How to Become a Smart Investor

Here’s everything you need to know about how to become a smart investor in Canada.

Learning to invest doesn't have to be daunting. It can be one of those tasks you know you probably should make a priority, but keep putting off because you just can’t deal. Fair enough — like anything unfamiliar, investing can seem daunting if you’ve never done it before. But it doesn’t have to be complicated. In fact, some of the simplest approaches to investing are the most lucrative. So, here is how to become an investor and get ready to cross “learn to invest” off your to-do list.

Why Invest?

If you’re diligently socking money away in a high-interest savings account, you may feel that’s good enough. Your savings are protected and earning a guaranteed rate of interest, while investing doesn’t guarantee anything.

It’s true — the value of investments can go up or down so there is some risk involved. But not investing carries risk, too, because of inflation. Unless your savings earn a rate of interest that outpaces inflation, the purchasing power of your money will eventually erode and could leave you worse off than when you started.

“Over time, stock market investments tend to trounce inflation. But over time, savings accounts don’t,” says Andrew Hallam, investment expert and author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School.

If, for example, you put $10,000 in savings in 2003, you may have earned a compound annual return of 1.73% over the 15-year period, which only matched the inflation rate. You’d now have $12,934, but the same buying power that $10,000 gave you 15 years ago. Your money essentially treaded water.

If, on the other hand, you had invested $10,000 in a Canadian stock market index 15 years ago (starting Nov. 1, 2003), it would have been worth $30,046 on Oct. 31, 2018, notes Hallam, which easily beats inflation.

Bottom line: if you learn how to become a smart investor you can minimize your risks and maximize your returns, so your savings don’t lose value to inflation.

Become an online investorWhen Should I Invest?

The best time to invest is now. What’s the rush? The earlier you start investing, the greater the effect of compound returns, what Hallam refers to as the world’s most powerful financial concept.

In his book, he uses the following example to illustrate the snowball effect of compounding. If you invest $100 with a 10% annual rate of return, compounding turns your investment into:

  • $259.37 after 10 years
  • $672.74 after 20 years
  • $1,744.94 after 30 years
  • $4,525.92 after 40 years
  • $11,739.08 after 50 years
  • $78,974.69 after 70 years
  • $204,840.02 after 80 years
  • $1,378,061.23 after 100 years

While most of us won’t have 100 years to let our money grow or earn consistent returns of 10% a year, the example shows how even modest savings can grow exponentially by compounding over time.

What Can I Invest In?

There are many types of assets you can invest in, the most common being stocks, bonds and mutual funds.

  • A stock is a share of ownership in a company, which entitles you to a percentage of profits in the form of dividends. Since you don’t know how well the company will perform in any given year, there’s no way to predict what your investment returns (or losses) will be.
  • A bond is a loan you provide to a business, government or other organization with the expectation that you’ll be paid back with interest after a given period. These investments are less risky, but don’t offer as high return potential as stocks.
  • A mutual fund is a professionally managed collection of stocks, bonds and other securities that individual investors can pool their money into.

A better question, though, is what should I invest in?

According to Hallam and other proponents of passive investing, smart investors should choose a diverse portfolio of index funds or exchange traded funds.

Index funds and ETFs are similar to mutual funds in that they are a collection of stocks, bonds or other investments, but with a key difference — they aren’t actively managed by a professional. Passive funds have two major advantages for investors, which we’ll explore below.

Passive vs. Active Fund Management: What’s the Difference?

Active fund managers conduct research and scour the business landscape to find the companies, stocks and bonds they think will do well for investors. To be compensated for their efforts, they take a percentage off the top of your portfolio each year, regardless of how well (or poorly) the investments perform. In Canada, that fee averages somewhere between 2% and 3%, and is among the highest investment fees paid in the world.

To be worthy of the fees they charge, active fund managers ought to be picking investments that earn at least 2% to 3% more than the market overall. The problem is, most don’t.

In 2017, for example, not a single Canadian fund manager investing in U.S. stocks delivered higher returns that the S&P 500 index (which includes the 500 largest U.S. stocks and is considered the best indicator of U.S. stock market performance at any given time). Research shows that even professionals who do manage to beat the market some of the time aren’t able to provide better-than-market average returns over the long-term.

