Getting started with in investing can be intimidating. One solution is to start small and scale up as you gain experience and confidence.
Gimme Shelter: Invest in tax-sheltered plans
The advantages of both the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) are that investments are sheltered from tax within the plans. The 2 key differences between RRSPs and TFSAs are:
- Tax breaks: Only RRSP contributions generate a tax break.
- Taxes: All withdrawals from your RRSP are subject to tax. No taxes are paid on TFSA withdrawals.
- Tax treaty: U.S. equities or funds are not subject to withholding tax if held in a RRSP but they are taxed in a TFSA.
For those new to investing or in a lower income tax bracket, the flexibility of a TFSA is appealing. Once the TFSA room is used up, contributing to an RRSP makes sense. The relative benefits of each plan will depend on changes in income over time. At high-income levels, and correspondingly high tax rates, investors will benefit more from the RRSP tax break. Conversely, if investors wish to withdraw funds when their income is high, the best source of funds will be the TFSA, since withdrawals are not taxed. Ideally, we should aim to contribute to both plans.
Contribution room for both the RRSP and TFSA can be carried forward to future years, so investors don’t lose out permanently by not contributing each year. What is important to remember is that holding investments in either the TFSA or the RRSP is better than holding investments in a non-registered, fully-taxed plan. Keep in mind that any capital losses in either your RRSP or TFSA cannot be applied against capital gains. That’s a good reason invest in quality to minimize the chance of a permanent loss of capital.
Risky Business: Understand risk
Economists have a favourite saying, “there is no such thing as a free lunch.” For investors, this means that the opportunity to earn high returns comes with a cost: the chance of experiencing losses. This risk/return trade-off is easy to understand in theory, but putting it into practice can be a challenge. If we look at investing in the three asset classes: cash, bonds and stocks, cash typically provides the lowest returns and lowest risk, stocks offer the highest potential returns and the highest potential risks, while bonds usually fall in the middle of the two extremes.
A conservative or cautious investor might keep her investments primarily in guaranteed investment certificates (GICs) and high-quality bonds. At the other end of the spectrum, the aggressive growth investor might keep all of her investments in stocks. Most of us land somewhere in between, opting for a portfolio with more stocks than bonds and cash combined. The proportion of assets in each of the three asset classes is called asset allocation. What I tell my students is that it is important to take the risk that allows you sleep at night – which means that the “correct” asset allocation can vary widely from one investor to another.
Variety Show: Diversify
The expression “don’t put all your eggs in one basket” could have been coined for investors. By holding a large number of securities, owning investments across asset classes (cash versus bonds versus stocks) and across regions (Canada, United States and outside North America), investors can achieve a better risk/return trade-off.
The ultimate way to diversify is to become a passive investor. A passive approach involves holding a basket of stocks or securities to replicate the overall performance of a market, i.e., the Toronto Stock Exchange or the New York Stock Exchange. Passive investing is easier than it sounds: you can invest using a robo-adviser, by buying index mutual funds, or by buying index exchange-traded funds (ETFs). The moniker “passive” is unfortunate, since there is nothing boring about these investment returns!
Active investing, in contrast, is attempting to outperform the benchmark index by selecting different securities, or by trying to anticipate moves in the overall market. An active investor may attempt to sell stocks if she expects a market correction, or may buy a particular company’s stock if she expects that company to outperform its competitors. Not surprisingly, this approach takes more time, involves higher fees, and can be a riskier strategy than passive investing.
Which strategy wins?
After paying fees (which are higher for active investors), passive investors win most of the time. What I emphasize to my students is that the market index is the best stock picker: winning stocks are included in the index as their price rises, and carry the index up along the way, while weaker stocks gradually drop out of the index. Diversifying geographically can be done simply by allocating one-third of the stock portfolio in each of the Canadian, U.S. and global market indexes.
How can investors put all of these 3 key ideas into practice?
Set up a tax-sheltered plan(s) and invest in diversified index funds. This can be done through a discount broker, an investment advisor, or on your own. Whichever route you choose, getting started is the first step towards becoming a successful investor.