From an early age, one of the first financial buzzwords you hear often tends to be “investing”. Almost everyone is aware of what the definition of investing is.
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From an early age, one of the first financial buzzwords you hear often tends to be “investing”. Almost everyone is aware of what the definition of investing is.
[Investing is the act of deploying money towards financial securities to earn a return on that over a specified time period.]
But despite its prevalence in the media and in our everyday lives, we sometimes forget core investing fundamentals. This investing guide for beginners attempts to revisit some of those basics and provide an overview of the different investing options available to the Canadian investor.
A stock represents ownership in a particular company. If a company has 1000 shares outstanding and you own 5 shares, you are a 0.5% owner of the company. Owning a stock of a company generally implies that you have confidence in the company’s growth prospects, meaning that as the company’s share price goes up, the value of your investment will rise too. Learn more about how to invest in stocks here.
Bonds (also known as fixed income instruments) are issued by companies, institutions and governments to investors. The investor loans the money to the issuer and receives principal and interest repayments on a defined schedule as per the terms of the bond when it was issued. With a bond, the investor is more concerned with the company’s ability to service the principal and interest payments than its ability to grow per se.
Money market instruments are short-term debt investments such as Treasury bills, municipal notes, certificates of deposit (CDs) etc. Money market securities are largely intended to provide safety and liquidity in a portfolio as the interest rate they earn tends to be relatively low.
Exchange Traded Funds are publicly traded securities that offer the investor the opportunity to invest in a portfolio of underlying securities without having to buy them individually. The most popular example of an ETF is the SPDR S&P 500 ETF, which tracks the S&P 500. Trading just like a regular stock, ETF prices can fluctuate from day to day depending on the prices of their underlying securities.
A mutual fund is a pool of capital collected from hundreds or thousands of investors which is then used to invest in securities including stocks bonds, money market securities and other such assets. The capital is deployed by professional money managers according to the fund’s objectives and constraints.
Real estate refers to physical property including land and buildings. Investors can invest in a variety of real estate including:
– Commercial real estate consisting of office buildings, warehouses and retail outlets such as malls.
– Residential real estate consisting of undeveloped land, townhouses, condominiums, and/or other types of inhabitable locations.
– Industrial real estate consisting of mines, farms, factories etc.
A REIT is a pool of money that is collected from hundreds or thousands of investors and deployed into a collection of properties or other real estate assets.
Commodities are raw materials or agricultural products that can be bought and sold on open markets such as oil, copper, gold, coffee etc.
The term risk appetite refers to the willingness and ability to take a specific level of risk. Different investors can have different risk appetites based on their age, objectives, and personalities. For example, a young graduate with a whole career ahead of him/her is likely to have a far greater level of willingness to take risks than someone who is on the verge of retirement. These differing risk appetites then inform what type of securities that investor would purchase.
The younger investor would likely have a greater weighting of higher-risk assets such as stocks which have historically provided greater long-term returns while the older investor would weigh his/her portfolio with government bonds or money market instruments. The rationale behind this is simple: in a scenario where the market crashed, the younger investor has 40+ years to recoup his/her money while enjoying significantly higher returns in the average year.
In recent times, one of the biggest debates in the financial world has been the question of active versus passive investing.
In active investing, there is a designated money management professional or team that works to screen securities and deploy money to the ones that they believe to offer outsized returns. Depending on the choices of the fund manager, the value of your investment would rise or shrink over the years. For the expertise and market knowledge that fund managers provide, they charge management and possibly performance fees as well.
In contrast, passive investing bets on the long-term upward trajectory that stock markets tend to exhibit. While the active investing strategy’s main goal is to outperform a defined benchmark, the passive investing strategy attempts to simply replicate it. The key difference here comes from the fee differential between the two strategies. Fund managers typically charge management expense ratios that oscillate around the 1% mark. Passive strategies that buy and hold ETFs mirroring the market are available for as little as 0.05%.
