By Ray Turchansky
Freelance
Edmonton Journal
“Your Money” Section
Thursday, February 17, 2005
EDMONTON - When financial author David Bach came to Edmonton recently, some e-mail writers mused that what he said was merely common sense.
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, "The majority of Canadians would be OK with a mix of equities between 40 and 60 per cent. And in those equities you'd have stocks and mutual funds and ETFs (Exchange Traded Funds) and index funds. The other 40 to 60 per cent would be OK in fixed income -- some cash, some bonds, things that are more guaranteed.”
And yet, more than 800 people had braved frigid temperatures to hear him, and there was no uproar that time had been wasted.
While Bach may have commercialized the delivery of financial advice beyond the wildest of dreams, even making appearances on the Oprah Winfrey show, his success points out that when it comes to personal finance, sense may not be all that common after all.
So for those who may have been absent the day when personal finance was taught in school, we present a review.
A recurring theme among studies and books written on how people become wealthy is that in most cases they didn't inherit it or even achieve it through investing, but they got that way by controlling their spending.
People who get a handle on their debt, and especially credit card debt with interest rates in the 18-to-20 per cent range, usually live to spend another day.
The generation of people that suffered through The Great Depression and learned to spend frugally gave way to a generation that has been inheriting trillions of dollars and spending it to live life to the fullest.
The lowest mortgage rates in 40 years and no-interest financing of cars has caused an embracement of the "What, Me Worry?" philosophy espoused by Mad magazine's Alfred E. Neuman.
But there is good debt and bad debt, as well as good credit and bad credit. A home improvement loan that will increase the value of your house usually makes more sense than borrowing to holiday in Maui for the fifth straight year.
Follow the money
The first thing is to know where your money is going.
Budgeting is usually a lot like dieting. It tends to be time-consuming, boring and hard to stick to.
But by glancing over your credit card and chequing account statements every month you generally get a sense of where your money is going. And actually reconciling your receipts with your statements can often save you money. About once a year I find I've been double-charged for a credit card purchase -- on one occasion for $600 worth of carpeting -- or else not received a credit for a return.
Bach trademarked the phrase "The Latte Factor," saying that by not buying a daily latte and investing the savings with a seven-per-cent return, you can turn a $1,300 yearly expense into a $55,275 investment after 20 years.
The latte, of course, is a metaphor for any small expense you regularly occur. It can be call-waiting on your telephone, that extra level of cable TV channels, or maybe that gym membership that just never gets used.
Use credit wisely
The next question you need to investigate is how you pay for your spending.
North Americans are in more debt than at any time in history, but you can use credit to your advantage.
First, limit your spending to a credit card balance that you can pay off every month, to avoid those 18 per cent interest charges. Set up an automatic payment plan, so the money stays in your bank account until the last day possible. Make major credit card purchases just after your monthly cutoff for purchases, which defers payment until the end of the following month.
This, essentially, gives you a seven-week interest-free loan from the credit card company each month.
And, if you select a low-cost loyalty credit card, you may never have to pay for an airline trip again.
In recent years it's almost become a status symbol to have a line of credit. And yet very few people know how much interest they're paying when they draw on it. If your bank suggests moving your mortgage into your line of credit, find out which would cost you more interest.
Mortgage choices
Speaking of mortgages, consider using a mortgage broker.
Start out with the shortest amortization period -- the time it will take to pay off your mortgage in full -- that you can afford. The magic figure with mortgages is eight years -- that's when half your payment goes towards the principal and half towards interest. For any period beyond that you're paying mostly interest. On a $100,000 mortgage at 7.0 per cent, you pay $112,034 in interest with a 25-year amortization period, but only $61,789 with a 15-year period. And your monthly payments only increase from $707 to $899.
Also, make mortgage payments bi-weekly rather than monthly, which essentially gives you an extra monthly payment each year. It means you would pay off a $200,000, 25-year mortgage at 7.0 per cent nearly 41/2 years earlier and save $45,940 in interest.
As for renewing your mortgage, a 2001 study by York University professor Moshe Milevsky showed that from 1950 to 1999 a homeowner would have saved money going with a short-term or variable rate mortgage 88.6 per cent of the time compared to locking in for five years.
Owning your own home not only builds up equity, but it prevents wasteful spending on rent. A renter paying $1,500 a month for 30 years spends $540,000 and owns nothing.
Save and invest
Once you've made moves to control your spending, the other way to increase your wealth is by saving and investing. The difference, as the financial industry describes it, is whether you want to be a loaner or an owner.
People who decide to save essentially loan their money to institutions who in turn loan it to people who want to own things ranging from a house to a car to equity stocks.
The difference between the 2.4 per cent the bank pays you and the 4.9 per cent it charges a mortgage-owner is the spread, which is how financial institutions make money.
Historically-low interest rates drove people out of regular savings accounts and guaranteed investment certificates, but the bear market of 2000-02 has produced "mutual fund refugees," who have been slowly migrating back to fixed-income products, putting a premium on capital preservation over risky chances of high returns.
