be going out of business easily (in Canada anyway).
Of course, there are also other types of stocks out there. Growth stocks are typically what gets covered in the news since it’s sexy to talk about their potential. There are also penny stocks, where I lost $30,000 in one day during university. I would highly suggest to learn from my experience and avoid these unless you know the business inside out.
If you do want to get involved in the stock market, but don’t have the knowledge or time to learn about it, read the index fund section – that’s probably the ideal place for you.
Guaranteed Investment Certificate (GIC)
What is a GIC
A Guaranteed Investment Certificate (GIC) is a Canadian investment that offers a guaranteed rate of return over a fixed period of time, most commonly issued by banks and other types of financial insitutions. When you buy a GIC, you are agreeing to lend the issuer a set amount of money for a set amount of time. In return, you are guaranteed to get that amount back along with interest.
Typically once you purchase a GIC, your money is locked in for the duration of the contract. You can take it out, but there can be a fee associated with doing so.
Although GICs are guaranteed, their returns are typically pretty low. The longer you are willing to have your money locked up, the higher the rates. But even then, they’re pretty low. Although you may like their guaranteed rates, I suggest you look into high interest savings accounts first to see what rates they offer.
GIC rates will vary from financial institution to financial insitution. Typically, your big banks will be on the low end of GIC rates, whereas your smaller financial institutions will be on the higher. So instead of trying to find rates one by one, I suggest using rate supermarket to quickly compare all the rates at once.
Also, when thinking about GIC investments, another question to think about is how long you want to lock up your money. Is it one year? Two? Five? As of now (May 2017), there are high interest savings accounts that offer rates higher than most 1 or 2 year GICs, and the best part with high interest savings account is you can take out the money at any time without any fees.
A bond is when you loan money to an entity (typically a government or some sort of corporation) money for a set period of time and they will pay you back that money, plus the agreed upon interest in the future. In the meantime, they will use the money they got from you to invest in their operations, whether it’s to run a country, fund a city, or to grow their business.
Since there are so many different types of bonds, it’s hard to know the quality of the bond you’re buying. Which is why there are two agencies who exist solely for this purpose: Moody’s Investors Service (AKA Moody’s) , Standard & Poor’s (AKA S&P). There are actually more than 2, but these two do over 80% of all the ratings.
These agencies will then research the company and what they plan on doing with the money before they give out a rating. If you ever get into buying bonds, I suggest staying in the investment grade rating.
Disclaimer: I have a huge bias towards real estate – I have one townhouse whose rent is covering my basic monthly expenses.
How to make money on real estate
There are many ways to make money on real estate, but the following are the most common ways for when you buy an investment property.
Everytime you make a mortgage payment, a part of the money goes towards the interest that you’re charged while the other part goes towards principal paydown. Since this is an investment property, your tenant’s rent should cover paying your monthly mortgage payments meaning that they are also helping you paydown your principal.
Tax write off
Before we get into the different types of tax write offs, it’s important to understand what a tax write off is. The Canada Revenue Agency (CRA) states that if you are incurring expenses to make money, you are able to write off those expenses against the revenue made.
So from a real estate perspective, some tax write offs can be your interest portion of your mortgage payments, your property tax, the hiring of contractors to fix the property, the utilities (if you pay for it), and even a portion of the cost of the property.
All of these things can add up to tens of thousands of dollars a year of tax write offs. For example, I probably made around $12,000 in rent last year but I also had enough expenses to write off all $12,000, meaning that I had to pay no taxes on it.
My current goal is to have my monthly cash flow cover my monthly expenses. By having my monthly cash flow be at least what my monthly expenses are, I will be able to work on projects that I’m passionate about as opposed to working to make ends meet. This is why my rental property cash flow is so important.
Cash flow from real estate is pretty straight forward: how much are you bringing in each month and how much are you paying out each month. The bringing in is pretty straight forward: the amount of rent. The paying out is where you have more control over. You have a mortgage payment, property taxes, maintenance, potentially utilities, and if your property is a part of a condo, condo fees.
For me now, my monthly real estate cash flow is $2000 and my monthly life expenses are around $2200. Which means I’m still short $300. But that’s where my stock dividends come into play. This is why I’m able to look at living (and working) in another country for awhile.
Real estate appreciation
And finally, the most popular conversation that you hear about real estate: appreciation. Real estate appreciation is when the value of the property increases. This is typically due to the fact that there are more people looking to buy than there are people looking to sell. Because of this, the price of the property will appreciate which means that if you sell, you will make a profit.
Real estate return on investment
So now that you have an idea of all the different ways to make money on real estate, let’s put it all together and talk about the return on investment.
Let’s say you buy a property for $100,000. You put down 20% and take a 25 year mortgage for the other 80,000. You sign up for a 5 year fixed mortgage at 3% which means your monthly mortgage payment will be $378.60. Your property taxes work out to be $100 a month and your condo fees at $200. This means that your monthly expenses are $678.60.
You are able to rent out your property for $750 + utilities and you find a great tenant who takes care of the place as if it were her own. You make $71.40 a month from the rental income. Come tax time, you are able to write off all your expenses, meaning that you owe no money for the rent that you’ve earned. By the time your 5 year fixed mortgage is over, you have $68,379.47 left on your mortgage. This means you’ve made $11,620.53 over the course of the 5 years. Because there were no other expenses those 5 years, you made $4,284 in rental income. To make things even better, your property has appreciated 3% each year for the last 5 years which means the $100,000 property is now worth $115,927.41 – you’ve made another $15,927.41 from appreciation.