Different types of investments have different payoff profiles. However, the income that they all provide can be segmented largely into 3 categories: dividends, capital gains and interest. In Canada, these income types are taxed in different ways. However, by placing your money in certain types of savings plans, there are several tax benefits to be yielded. The most common ones include:
Some of the most common questions asked by beginners are how to invest money, where to invest money, what to invest in, or even how to start investing. If you are a young investor, one of the most traded asset classes in the world is equity i.e. stocks. Analyzing stock markets and picking out the ones with the highest growth prospects is truly a skill that is learned and honed with practice. However, while growth stocks win the most attention, dividend stocks tend to fly under the radar. If the investor is looking for a regular income stream similar to a fixed income investment, but with slightly better growth, the dividend stock offers an attractive proposition.
There are two main ways to invest in dividend-paying stocks: via exchange traded funds and by buying the stocks directly.
The ETF solution offers a quick and easy way to increase exposure to dividend-paying stocks as a dividend ETF generally includes dozens of dividend stocks within its constituents. This means that by buying the ETF, you are already diversifying your income streams as dividend cuts in one or two stocks would largely be offset by other dividend growth in the broader portfolio.
In the second way, the investor actively screens for and selects a basket of dividend stocks to buy. This is more of an intensive task as research has to be conducted into the individual company and wider industry to ensure that it is conducive to long-term growth. Next, the safety of the dividend has to be analyzed from a dividend payout ratio perspective. Defined as the percentage of income that the company pays out in dividends, a low payout ratio generally indicates that there is room for the dividend to grow over time. Lastly, the investor then needs to assess how to allocate his/her capital across the opportunities available.
In growth investing, generating income via shareholder distributions such as dividends is not a major priority. Here, the investor attempts to select stocks that are poised to offer the maximum capital gains i.e. increases in stock price year on year. This entails identifying stocks that are undervalued and thus mispriced, and holding them until they rise in value. When investing in the stock markets, investors have access to a wide variety of publicly available information that companies are obligated to disclose about themselves at the end of each fiscal quarter and year. By piecing together this information, investors can make informed decisions about mispriced equities and invest accordingly.
When performing fundamental analysis, the investor takes both qualitative and quantitative factors into consideration. Some qualitative factors that may be looked at include:
Business Model and Corporate Strategy
By analyzing how the company makes its money and what its growth plans entail, investors can make a judgement on how they will fare in the industry long-term.
Even if the company has a great product and is located in a great industry, its stock may not be the best buy if the product is easily replicable by competitors, if there are lots of competitors in the industry or if there are low barriers to entry for new companies entering the industry.
Experienced management teams have an ability to steer companies through challenging circumstances where less experienced teams might fail.
This refers to the organizational relationships between management, directors and other stakeholders of the company as stipulated by the company charter and bylaws. Businesses that run their operations fairly and ethically are more likely to survive long-term from a regulatory perspective.
Industry and Macroeconomics
Assessing the company`s positioning within an industry in terms of brand and market share is a critical factor in growth investing. Macroeconomic and regulatory issues should further be considered to ensure that you are not investing in companies facing a restrictive regulatory environment or adverse financial forces.
The story doesn’t end there though. While qualitative factors are important, they need to be backed by sound numbers. To assess these numbers, a company’s financial statements (quantitative factors) are some of the most useful documents to read. These are:
The income statement defines the revenues, profits and losses earned over a certain fiscal period. Investors may assess a variety of variables here including revenue growth, net margins, gross margins, dividends etc.
The balance sheet outlines the total assets, liabilities and equity of a business at a particular point in time. Assets can include inventories, land, buildings, equipment etc. while liabilities represent debt that has to be paid back. The difference between assets and liabilities is equity, which is calculated as the total capital provided by shareholders plus retained earnings from the previous year.
Cash flow Statement
Divided into three sections (Cash flow from Operations, Cash flow from Investing, Cash flow from Financing), the cash flow statement tracks the movement of cash in and out of the business. Often ignored by rookie investors, the cash flow statement is often hugely valuable as it is difficult to manipulate cash in a business. On the other hand, earnings from the income statement can easily be manipulated by creative accounting practices.
