Investment

In this section we will discuss investment. The focus will on preserving wealth for the future; in other words how to use this vehicle for savings. For details on any specific area you can contact us or check the web as there are number of sites which can provide detailed explanations.

Investment means growth. It is just like a savings account but with a better return. The returns are better because you has far better control over your money than ina savings account. In savings accounts banks have full control. Another factor that distinguishes investments from savings accounts pertains to time. Usually money is invested with a long term focus and this is the key element of the explanation presented here.

You can only guarantee a better life in the future by investing in future therefore we need to know what these vehicles are. We will limit our explanation of future savings or investment to that made by an individual.

Investments comes in two types – Registered and Non-registered. The key difference between the two is management. Registered investments usually are for a long term and are registered with the government. On the other hand non-registered are for long term and short term both and usually not registered with the government. There are some types of non-registered investments which are registered with the government as well. One of the most important registered investment vehicle is the RRSP. The following are the most common forms of registered investments:

RRSP (Registered Retired Savings Plan).
RESP (Registered Education Savings Plan).
RIF (Registered Investment Fund).
RRIF (Registered retired Income fund).

We will explain each one later. Please note that there are other similar kinds of plans as well such as LIF and LRIF but we are not going to cover them as they are not vehicles for the creation of future wealth. RIF and RRIF are included as they are very common and people sometimes think that they can be used to create future funds. They are vehicles to draw funds after retirement.

There are a number of non-registered plans. Depending upon your need you can use them for long term or short term. Some of the most common are:

TFSA (Tax Free Savings account). TFSA can be grouped with registered vehicles as well but we decided to include it here as it functions differently.
Regular savings account.
Term deposits.
Insurance policies (especially Permanent).
Regular cheuqing account.

Please note that the grouping of registered and non-registered may not be conventional but the idea here is to provide a simple explanation that the ordinary person can understand.

Before we look into these investment vehicles let us review investment instruments. Again, we are not going to discuss them in detail as the main purpose is to give basic knowledge so that everyone can make well informed decisions.

Investment instruments or products usually are Cash or cash equivalent, fixed income or equity. In the following section we will provide an explanation of the instruments by their common names and then mention the category whether it is cash, fixed or equity.

Bonds

It is one of the most common types of instrument and it is considered a fixed income. Bonds can be short term or long term. Usually, short term bonds are for 5 years or less and long term over 5 years. Bonds are backed by the assets of the issuing entity. Therefore, they are guaranteed. In essence Bonds are the debt owned by the entity to the person buying the bond. Therefore they provide fixed interest plus the face amount at the end of the period. The interest is usually given twice a year. Bonds are issued by Governments and Corporations. Usually, government bonds are considered safer than corporate bonds. Think of bonds as loans given by an individual to the issuing entity. Since it is a loan, one receives interest and the principal amount. Interest received is taxed. The most common type of bond is the Canada Savings bond.

Debentures

These are also bonds but they are not secured like bonds and usually are issued by corporations. Since they are unsecured, they pay better interest than bonds. These are also part of the fixed income group.

Stocks or Shares (Common and Preferred)

Stocks represent the most common type of Equity investment. There are 2 types of stocks – Common and Preferred. This type of investment pays dividends which the profit of the company after taxes. Dividend amount varies and sometimes company may decide not to issue the Dividend. There is no guarantee. However, Preferred stocks or shares are guaranteed Dividends therefore, some time they are considered part of Fixed income group. In case company decides not to issue Dividends but after some time decides to give Dividend then Preferred stock holders receive Dividends first before Common stock holders. Another difference between common and preferred stock holders is in the control of the company. Common stock holders have voting rights whereas preferred stock holders do not. Voting right allows the stock holders to exercise some degree of control or say in the affairs of the company. Think of Stocks or shares as the ownership in the company. Since stockholders are the owners therefore, return is not guaranteed. If company does well stock holders do well and if company does not do well then stock holders see their investments go down as well. Stocks are also categorized as Growth oriented investments.

GICs (Guaranteed Investment Certificates)

These are like bonds but usually issued by financial institutions. GICs are usually, considered safe investments. They provide like bond, interest and principal amount therefore, they are part of Fixed income group.

T-Bills (Treasury Bills)

These are usually considered to be a cash or cash equivalent instrument. They are issued by the government but are bought through financial institutions. There is no interest. Usually you buy them at a price which is lower than the face value and when cashing receive the face value. For example you buy $100.00 T-bill for $90.00 and get $100.00 when it is cashed. The difference is taxed as interest income.

