|
By Ray Turchansky
Alberta Venture
February 2007 Issue
In the world of investing, there are numerous options and places to put your money, some riskier than others. You can pay into an RRSP fund and immediately get a tax break. Fixed-income and equity options look appealing if you can manoeuvre the complexities. And then there’s the garden-variety mutual funds – equity funds, bond funds, index funds, segregated funds, hedge funds – and exchange traded funds or ETFs.
Adrian Mastracci, fee-only portfolio manager at KCM Wealth Management in Vancouver, says, "Making portfolio selections is not always about being right. It is important to admit that one was wrong about the initial investment analysis, and equally important to do something about it."
Regardless of which vehicle you go with, investing basically boils down to making a choice between “loanership” and “ownership.” Once you learn the advantages of lending money to people and financial institutions (less risk) versus buying a stake in a company or other property (greater rewards but more volatility), you’ll be well on your way to financing your future.
Here are 10 investment tips, some basic and others somewhat complex.
1. The magic of compounding
One of the simple rules of investing is one of the most amazing. The Rule of 72 dictates that dividing the number 72 by your yearly rate of return on an investment will tell you how many years it takes for the investment to double. For instance, if an investment returns 6% a year, the principal will double in 12 years. If you can get 8% a year, your investment doubles in nine years.
The rule shows the importance of investing early in life. Making small contributions early can produce better results than making large contributions late. In his book The Automatic Millionaire, David Bach uses the example of Billy and Kim. Billy starts investing $3,000 a year at age 15 for five years, then never invests another penny. If he has a 10% return compounded annually, by age 65 his $15,000 investment will be worth $1,615,363.40. By contrast, Bill starts investing $3,000 a year at age 27, and does so each year until he turns 65. If he also has a 10% return compounded annually, at age 65 his $117,000 investment will be worth $1,324,777.67.
While it’s never too late to build up a retirement nest egg, it takes a lot less money to do so if you start young.
2. Fishing in foreign waters
People seldom stray beyond their borders when investing, a phenomenon called “home country bias.” They tend to play it safe, investing in Canadian companies they know about and are most familiar with and avoiding the additional complexities caused by ever-changing foreign-exchange rates. But Canada’s TSX-listed companies make up a fraction of the world’s stock market capitalization, only 3%.
In the spring of 2005, the federal government eliminated the 30% foreign content limit within registered retirement savings plans and other tax-deferred savings plans, making it easier for Canadian investors to take advantage of emerging world markets.
“When you take a chunk of the world that has not consumed before and bring them into the consumer market, you create tremendous opportunities and challenges,” says Warren Jestin, chief economist with Scotiabank. “It’s China, Brazil and India. You’re getting consumers moving into the consuming market vigorously, and businesses starting up where there were no businesses – so all of a sudden you have demand for energy and industrial commodities such as nickel, zinc, copper and uranium.”
Proof that the foreign markets should not be overlooked, the Morgan Stanley Capital International World Index neared the end of 2006 up 16.8%, compared to 13.2% for the MSCI North American index. Moreover, the total market capitalization of the Shanghai Stock Exchange increased by 120% in 2006 over the previous year.
3. Don’t believe the hype
The saying in investment circles is that once your cab driver starts giving you stock market tips, it’s time to get out. The explosion in communications – the Internet, investment newsletters, blogs and financial TV channels like ROB-TV in Canada and CNBC in the United States – has educated people about investing beyond anything imagined even a decade ago. But amid this information overload, it’s often hard to distinguish between unbiased research and “market noise,” what Investopedia.com, the online investment dictionary, defines as stock market activity that is not reflective of overall market sentiment.
Buying shares of XYZ Explorations Ltd. based on a brother-in-law’s hot tip is gambling. Doing your due diligence by researching earnings and profits and debt and management and market forces is called investing.
4. The difference between a good company and a good stock
Two major types of investment styles are value and growth, and there is point in every investment cycle when one does better than the other.
Value companies tend to be mature firms whose stock prices may not vary much, but whose low expenses result in large profits that often mean continually increasing dividends. Growth companies reinvest most of their income back in the company to increase production, often resulting in rising share prices but little if any profit left for dividends.
Ben Graham, the father of value investing, had a protégé named Warren Buffett. Value investors like Buffett, who became one of the world’s richest people largely by investing in common stocks, try to find companies whose shares have fallen for a variety of reasons – too much debt, bad management, bad products – and patiently wait for things to turn around. Factors that can change for the better, such as economic conditions, new management, solving legal problems and reducing debt levels, can represent hidden value in the stock of a company that seems down and out. The adage is that these investors “try to buy a two-dollar share for one dollar” by investing in a bad company that may be a good stock.