Passive funds like index funds and ETFs, however, aren’t curated by a professional to outperform the market. Instead, they simply hold all the stocks or bonds in a particular index, with the purpose of matching the returns of the market overall.

Passive funds provide a couple of major advantages over those that are actively managed:

  • There’s less risk, since you’re not betting on a fund manager to pick market winners that could end up being duds.
  • Fees are way lower — usually in the tenths of a percent — because you don’t have to pay for those fancy fund manager services. The less you pay in fees, the higher your earnings, and the greater the compounding effect over time.

What is the “Couch Potato Strategy”?

The couch potato approach to passive investing is a very low-maintenance way of creating a balanced and diversified portfolio of low-fee investments that will give you solid returns over time. It requires so little effort, it’s couch-potato-esque.

Here’s how it works.

You divide your investment contributions between low-fee index funds or ETFs that track the following markets:

  • Canadian stock market index
  • International/U.S. stock market index
  • Canadian bond market index

How you divvy up your investments — say, a third in each one, 25%/25%/50%, or any other allotment — depends on your comfort with risk and investment time horizon. As mentioned above, stocks are riskier than bonds, but offer the potential of higher returns. Generally, the more time you have to let your investments grow, the better you can withstand the risks of short-term market fluctuations and the more heavily invested you can be in stocks. Short-term investments, on the other hand, should be weighted more heavily toward bonds to minimize risk.

So, your money is now invested in a huge smorgasbord of assets that vary by type (stocks and bonds), industry (since each index is made up of all the companies in that market, not just a few supposed “winners”) and geographical region. This diversified, balanced portfolio will give you a very close match to overall market performance, which is the goal. Remember, you don’t need to beat the market to be a successful investor – you just need to beat inflation, which markets as a whole are proven to do over time.

After you’ve set up your portfolio, you’re pretty much done. Once a year, check to see if the value of your investments has strayed from your chosen allocation. If necessary, rebalance your portfolio to get back to your original allocation.

That’s it. A set it and forget it strategy that requires your attention for a few minutes a year.

Now, for those who want to take the couch potato hands-off approach to the extreme, robo advisors and discount brokerages such as Just Wealth, BMO SmartfolioQuestrade, NestWealth, WealthBar, Wealthsimple, Planswell and ModernAdvisor will build a portfolio of low-fee funds for you that match your risk profile, set up automatic contributions, and many will even rebalance your investments annually. It doesn’t get any easier than that.

How to become a smart investorHow Much Money Do I Need?

Contrary to what you might think, you can start investing with any sum of money, large or small. There is no minimum required to buy index funds, and you can set up automated transfers online for free. To buy ETFs, you need to open a brokerage account, which may require a minimum portfolio size. While ETFs charge lower investment fees, you have to make each online purchase manually and pay a small commission for every transaction.

If you’re going the discount brokerage or robo advisor route, some require a minimum investment that’s not too onerous — around $1,000 — while others have no minimum at all.

Why Robo Advisors and Discount Brokerages are your Best Bet

Aside from the ease and convenience they provide, robo advisors can give many investors better returns than if they took a DIY approach, says Hallam.

“Most DIY investors underperform the funds they own because they have a hard time sticking to a long-term plan,” he says. “When the markets drop, they often fear adding fresh money or they suspend their monthly investment contributions. Many others sell when the markets drop.”

A robo advisor that dispassionately rebalances a low-cost diversified portfolio of ETFs without any speculation can help eliminate or reduce this foolish, emotional behaviour, he says.

To recap, robo advisors are a smart choice because they:

  • build low-cost, diversified portfolios for you;
  • dispassionately rebalance those portfolios once a year;
  • don’t chase winners or shun falling asset classes;
  • are convenient and easy to use.

How Do I Get Started?

DIY investors that want a hands-free approach should look into index funds, such as TD’s e-Series indexes or Tangerine’s index fund portfolios, while those with plenty of money to invest might prefer to open a brokerage account and go the lower-cost ETF route, says Hallam. You can easily get started investing online in Canada.

If DIY investing isn’t your thing, check out the various robo advisors in Canada to find one that meets your needs. Some, such as WealthBar, even have advisors that can help with your financial planning needs, so you can find more money in your budget to invest.

Honestly, though, any of these options are good if you want to become a smart investor. They all beat inflation as well as the high-costs associated with Canada’s actively managed fund industry.

How to become a smart investor

 

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