Using a combination of these historical financial statements and their own assumptions regarding growth and profitability, investors will attempt to triangulate a suitable valuation for the company. This is known as the stock’s intrinsic value. If this valuation turns out to be greater than the company’s current stock price, the investor will buy the stock and hope for the price to rise over time.
While the two practices mentioned above fall under the fundamental investing umbrella, there are also a large number of technical analysts who use chart trends and statistical techniques to make returns. While fundamental investing revolves around analyzing public information to make informed decisions, technical analysis looks at a stock’s trading activity including price movement and volume to gauge strength or weakness. Some indicators that technical analysts use are:
When it comes to initiating your investment journey, it can be daunting to try and find the best investments and/or best investment companies. What is important to remember is that the best way to invest money is a process that is experimented with over time and may not be the same for you as it is for someone else. But even before you start investing, there are some tips and best practices that you should be aware of:
People have a tendency to upsize their life in-step with upsizes in their income. As they earn more over the years, they then find that regardless of the higher income they generate, they still do not incur too many savings. While it is important to enjoy your wealth, it would be advisable to upsize only slightly with the majority going to savings that can be turned into investments.
But while saving is important, saving alone does not generate additional growth. If you keep $100 under a mattress for 5 years, it will still be $100 when you remove it too. However, in those same 5 years, inflation has not ceased meaning that the $100 today are not worth as much as they were 5 years ago. Inflation is almost always going to outpace any rate that banks offer you for your deposits meaning that that it is essential to start saving even small amounts.
Don’t put all your eggs in one basket. Never test the depth of the river with both feet. The list of proverbs that talk about diversification goes on. And rightfully so. By placing all your money in one asset or asset class, you are exposed entirely to movements within that space, leaving you at the mercy of the market. Diversification can help mitigate this to a large degree.
As noted above, differing objectives can bring about differing risk appetites. Prior to investing, ensure that you know what your exact objectives are and invest accordingly. If you are investing for retirement that is 45 years away, you can probably afford to place your money in riskier asset classes like stocks. However, if you are investing for a short-term goal, then a conservative fixed income investing approach may be the way to go.
Prior to trusting a money manager with your capital, ensure that the fees they charge are justifiable given their long-term track record. If they are charging you 1% for performance that is barely above the benchmark, then you would be better off investing via a passive ETF strategy.
For sophisticated investors, there are several types of alternative investments on the market. Defined as assets that cannot be classified under conventional asset classes, alternative investments may include investments in:
For conservative investors, investment bonds are a solid way of gaining fixed returns at low risk. In some cases of municipal bonds, the bonds are also tax-free. The risk from these investments can vary based on the issuer’s financial strength. For example, bonds issued by the federal government are generally assumed to be risk-free as the rationale is that the government can always print more money to make payments. Corporate and institutional bonds are thereafter priced based on these federal bonds. When analyzing fixed income bonds, investors might look at a range of factors including:
1. Financial statements to assess cash flow
2. Creditworthiness and capacity to pay based on credit ratings
3. Collateral that can be offered in the event of a bankruptcy to cover the debt
4. Covenants that govern the bond and its payments
5. Other risks comprised of:
Canada Savings Bond: A savings product that is issued and guaranteed by the federal government, the CSB provides a guaranteed rate of return with 3-year maturities. The bond itself can be cashed out any time and earns interest until the cash-in date. At maturity, new rates based on the going market conditions are set.
Segregated Funds: Similar to a mutual fund, segregated funds are pooled investment funds that are set up by insurers. The difference from a mutual fund arises from that fact that notwithstanding fund performance, a minimum percentage of payments are returned when the fund matures.
Guaranteed Investment Certificate (GIC): Offering either fixed or variable rates, GICs are protected investments where the initial principal will not be lost.