Working can be such a drag. If only your investments could earn money – then you wouldn’t have to! Quitting work to manage one’s money is a dream for most of us, though there are a rare few, such as Derek Foster (“Canada’s Youngest Retiree”) and Andrew Hallam (“Millionaire Teacher”), who have managed to pull it off.
You might think that in order to be successful in the stock market, you need to become obsessed with individual stock selection. What’s going up, when to sell, analyzing P/E ratios – who has the time? The amazing part of stories such as Mr. Foster’s or Mr. Hallam’s is that they achieved their investment wealth without becoming slaves to the stock markets. In fact, experts will admit that building wealth has little to do with selecting the right stock and everything to do with time, tax efficiency and balance.
Factor #1 - Time
The major difference between investing your money to build wealth and speculating on the stock market is time. Time is important in three ways.
First, a wise investor takes a long view – she does her research, selects a company she believes will do well for years to come, then buys and holds. As Warren Buffett likes to say, “the best time to sell a stock…is never.” Leave the market timing, the dipping in and out, the constant buying and selling (and commission paying) to the speculators, the day-traders and the outright gamblers. (The only exception to this is when it comes to keeping your portfolio balanced – which we’ll get to below.)
Second, time provides the powerful magic of compound interest. This means the interest you earn gets added to your original investment in order to then earn interest on itself. The earlier you get started investing, the more your interest will have time to compound.
Finally, time allows for dividends to compound as well. Dividend reinvestment plans allow for the dividends you earn to be automatically spent on buying more shares in the company. The effect is that your investments can practically grow themselves.
Factor #2: Tax efficiency
Most people are so happy to achieve investment growth or gains that they dismiss the little matter of how much tax they will be charged. Yet tax is the biggest bill you will ever pay – whether it’s on your investments, your income or eventually, your estate.
When you sell an investment outside of a registered account (such as an RRSP or a TFSA), the money you end up with is taxable. How much tax you are charged depends on what the investment has done – has it grown in terms of capital gains (ie: profits), issued dividends or paid out interest? Each of these will have an impact on your annual tax return, so if you’re not sure of how to handle the investment taxes, do get a hold of a good accountant who can guide you through the steps.
When it comes to your RRSP and your estate – taxes can erode your nest egg as well as any amount you hope to preserve for passing along to your kids or grandkids. When you reach retirement and begin withdrawing money from various sources as income, a qualified advisor can help you to create an income withdrawal strategy that is tax-efficient, so you don’t pay more tax than you must. Similarly, if you plan to leave a legacy for your family or your kids, an estate planner can help make sure your investments are set up in a way to minimize the tax burden on your heirs.
Factor #3: Balance
Many advisors will tell you that getting the ratio of equity to bonds to cash is even more important than choosing the right stocks. Mr. Hallam even advocates forgetting about individual stocks and just using equity indices and bond indices to construct your portfolio. So how much of each do you buy?
A good rule of thumb is to keep the bonds or fixed income portion of your portfolio equivalent to your age. So for example, if you are 35, you might consider a 35% weighting in bonds with the remainder in equities and a small portion in cash. Over time, you will likely move from being an aggressive investor focused on growth and building wealth, to being a more conservative investor with a greater interest in preserving the capital you’ve amassed. As a result, your asset allocation will need to change, meaning your ratio of equities to bonds will shift.
Checking in with your portfolio two to three times a year is a good idea to make sure that those investments that have grown in value are not now dominating your portfolio. You want to maintain the overall asset allocation by selling off shares in securities that have grown and investing the profits into the area where your asset allocation needs a boost. This is called portfolio rebalancing and by doing this, you will always “sell high” and “buy low” - one of the most important factors in building wealth.
KISS (Keep it simple, sister)
So forget about all those complicated financial tables and the hot stock tips your Uncle Joe likes to go on about at the family barbeque. By paying attention to these three factors – time, tax-efficiency and portfolio balance – you will have an awesome headstart in terms of retiring rich and getting your money to work for you (instead of the other way around).