Mutual Funds

Mutual funds in reality are not investment instruments. Think of a mutual fund as a company which collects money from its people and invests in regular investment instruments (given above) and manages the money on their behalf and then shares the profits or losses. There are number of privately owned companies who have their own mutual funds and almost all financial institutions have their own mutual funds.

A mutual fund consists of various kind of fixed income instruments and shares of various companies. Shares can be common or preferred. Mutual funds are of various types like fixed income mutual funds, growth oriented mutual funds (primarily the investments are in stocks) etc. The main advantage of investing through mutual funds is diversification. The diversification feature allows a small investor to invest in larger companies. The investor who invests through mutual funds receives shares or units depending upon the structure of the mutual fund company. The number of units or shares are allocated based on the amount invested. People invest in mutual funds because of the diversification feature and the management of their money by seasoned professionals, which a small investor can not afford on his/her own.

Mutual funds have one huge drawback that is not liked by many investors. It pertains to MER or Management Expense ratio. MER represents the fee charged by the professional managers who manage the investment instruments within the Mutual Fund. Think of it this way. If one lives in a condominium then there is a maintenance fee. This service is charged irrespective of whether one receives any service. However it is to maintain and take care of the condominium building. The MER varies from institution to institution. The fee itself varies from 1% to 3% of the investment. This could be a substantial amount therefore you have to be careful. Before investing in investment vehicles that charge a MER you should ask about the services provided. The point here is you should not look at MER in a negative manner. If the financial managers are doing a good job and providing good service then it is worth it. It is not possible for an individual to manage the invested capital properly as the financial markets have too many unknowns which cannot be managed by average person.

Segregated Funds

Segregated funds are very similar to mutual funds. However, segregated Funds are insurance products and can only be bought through insurance companies. Segregated funds have two major components: Death Benefits (similar to an insurance policy) and Maturity Guarantee (similar to bonds or GICs). Each component is guaranteed separately. For example 100% and 100% means that the Death Benefit is guaranteed for the full amount as well as is the Maturity amount. If it is 100% and 75% then the Death Benefit is guaranteed for the full amount but the Maturity amount is only guaranteed for 75% of its value. The invested amount is invested in various instruments and you receive the value depending upon market conditions and the guarantee provided. If the investments do well then you receive a higher value at maturity. The Maturity period is usually 5 years or more.

Annuities

Annuity Annuity is reverse of Insurance. For Insurance one pays certain amount upfront so that at death beneficiary receives the policy amount. In case of annuity one pays the amount upfront and receives certain amount (agreed before) per month. Annuity can be Term or Life. Term Annuity lasts for the fixed period. Life Annuity is for the life. However, Life Annuity can be purchased from the Insurance companies only. There are number of types of Annuities. As mentioned earlier our key objective is to provide information so that one can make intelligent decision. Please contact us for more details or read on the web. There are number of investment vehicles however, we have briefly explained the key ones since they impact the average investor. Also, the explanation is limited to provide that much information so that one can make knowledgeable decision. We encourage everyone to either contact us or read on the web. Let us now review the Investment vehicles or plans.

RRSP (Registered Retirement Saving Plan)

RRSP (Registered Retirement Saving Plan) This is the most common and well known investment vehicle available to everyone. Contributions to the plan vary every year and are based on earned income. There is a maximum limit, which is set by the government. The amount you can contribute is provided by the Canada Revenue Agency on the annual Assessment statement. In general it is 20% of the Earned income (this is not the exact amount. The formula to calculate exact amount is not simple) to the maximum limit.

The biggest advantage of an RRSP is it reduces your taxable income dollar for dollar. However very few people know that its full potential is obtained when tax saving is invested back into the RRSP, particularly for those who can not contribute the maximum allowable limit. One can only contribute until the year they turn 71.

RESP (Registered Educational Savings Plan)

This is one of the most misunderstood tax deferral plans. The main objective of this plan is to save money for your children’s post secondary education. You can contribute a maximum of $50,000.00 per child. The government contributes 20% of the individual’s contribution to the maximum of $7,500.00 per child. Contributions are not tax deductible. The idea is when child goes for post secondary education and withdraws the amount they pays tax at a much lower rate then the contributor. Not very many people understand this taxable benefit. For high earners this is one of the most useful ways of not only funding post secondary education but also passing the payment of taxes to lower earning family member. Growth is not reported by the contributor for tax purposes.

RIF (Registered Income Fund)

This is the plan that one starts after retirement by transferring money from RSP (Retirement Savings Plan). The growth within RIF is tax free until it is withdrawn. At age 69 one must start withdrawing from a RIF. A RIF is an after retirement plan. It is not a vehicle to build funds for future.