Emulating Warren Buffett, of course, takes painstaking research, but you can share the workload by pooling knowledge with fellow investors. Popping up all across the country, investment clubs represent a safe environment to learn about the ins and outs of financial markets. John Bart, founder of the Canadian ShareOwner investment club, regularly publishes research on “great stocks” and “grief stocks.” He charts each company’s revenue and earnings per share over a period of time. His members look for companies that have both lines moving steadily upwards.
5. Investing in real estate
Despite a slight cooling of the Canadian real estate market, there are many investors eager to make their fortune in real estate because the housing reports make it sound like an easy-peasy investment. Yet many of these reports don’t mention that owning rental property can be a full-time job, managing tenants and maintaining property.
Don Campbell, a real-estate investor and instructor with the Calgary-based Real Estate Investment Network, says there are four mistakes home buyers make: not having a real goal; not doing their homework or asking critical questions; creating a confrontational relationship with tenants; and signing documents that are not true.
To avoid the headache of managing the property yourself, consider buying stock in a real estate company or investing in real estate income trusts (REITs), which will continue to be exempt from taxation under new rules proposed to tax income trusts. Calgary-based Boardwalk REIT, which builds, manages and owns apartments and condos in the Alberta and Quebec markets, saw its unit price more than double during 2006. RioCan REIT, Canada’s largest REIT with $8 billion in market capitalization, saw its unit price shoot up nearly 35% during the last half of 2006.
6. How bonds work
Bonds usually increase in value when interest rates are falling and vice versa. If you buy a $1,000 bond with a 4% coupon or interest rate, and the rates move up and a new $1,000 bond yields 5%, you have to reduce the asking price to sell the bond. For this reason, bonds are often considered a defensive holding, going up when stock prices are falling.
In the ’80s, North America experienced a two-year recession, the longest in the last half of the century. The prime interest rate, which hit a record high of 22.5% in 1981, began a 20-year decline that eventually took it to 3.75%. During this period, long-term bonds earned a compounded average of 13.8% a year.
But since August of 2004, the prime interest rate has been rising, and for 12 months through July 2006, the average bond fund had a 12-month gain of only 0.65%. The U.S. now has an inverted yield curve – where short-term bonds actually pay more than long-term bonds – and that usually foreshadows a recession. However, with the Bank of Canada and the U.S. Federal Reserve on the verge of reducing interest rates again, many analysts feel bonds could outperform equities during the next 12 months.
An investor can buy individual bonds, either government (federal or provincial) or corporate, and either short-term or long-term. A general rule is to “ladder” your bonds, buying some for short, medium and long terms. The Money Letter investment newsletter recommends government bonds for secure but limited returns, and corporate bonds for riskier but potentially greater returns. If buying individual bonds seems too onerous, you can also buy bond funds, namely a mutual fund that includes a variety of bonds chosen by a fund manager. While this gives you some diversification and expertise in choosing bonds, the fund fees often reduce returns significantly. If inflation is a concern, you might want a real return bond fund, which guarantees a return greater than inflation.
7. Know when to fold ‘em
Investors spend the majority of their time plotting what stocks to buy and when, but the truth is more money is lost holding onto stocks and not knowing when to sell. Many investors who bought Nortel Networks at $40 or $80 a share watched their stock soar to $123, and then rode it all the way back down to 69 cents.
Investors tend to hang on too long, becoming emotionally attached to their investments. They sweat over their selection, stand buy them during rough times, and are reluctant to let go when they are hopeless. “Making portfolio selections is not always about being right,” says Adrian Mastracci, financial adviser with Vancouver-based KCM Wealth Management. “It is important to admit that one was wrong about the initial investment analysis, and equally important to do something about it.”
Ask yourself why you bought the stock in the first place, and whether those reasons have changed irreversibly, or whether conditions that caused the downfall could improve so significantly that a rebound is possible.
One way of removing the emotion from selling an investment is to place a mental or physical “stop loss” order on it. Adopt a rule of thumb to sell any stock that has lost 20%, unless there is compelling reason to keep it. (By the same token, many investors set an upside goal -- either a target price or a time period -- to sell a rising stock and take their profits.)
Also, realize how great the rebound must be just to get back to even, let alone make money. If an investment loses 50%, it has to gain 100% just to break even; and if the investment tanks 60%, it has to gain 150% just to get you back where you started. “Now those are miracle turnarounds. The bad news is that I can’t recall many of them,” says Mastracci. Successful investing isn’t about being right all the time, just more times than you’re wrong.
