In this post, we’ll cover some key investment terms, how to determine your risk appetite, the common types of investments available, setting up your investment portfolio, rebalancing among other things.
It’s a long post but I’m sure it’ll be worth it. So let’s begin
Some Investment Terms
Return is simply the money or profit made on an investment. It can be negative if the investment loses value.
Risk is the potential for losses in your investment or the uncertainty in the returns to be earned.
In general, the higher the risk, the higher the potential returns.
Risk tolerance is how comfortable you are with risk or investment loss; your ability to stomach drops in your investment value without panicking.
Diversification is a way of managing risk by having a mix of investments. With a well-diversified portfolio, you sleep well at night because a huge loss in one investment will not materially affect the entire portfolio.
Asset Allocation is a way of diversifying your portfolio by apportioning your money to different types of investments, for example, stocks, bonds, real estate, and cash. The ideal asset allocation is determined after considering your risk appetite, your investment goal, and the investment timeframe.
A common asset allocation for someone with moderate risk appetite is a portfolio with 60% in stocks and 40% in bonds.
Rebalancing is a way to maintain your desired or original asset allocation. Over time, as the value of the different investments change, your asset allocation will change. Rebalancing periodically ensures your portfolio won’t stray too far from what you’re comfortable with.
Robo-advisors are online platforms that offer automated investing services to individuals. They can help you manage your investments, save you time and money, and generally cost less than banks. Two of the most popular robo-advisors in Canada are Questrade and Wealthsimple.
Management Expense Ratio (MER) is the fee charged by investment funds for managing the funds. It is calculated as a percentage of the fund and charged whether the fund makes money or not.
Determine your risk appetite or risk tolerance
Before you start investing, it is important to know your risk tolerance and appetite because all investments have some level of risk.
Knowing your risk tolerance will help you decide on the right asset allocation and the investment products to use. Your risk tolerance can be Conservative, Moderate, Aggressive – or somewhere in between.
Some of the factors to consider are:
Age: Generally, the older you are, the less risk you should be willing to take. A younger investor may be able to hold on through a downturn. As you move towards retirement, having stable and predictable cash flow becomes more important. This also means your risk tolerance can change over time.
A rule of thumb used by some planners is to allocate 100 minus your age to equities (stocks).
Investment timeframe: This is closely related to the first point. The shorter the investment horizon, the less risk you should be taking and vice versa.
Investment Goals: What are you saving or investing for? What are your objectives?
Once you’ve identified your goals, it is important to determine the risk you are willing to take to achieve them. Someone saving for the down payment of a car or house has a shorter timeframe than another investing for retirement. The risk they are exposed to should reflect this.
Other factors to consider include liquidity needs and tax considerations.
How do you determine your risk profile?
There are various tools available online for anyone interested in knowing their risk tolerance. As part of their onboarding process, many Robo-advisors will also let prospective investors go through the exercise.
Some of the questions that’ll be asked include:
- Your age and you’ll need the money
- How much you are willing to lose
- How worried would you be and what you would do in a market decline
Here are links to some of the tools:
- Vanguard’s Investor’s Questionaire
- Fool.com’s Risk Tolerance Quiz
- Charles Schwab’s Investor Profile Questionnaire (PDF)
Choosing the investment route: Managed or Self- directed
The financial industry thrives on making investment more complex than it actually is. Granted, there are many things to consider: the right mix of assets, the optimal account types for different financial goals, using a managed account or going DIY etc.
Managed accounts are a convenient and easy way to start investing. The portfolio manager handles all the investment decisions: which assets to buy, when to buy or sell, the timing of rebalancing etc.
All the research and trade execution are done for you. This convenience and timesaving however comes at a cost.
The annual fee for an investment manager typically starts around 2% of the asset under management – as high as 5% in some cases.
Robo-advisors are digital alternatives that allow anyone to start investing with a little knowledge. They offer a low-cost investment management service at a fraction of what you’ll pay to a traditional investment company.
Fees typically vary depending on the amounts they manage for you. WealthSimple’s management fees is 0.5% on the first $100,000 and 0.4% for amounts over $100,000. On the other hand, Questrade’s fees on their managed portfolios start at 0.25% for balances between $1,000 and $99,999 but drops to 0.2% on a balance above $100,000.