All in all, you were able to make $31,831.94. Since you’ve only put in $20,000 as a downpayment, it means you made 150% of your initial investment over 5 years, or an average of 30% a year.
Of course, all this is hypothetical, positive scenario. The best case, if you will. Real estate investing can be much uglier where you can lose $100,000’s as well.
If you ever decide to own real estate, do not ever fall into the asset rich, cash poor situation. You see, when you own real estate, you will have to pay cash for your mortgage. You will pay cash for property taxes. You will pay cash for fixing water leaks or a broken furnace. Also, with the way real estate prices have been, the chances of you making enough from rent to cover these expenses is quite low. Moreover, the appreciation of a house is not money you can take out (without having to pay interest). You need cash to survive. Not a virtual number.
What is a mutual fund
A mutual fund is when a bunch of people put their money in an investment vehicle that will invest in stocks, bonds and other types of investments on behalf of the investors. The advantage of this type of investment is that you are able to have your money invested a diverse set of investments as opposed to if you were to do it yourself. This is because the mutual fund would pool all the money, invest it and you would then own a fraction of those investments (as opposed to having to own whole shares).
Mutual funds are typically known as an actively traded fund. The job of the mutual fund manager is to invest it based on what is governed by the mutual fund you bought into. Their goal is to make as much money as they can for you. In order to do so, many of them will actively buy and sell based off what they believe is best (hence the actively traded fund).
In return, they will take a certain percentage of your money as “management expense fees”. This fee covers their salary, an amount for the company, and any other administrative expenses, such as marketing the mutual fund. I don’t know how high these fees can go, but I see many around the 2% mark.
My biggest problem with them is that the majority of actively traded funds fail to beat the market. In other words, you can just buy an index fund, pay no fees, and be better off. Read the index fund section for a better idea as to what I mean.
What is an index fund
Another common phrase for index funds is passive investing. An index fund is actually a type of mutual fund, except the goal of the index fund isn’t to pick out stocks, but to track a specific index, such as the S&P TSX (Toronto stock exchange). Because these indicies don’t normally change, there are no real fees associated to maintaining.
How to invest in index funds
The best way to be invested in the index is to buy exchange traded funds (ETFs). ETFs are just like stocks in that you can buy and sell them through the stock exchange. Different types of ETFs track different types of indices. They are also priced in a way that’s affordable (since each ETF share will simply represent a fraction of all the companies inside the index). If you are interested in buying and selling ETFs, I suggest using Questrade as they allow you to buy EFTs for free and have one of the lowest commissions for buying and selling stocks in general.
Because the companies within an index does not change often, ETFs do not need to be updated often. That means that there are no active trades being made, meaning the management expense fees are minimal. In fact, you can find fees as low as 0.06%.
Index funds vs mutual funds
I have no track record to give you a index fund vs mutual fund analysis, but I think I know someone who does have that track record: Warren Buffet.
Warren Buffett is a heavy promoter of passive investing. I’m not going to get into the details here (you can read Why actively managed funds fail to Beat the market for more), but he issued a challenge out to all the actively managed funds asking them to beat the S&P 500 index over the course of 10 years. Only one person has taken him up on the challenge. Before we go any futher, think about that. Warren Buffet issued a public challenge to all the hedge funds (the people who typically promote actively traded funds) out there. ONE person took him up on it.
Anyway, this hedge fund manager got to choose 5 funds. 9 years has passed since the challenge started, and the best one has a compounded annual growth rate of 5.6%. So that means if you had $1000 invested, it would be worth 1000 x 1.056^9 = $1632.96. The worst one has a compounded annual growth rate of 0.3%, meaning $1000 invested 9 years ago would be worth $1027.33. The average of the 5 came out to be 2.2%, meaning $1000 invested 9 years ago would be worth $1216.35. How did the index do? A compounded annual growth rate of 7.1%. $1000 would be worth $1853.98 after 9 years.
And the best part? A 7.1% S&P 500’s compounded annual growth rate is actually lower than the historical average. The average from 1965 – 2016 is closer to 9.7%.
So if you’re more interested in investing in index funds, but don’t have the time to learn where to start, you should look into using a robo advisor. The name that stuck is kind of misleading; it’s not completely done with robots. A robo advisor is just like a portfolio manager, except they will invest in ETFs (meaning the fees are minimal) on your behalf. Up to this point, everything is automated, meaning you can simply login with your smartphone to check how you’re doing or to make changes.
Of course, if you have questions, a robot won’t be on the other end. It might one day, but for now, you’ll have a real person helping you.
I haven’t used robo advisors yet, I’m still in the cash flow side of things for robo advisors to make sense for me. However, if you’re less inclined to do things yourself, or you simply don’t have any interest in learning it all, a robo advisor is a great choice.
The largest robo advisor company is WealthSimple, and from my understanding, the people using them are all pretty happy with their experience thus far. Oh and if you sign up from that link, WealthSimple will give you an additional $10,000 managed for free (on top of the $5000 that they give).
Now that you have a basic understanding of the most common investment vehicles, which ones are you going to explore in more depth?