The Dutch bank ING capitalized on frayed investor nerves by offering savings accounts with rates roughly 2.15 per cent higher than most bank accounts. ING's success is causing most institutions to come up with a comparable high interest-rate product, but ING is also a virtual bank with little or no service charges.
The difference between having a low-rate account with a monthly full-service package and having a high-rate account with no service charges can make a difference of up to $600 a year.
Also making a comeback this RRSP season are GICs, many of which have been spiced up by being linked to stock indexes, or to dividends in the case of a new offering from BMO.
Up to $60,000 in most bank accounts and GICs are guaranteed by the Canadian Deposit Insurance Corporation against failure of the financial institution that holds them.
The allure of fixed-income assets lies in the effects of compounding, known as the Rule of 72. You divide 72 by your annual rate of return to find out how many years it takes to double your money. So an eight-per-cent return turns $10,000 into $20,000 in nine years.
People who are willing to take more risk in hope of higher returns become owners by investing in companies through stocks, mutual funds, income trusts, bonds or real estate.
The two major principles of investing are asset allocation and diversification.
Asset allocation was developed in the early 1950s by Harry Markowitz, a University of Chicago economics and mathematics grad student, who discovered that if a person invested in different stocks that had a negative correlation -- when one went up in value the other went down -- it reduced the overall risk in a portfolio over time.
What became Modern Portfolio Theory earned him a Nobel Prize in economics in 1990, along with William Sharpe and Merton Miller, for showing that between 87 and 95 per cent of your investment returns will depend on which asset classes you are invested in. Only five to 13 per cent is a result of which stocks or mutual funds you pick and when you buy them.
They suggested the way to reduce risk by investing in stocks with negative correlations was by spreading out your investments among various assets -- equities, fixed income and cash.
Furthermore, within each asset class you should diversify -- by geography, by market capitalization and by sectors.
"Diversification is about being right more often than you're wrong," said Adrian Mastracci, president of Vancouver-based KCM Wealth Management.
"When people first come in, quite often they're quite heavily into equities, like 80 or 85 per cent. But when you do their profile they probably wouldn't be comfortable with 60 or more. We generally have to cut it back."
The usual rule of thumb for asset allocation has been to have a percentage of investments equal to your age in fixed income and cash.
"The majority of Canadians would be OK with a mix of equities between 40 and 60 per cent," said Mastracci. "And in those equities you'd have stocks and mutual funds and ETFs (Exchange Traded Funds) and index funds. The other 40 to 60 per cent would be OK in fixed income -- some cash, some bonds, things that are more guaranteed."
Many mutual funds have a mandate for either growth, investing in companies that expand either internally or through acquisitions, or in value, by investing in mature firms that often pay dividends rather than reinvesting profits back into building the company.
Bonds generally perform inversely to the direction of interest rates, doing better when interest rates are falling. Corporate and government bonds often switch in and out of favour, as do length of terms, although the common advice is to ladder different lengths of bonds so they mature at different stages of economic cycles.
Tax strategies
The taxation of income varies greatly according to type.
The least tax efficient investment income is interest, because you are fully taxed on 100 per cent of it, as with salaries. Dividends are taxed lower due to the dividend tax credit. And capital gains become the most efficient in high tax brackets due to a 50- per-cent inclusion rate.
For instance, an Albertan making $30,000 in 2004 would have a marginal tax rate of 26 per cent on interest, 13 per cent on capital gains and 4.6 per cent on dividends. But an Albertan making $70,000 in 2004 would have a marginal tax rate of 36 per cent on interest, 20.3 per cent on dividends and 18 per cent on capital gains.
Popular methods to defer taxation are to invest in registered retirement savings plans, spousal RRSPs and registered education savings plans.
RRSPs and spousal RRSPs offer a tax deduction for contributions, which grow tax-free until money is taken out of a plan, when both the principal and the income are fully taxed, although usually at a time when the investor has less income and is in a lower tax bracket. There are some provisions to withdraw money tax-free to buy a house or to return to school, as long as it is replaced within certain guidelines.
A spousal RRSP allows income splitting, so that both spouses will have similar incomes in retirement, thus reducing taxes.
RESPs do not offer a tax deduction for the contribution, but the growth is tax-free and withdrawals are usually made by students making insufficient income to have to pay taxes.
Pension options
Many companies offering pension plans are changing from defined benefit to defined contribution plans to shift the responsibility of investing from the employer to the employee.
A defined benefit plan is run by a company's pension plan administrator and guarantees benefits regardless of the plan's performance. It is a great vehicle for employees, since they usually get an automatic return of around 100 per cent in the form of employer matching, plus the four or five per cent the plan itself returns.
A defined contribution plan places investment decisions in the hands of the employee and benefits will vary According to how well the investments fare.
While much of personal finance may be common sense to some people, it remains a learning experience and work-in-progress for many.
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