You can expect the MER on the ETFs used by either robo-advisor to add another 0.2% on average to these fees. Notwithstanding, the total fees are still a fraction of what you would pay using any of the other incumbents, especially mutual funds.
In addition to the managed portfolios provided by the robo-advisors, you may decide to go the self-directed route. While this may seem daunting and overwhelming at first, with practice it’ll become easy.
With a self-directed account, you’re in total control of all aspects of your investment: when you contribute, what you invest in and, ETFs or individual stocks, etc.
However, with more control comes more responsibility. While the promise of higher control is thrilling, it could lead to making financial decisions fueled only by emotions. You’ll need to be disciplined and stick to your investment objectives, avoid speculating and going with the fad (e.g. cryptocurrencies), timing the market, over trading and paying more than necessary in fees.
These mistakes can be costly and prevent you from getting to your financial goals earlier. Remember that while the rich may recover from some of these mistakes, many average investors may not. And if you do recover, achieving financial freedom will take longer.
A note about using financial advisors:
Sometimes, it is prudent to work with a financial advisor or planner. This is especially true if you want a holistic review of where you are financially and develop a concrete and actionable plan to achieve your financial objectives.
But note that financial advisors are not created equal: there are differences in the customers they serve, how they get paid among other things.
In terms of compensation, most financial advisors fall into one of these three categories
- paid a percentage of the amount they manage for you (asset under management);
- paid a commission or fees for sales of a product or a transaction, e.g. investing in a fund, buying/selling a stock, buying insurance, etc; and
- a combination of the two
Anyone of these compensation models creates a conflict of interest between what is good for you and which products or funds pay the advisor best.
On the other hand, using a fee-only advisor avoids this potential conflict of interest because they are paid by the client. You pay a flat fee or per hour for their consultation. They’ll run the numbers for you and build a plan you can easily implement using any of the robo-advisors.
Types of Investments
Guaranteed Investment Certificates (GICs)
GICs are a safe way of investing your money. They provide a guaranteed return on your investment over a fixed period, such as 6 months, 1 year and up to 5 to 10 years. In general, the longer the term the higher the interest rate offered.
GICs are widely available from banks, credit unions, and online banks.
Investments in GICs with maturities of five years or less are protected by the Canada Deposit Insurance Corporation (CDIC) up to a maximum of $100,000. U.S. Dollar GICs are not covered.
Bonds are a type of investment in which the investor lends money to an entity (the issuer) for a specified period, in exchange for agreed periodic interest payments and the principal at maturity (end of the term).
Bonds are the major vehicle used by Government (federal, provincial and municipal) and corporate bodies to raise funds from investors.
In general, bonds are safer than stocks (discussed next) but investors can lose money in it if they sell before maturity at a price lower than what they paid for it or the issuer defaults.
Stocks are one of the most common investment products available to investors. Also called shares, stocks represent fractional ownership in a company. When you buy a stock, you become a part-owner (shareholder) of the company. They are very liquid (i.e. easily bought and sold) and traded on an exchange e.g. the Toronto Stock Exchange
As a shareholder, you’re entitled to a portion of the company’s profit and dividends. You also have the right to vote on key decisions affecting the company like electing the board members, choosing the auditors, etc.
There are two main ways to make money from your stock investments:
- Dividends paid periodically to the shareholders, representing a share of the profit made. In Canada, many listed companies pay dividends quarterly.
- Capital Gains: increase in the value of the investment over time. In general, the share price will rise as the company increases its profit and investors continue to believe in its continued ability to generate more profit.
Exchange-Traded Funds (ETFs)
An Exchange-traded fund is a fund that holds different individual stocks or bonds. Like stocks, ETFs are also traded on an exchange and offer an easy and low-cost way to invest your money and diversify your investments.
With a single purchase, you get a diversified portfolio which can potentially reduce your return compared to buying individual stocks or bonds. For example, instead of buying individual stocks of Canadian banks and paying trading commissions for each, you could buy a single Banking sector ETF.
