PERSONAL FINANCE AND INVESTING
This post covers how to get your money in the markets and how to set up a portfolio that's right for you by exploring some of the more common personal finance and investing concepts that should help you better understand how to approach your investment and saving goals.
But First, Let’s Talk Risk Tolerance & Asset Allocation
Before you start investing it is important to understand your risk tolerance. Knowing how much “Risk” you can handle will help determine your appropriate asset allocation. We have attached an ‘Investor Profile Questionnaire’ that you can try out. Although this questionnaire is not totally exhaustive in determining the best asset allocation for you, it does serve as a very good starting point. Please fill it out, and print screen your results for your records.
But first, what exactly is asset allocation? In short, it is the mix of different assets you hold. It is the make-up of what percentage of your funds are invested in Cash, equites (stocks), fixed income (bonds, GICs, etc.), and alternative investments (anything else - eg. Hedge Funds, REITs etc.).
For example, this is the asset allocation of a ‘maximum growth’ profile:
The main reasons that asset allocation is important are risk management and diversification in your portfolio. Diversification is essentially ‘not putting all of your eggs in one basket’.
Now on to risk. In general, the younger you are, the longer your time horizon is until you need the funds you are investing, and the more ‘risk’ you can afford. This typically means you hold a higher percentage of equities and less bonds. Although bonds are safer, since their prices fluctuate less, they also have lower long-term, historical returns. This concept is what is referred to as the risk-return tradeoff.
On that note, in the last newsletter, we saw that the long-term average annual returns for stocks is very good, but we also saw that stocks do not always go up and that in the short-term stocks can be very risky.
Because of the short-term risks with equities and the risk-reward tradeoff in mind, you can see why younger investors who have short-term goals like saving for a down payment on a house and older investors who are closer to needing funds for things like retirement, do not want to take as much risk (eg. less exposure to equites) as they don’t have as much time to make up for potential negative (downturn) periods.
How to get started
So what is the best way to actually put funds to work and get them invested? What is the best way to get funds from your bank account to your investment account? The most popular, and our favorite method, is dollar cost averaging, through pre-authorized contributions using the ‘pay yourself first method’.
Pay Yourself First
Pay yourself first means automatically moving a specified amount of money from your bank account to your investment account each paycheck and paying yourself before spending money. Some finance professionals have even gone so far as to call "pay yourself first" the golden rule of personal finance’.
A rule of thumb is to pay yourself a minimum of 10% of your paycheck. Once you automate this strategy, it becomes much easier to maintain and overtime you will not miss the deduction from your pay.
The essence of pay yourself first is that it removes the temptation to skip a contribution and spend the funds on discretionary items or expenses rather than savings. Regular, consistent savings contributions go a long way toward building a sizeable nest egg over the long term!
Dollar Cost Averaging
Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset. The purchases occur at regular intervals, regardless of the asset's price (eg. every two weeks when you get paid). This strategy removes much of the detailed work of attempting to time the market in order to make purchases of equities at the best prices.
A Few Words from the President of National Bank Investments on Market Timing
In a February Globe and Mail article Five bad investor traits – and how to correct them, NBI President Jonathan Durocher listed trying to time the market as one of five bad investor traits. Here is what he said:
Timing the market is extremely difficult to do because you need to be right twice. It’s hard enough to figure out when you need to get out, and it’s often close to impossible to know when you need to get back in.
There are countless examples showing how attempts to time the market is a fool’s errand for most investors – and believing that they can do it is one of the worst characteristics they can have. For advisors who have clients looking to do just that, the table below provides some evidence on why they should not attempt this as missing just a few days can have a significant impact their returns.
How to Implement Dollar Cost Averaging
The best way put dollar cost averaging to work is by setting up pre-authorized contributions (PACs) to a mutual fund or a turnkey investment solution. We will cover some of our favourite options in terms of mutual funds and highlight a National Bank turnkey solution we love in our next newsletter. We will also explain why these are typically better solutions than trying to pick stocks yourself, and why your dollars are in better hands with professional investment managers.
In each post we plan on providing a book recommendation to help expand your investing acumen.
This month’s recommendation: The wealthy Barber – David Chilton
Other Quick Reads and Useful links