8. The mortgage question
The classic dilemma facing millions of Canadians when they receive their income tax refund each spring is whether to invest the money or use it to pay down the mortgage.The answer may depend on your tax factor, and here’s how you figure it out.
An Albertan making $25,000 has a marginal (federal and provincial) tax rate of 25.25%. You divide 100 by 74.75 (100 minus 25.25) and that gives you a tax factor of 1.34. That means you must earn $1.34 before taxes to have one dollar left after taxes.
Say your mortgage rate is 6.5% a year. That would mean you would need an investment making an annual return of at least 1.34 times 6.5, namely 8.71%, to be better off investing your money than putting it down on your mortgage.
Similarly, an Albertan making $75,000 has a marginal tax rate of 36%, and therefore a tax factor of 1.56. Given the same mortgage rate of 6.5%, you would need an investment making you 10.2% a year to be better off investing than paying down your mortgage.
You can also use your tax factor to check for inflation. A person making $25,000 has a tax factor of 1.34 and if inflation in Alberta is running at 4.7% (twice the national average), you need an investment return of 6.3% annually just to cover your taxes and inflation. For a person making $75,000 with a 1.56 tax factor, you need to earn 7.3% from an investment to overcome taxes and inflation.
Sadly, if you’re purchasing a guaranteed income certificate (GIC) that pays you 3% a year, you’re losing money if you take taxation and inflation into consideration.
9. Investing inside and outside of RRSPs
There was a time when investing inside a registered retirement savings account was a no-brainer – you got a tax deduction for the investment up front, all growth was tax-deferred, and you only paid tax when you withdrew the money, usually when you retired and dropped to a lower tax bracket.
But beginning in 2000, the federal government lowered the portion of capital gains earned in non-registered (investment) accounts that you pay tax on from 75% to 67%, then 50%. This poses two difficult questions for investors. Should you take no tax deduction up front in an investment account, but then pay tax on 50% of the capital gains profit at your marginal tax rate? Or should you take the tax break up front but then pay tax on 100% of the original investment plus all profit at your marginal tax rate?
There is growing sentiment that investors should put their first $100,000 into an RRSP and at least some of any further amount into investment accounts. This gives you the flexibility to pay less tax on money withdrawn from an investment account when you’re in a period of high income, or to withdraw money from an RRSP when you have little other income, or before you start collecting pensions.
Another thing to consider is how various investments are taxed. In an investment account you are taxed on 100% of the interest you earn, 50% of your capital gains, and generally somewhere in between on dividends, depending on your marginal tax rate.
The rule of thumb is to hold investments that produce capital gains and dividends, in most cases due to enhanced dividend tax credits, inside an investment account. Hold investments that produce interest like bonds and GICs inside your RRSP.
10. The income trust shuffle
An income trust is a structure whereby a corporation avoids paying tax on profits by putting them into a trust that disperses them to unitholders as distributions. The distributions include mostly interest, plus some return of the unitholder’s investment, that is, a return on capital.
If you buy a stock for $10 and it goes up to $12 and you receive a $1 dividend, you make a profit of $3 ($2 when you sell your share and $1 when you receive your dividend). If you buy an income trust unit for $10 and it rises in value to $12 and it pays a $1 distribution, you make a profit of $3 ($2 when you sell your unit and $1 when you receive your distribution.)
Trusts have been embraced by companies because they avoid taxes, and by investors because they usually provide a healthy income stream plus an increase in unit value.
To increase the attraction of dividends, the federal and most provincial governments announced increases in the dividend tax credit. Fearing more lost taxes from Telus and BCE’s planned trust conversion, last October the federal government announced its plan to tax new trusts in 2007 and existing trusts starting in 2011. That caused trusts to immediately lose $30 billion in market capitalization, as the S&P/TSX Capped Income Trust Index fell 16.2%.
However, after the sell-off, CIBC World Markets over-weighted its investment in income trusts, and said in its 2007 Canadian Portfolio Outlook that the trust market “continues to offer good value.” Its advice: “With average yields above 9%, the sector will continue to hold appeal, particularly for income-oriented investors. Ottawa’s recent clarification of expansion rules for trusts gives some room for growth over the next four years, particularly for oil and gas royalty trusts.”
If the new rules have scared you away from trusts and you’re still looking for good yields, move into common shares paying large dividends, such as bank stocks, or the oft-forgotten, old standby, preferred shares.
|