Most ETFs seek to closely match the performance of an index like the S&P 500, S&P TSX, sectors and commodities. On the other hand, actively managed ETFs try to beat the index.
Mutual funds pool together the money of several small and individual investors to build a portfolio of investments. Mutual funds also offer a diversified collection of stocks, bonds, and other investments.
They are bought directly from the fund but unlike stocks or ETFs, prices are determined once a day after the market closes.
Like ETFs, mutual funds are professionally managed. However, they are more expensive – the difference in fees is significant over time.
Choosing the investments
If you haven’t completed any of the questionnaires to determine your risk tolerance, please go back and do that now. If you have, you should know the right asset mix suited to your risk profile and investment goals.
It’s time to choose a model portfolio
There are a number of model portfolios, built using low-cost ETFs, available to DIY investors. Two of the most popular ones available to Canadians are:
Model Portfolio 1:
Justin Bender of Canadian Portfolio Manager (CPM) has done a great job putting together some model ETF portfolios, built using ETFs provided by some of the major ETF providers in Canada.
Model Portfolio 2:
Another popular option can be found on the Canadian Couch Potato. It is built using just three low-cost ETFs.
Rebalancing your Portfolio
Once you’ve started investing and putting your money to work periodically, your target asset allocation will change over time because of differences in the performance of the investments you hold.
So how do you rebalance?
You will need to periodically check the performance of your portfolio and rebalance it if needed. Rebalancing is done by
- Selling a portion of the investment that has grown beyond the target allocation and buying more of the one that has underperformed.
- Alternatively, if you have new funds to contribute, you can simply buy more of the asset that is underperforming
What are the tools available for rebalancing?
There are a few options, depending on the number of individual ETFs you have, the number of accounts and how much time you want to spend on the exercise.
Depending on the number of ETFs in your portfolio, a simple Excel spreadsheet may be enough. You can build one from scratch or check out the one at CPM’s blog.
With a spreadsheet, you’ll need to manually enter your current holding to determine how much of each investment to sell or buy. This may become cumbersome for an investor with a number of accounts across different brokers or registered accounts.
Passiv is one of the tools that should be in every Canadian DIY investors’ toolkit. It automates the allocation of funds and rebalancing of your investments.
There are 2 plans:
Free Plan: The free option does all the calculations and you initiate the trades through your broker. In addition, you get notified of activities in your account, like dividends and cash contributions.
Paid Plan: The elite plan costs $99/ annum (or free for Questrade clients) at the time of writing this post. In addition to everything that comes with the free plan, the elite plan allows you to connect multiple brokerage accounts and initiate trades from inside the tool.
How often should you rebalance?
Portfolios can be rebalanced at set periods (monthly, quarterly or annually) or when the asset allocations change beyond a certain range. 5% is a good rule to use, that is you only rebalance if your asset allocation has changed by more than 5 percent.
For example, if your target allocation to Stocks is 60%, you should only rebalance when the asset allocation goes beyond 65%.
Depending on the size of your portfolio, annual rebalancing should be enough for most investors to avoid overdoing it.
Vanguard and iShares Asset Allocation ETFs:
Vanguard and iShares, two of the biggest ETF providers in Canada, have asset allocation ETFs. These are one-fund investments that hold assets across different investment classes.
They are much easier to manage than individual ETFs since rebalancing is done for you. However, they are more expensive.
Automate your contributions
A good way to keep your investing on track is to put your contributions on auto-pilot.
The easiest way is to have a fixed amount deducted directly from your paycheck and deposited into your investment account. The money is set aside before you get to see it or spend a penny. Think of it as paying yourself first.
If you can’t set up a payroll deduction, then a pre-authorized debit from your bank account to your brokerage account is another alternative. As much as possible, match the dates of these debits to your payday.
What are some of the benefits of automating your investments?
- Once set up, it is convenient and seamless. You save yourself some valuable time moving funds around and checking the status of your transfers.
- Every now and then, you may be tempted to spend rather than save. You can’t spend the money since it’s not lying idle in your bank account – a good way to cut down on discretionary spending
- It helps you leave emotions out of your savings and investment.