RRIF (Registered Retirement Income Plan)

An RRIF is similar to a RIF except that you have to transfer your RRSP amount at age 71 or before. After age 71 the RRSP account has to be closed. It is also not the vehicle to build funds for the future.

TFSA (Tax Free Savings Account)

This one of the most misunderstood savings account. In fact it is far better than any investment vehicle available for generating wealth for the future. Contributions to this account are not tax deductible but the growth within the account is totally tax free. You can contribute a maximum of $5,000.00 every year. the balance can be carried forward. For example if you contribute only $2,000.00 in the current year then next year your contribution room increases to $8,000.00. Similarly, if you withdraw from your account then you cannot deposit in that year. For example if you withdraw $2,000.00 from your account after depositing $5,000.00 then you has to wait till next year to deposit $7,000.00. The $2,000.00 withdrawn is tax free. This is one of the best vehicles available for future savings. Refer to the Ideas section for discussion on RRSP and TFSA.

Regular Savings and Checking accounts.

These accounts are more or less considered as liquid accounts or cash on hand accounts. Since they are not considered accounts to generate wealth for future therefore, interest payment on these accounts by the financial institutions is very small or insignificant. People can use it as vehicles for saving for future but growth is so insignificant therefore, keeping large amount in these accounts is simply waste of money. We do not consider them as vehicle for future savings.

Term Deposits

These can be considered to be vehicles for future savings. However, the interest payment is very small therefore, potential for significant growth is not great. However, these are very safe investments, almost risk free. Since, money can be withdrawn before the term by giving advance notice therefore, financial institutions do not give high interest.

Insurance Policies (Permanent)

As explained under Insurance, Whole life and Universal life both contain a component called the Cash Reserve Value. This component is the insurance industry’s version of investment because growth is treated on a tax deferral basis. This method of investment is good for those people who have maximized their RRSP contribution or have a large estate to pass on to the next generation. Once the reserve has been built, then you can take a loan against the value as well. However you may have to pay taxes as well as the death benefits. We do not suggest using this vehicle for the average person.

The above details have given us some basic ideas about various investment instruments and vehicles or plans. The next step is how should they be used? There is no right or wrong method. We will try to give some basic ideas based on our own experience. The Process section of the site provides the basic methodology. You should be able to put together a plan for the creation of income for the future.

Some very basic but important steps are:

Know your risk tolerance. This is the most important step in investing or saving for the future. The higher the risk tolerance, the higher the growth. As we say, no pain no gain. In simple terms the risk tolerance means how much can you lose without losing sleep. If you have $1,000.00 and you are prepared to lose everything then investment vehicles can be very different than for the person who cannot afford to lose any amount. Once you know your risk tolerance then investment instruments are selected within the investment plan. Usually financial advisors have software to determine the risk profile or tolerance of an individual.
In our opinion the next step is to determine whether you feel confidant in investing by yourself or if you need a professional financial advisor. Studies have shown that people working with financial advisors feel far more confidant about their future than those who do it themselves. Contact us for a free consultation. We have covered under our Ideas how to go about selecting a professional.
The next step involves the creation of a portfolio. This again is one of the key element of the investment process. A portfolio represents investment instruments based on your risk tolerance. If the financial advisor is involved in creating the portfolio then the financial advisor must have vested interest. In other words the financial advisor must create it in such a way so that it shows the portfolio is being created for the advisor. There should not be any self interest involved. Keep in mind that one must create the portfolio by giving serious thought to its future purpose. This is very important and most financial advisors and individuals make mistake. For example, if the portfolio is for RRSP then risk tolerance can be computed differently because growth is for future therefore, instruments can be selected that provide better growth of the capital. If portfolio is for TFSA then risk tolerance must take into account the potential to withdraw money earlier therefore, instruments must be selected accordingly. If in doubt one can always contact us for no obligation advice.
Developing a portfolio for non-registered investment plans is more complex than most people think. The role of risk tolerance is critical as it helps determine the mix of fixed versus equity. We think that you should invest the amount that you can afford to lose in equities and rest in secured investments. For further information we suggest contacting us.
Once your portfolio has been created then the next step is monitoring it on regular basis and changing it as conditions change. Balancing of your portfolio is very important. This is where an advisor must play the role of vested interest. If the advisor treats the portfolio as his/her own then the portfolio will show growth on a regular basis.

In essence you should first invest in RRSPs, then TFSA and then non-registered plans. Read the Ideas section for more concrete information like investing in Bonds or Stocks etc. The Ideas section provide specific information on specific topics.