Your contributions are automatically invested in line with your desired asset allocation if you have a managed account. For self-directed accounts, you will have to execute the trades yourself each time you contribute to the account.
How much do you need to start investing?
This varies depending on the broker you choose. For example, Wealthsimple has no minimum balance to open and start investing. This means you can start investing immediately with any amount you have and grow it over time.
Questrade also has no minimum balance to open an account but you need at least $1,000 to start investing.
Monitoring your investments
You’ll be able to monitor your investments through your brokerage account. Your portfolio holdings, the average cost and current market price for each security and the weights are some of the information provided.
However, you may discover you need more information than what is provided. Also, this is not ideal for multiple accounts in different registered accounts or in multiple brokerages.
While you could use a simple custom spreadsheet to monitor your investments, there are automated tools available to streamline this. Unlike spreadsheets, once setup and linked to your brokerage accounts, these third-party apps will automatically pull in your data daily.
One of these tools available to Canadians is Wealthica.
Wealthica is a free tool that lets you see all your investments in one place. In addition to your investment accounts, you can also add your other assets like bank accounts, real estate, etc. And because the value is updated daily, you can view your net-worth over time, get notifications on the activities and even idle cash in your accounts.
Taxes are one of the biggest expenses for most people in Canada. So, it makes a lot of financial sense to structure your investment to minimize the taxes paid on your returns where possible.
Luckily, Canadians have access to a number of tax-advantaged saving plans, called registered accounts. Three of the most popular ones are registered retirement savings plan (RRSP), registered education savings plan (RESP) and tax-free savings account (TFSA)
Though returns in these accounts are not taxed, there are differences in how the withdrawals are taxed and the intended use of each account.
Registered Retirement Savings Plan (RRSP)
RRSPs are meant to help Canadians save for retirement. Contributions to the account are tax-deductible – that is, any amount put into the account will reduce your taxable income and you’ll get a refund when you file your tax.
The annual contribution limit is based on your earned income – 18% of your earned income up to a maximum of $ 26,500 for 2019. Unused contribution room can be carried over to another year.
Withdrawals of both the contribution and returns are taxed at your current marginal tax rate. The marginal rate is the tax rate for each additional dollar of income – hopefully during retirement when you’re in a lower tax bracket. So, it’s prudent to do an assessment of your individual tax circumstances.
Withdrawals before retirement are subject to a withholding tax (as high as 30%). However, withdrawals can be made under the Home Buyer’s Plan and Lifelong Learning Plan without incurring the withholding tax.
RRSPs are ideal when you need to reduce your taxable income, want a steady income during retirement or want to save in a place that’s not easily accessible.
Registered Education Savings Plan (RESP)
RESPs are used for savings for post-secondary education. Unlike RRSP, contributions are not tax deductible and tax-exempt when withdrawn. The returns or growth on the investment are taxed in the hands of the beneficiary of the plan.
There is a 20% annual matching of your contribution, up to a maximum of $2,500, under the Canadian Education Savings Grant (CESG). This means you get an additional $500 on your contribution of $2,500. Also, low-income families can get an extra match of up to 20% on the first $500 contributed.
Tax-Free Savings Account (TFSA)
TFSA are a flexible means of saving for any goals, from saving for a down payment to even retirement. Contributions to TFSA are after tax so they are not tax deductible.
Introduced in 2009 with a limit of $5,000, the lifetime contribution limit has grown to $88,000 in 2023 for someone that has never contributed to a TFSA. The 2023 annual limit is $6,500. There’s a penalty for overcontribution – 1% per month on the overcontribution.
Any return on your investment – interest, dividends, capital appreciation – is not taxed even when withdrawn.
The main difference between an RRSP or a TFSA is the timing of taxes and the choice between the two depends on individual circumstances: investment goals, current income, tax bracket etc. When uncertain, choose a TFSA since you can easily transfer your investment to an RRSP later.
Investing in Canada is not as complicated as many people make it out to be. With a little knowledge and time, you can start investing and putting your money to work.
Always remember: Invest according to your risk appetite and financial goals, don’t follow the fad, invest only in what you understand, diversify – don’t put all your eggs in one basket.
Do these, and you’ll be on your way to financial freedom.