Back to Basics – Investing 101
The Financialist • Issue 106 • July 2010
BY CHRIS EYNON BA CFP CIM
After the rollercoaster markets of the last couple of years, now is a good time to take a look at some of the basic tenets and fundamentals of investments and portfolio construction.
Investing vs. Speculating
Investors focus on the long-term prospective yield of assets in relation to their personal goals and objectives. Speculators look for short-term profit with the intent to capitalize on market fluctuations.
Acting on a hot stock tip overheard at a dinner party can be exciting when things work out favorably. However, more often than not, these types of speculative investments bring disappointment. Timing is key when speculating: knowing when to buy is one thing; more important, though, is knowing when to sell. When a speculative stock rises rapidly, human nature kicks in and the desire to hold off on selling as “it may go higher” takes over. Stocks that rise quickly often fall just as quickly and can lead to disappointment and losses.
Market timing is of much less significance to an investor. Investors complete a thorough analysis of the potential long-term returns, safety and suitability of any investment they make, relative to personal goals and objectives. When this process is followed, it becomes simple to determine the right time to make investment changes in your portfolio.
Asset Allocation
The purpose of asset allocation is to balance risk vs. reward in your investment portfolio.
The process of asset allocation starts with determining your personal risk tolerance. Either through a formal questionnaire or a personal interview, your Rogers Group Financial advisor will work to create an asset allocation strategy that is specifically tailored to you.
Once your asset allocation strategy is set out, your portfolio construction can begin. Your advisor will then help you select securities amongst the various asset classes such as cash, fixed income and equities.
Most financial professionals agree that asset allocation is the most important decision an investor can make.
Diversification
Diversification is a technique that is employed to lower unsystematic risk in an investment portfolio.
Risk reduction though diversification works because each security in each asset class will generally not move up or down at the same rate or time.
Equity diversification is accomplished by owning stocks in different industries, sectors and geographical locations.
Fixed income diversification can consist of owning various types of bonds such as government and corporate, as well as holding guaranteed investment certificates with differing maturity dates.
Although systematic or “market risk” cannot be completely eliminated, adequate diversification will allow the investor to achieve higher average long-term returns while experiencing lower volatility.
Dollar-Cost Averaging
When is the right time to buy? There are numerous theories as to the best hour, day, month or even season to invest in the stock market.
A very simple strategy to take away the decision of timing contributions to your portfolio is Dollar-Cost Averaging (DCA). Dollar-Cost Averaging is the process of investing a fixed dollar amount in a specific investment on a set schedule. More units of the investment are purchased when the markets are low and fewer are purchased when the markets are high. Over time, this generally lowers the average cost of the investment as well as lessens the risk of buying at the wrong time.
Tax-Sheltered Accounts
Canadians are afforded the opportunity to shelter some of their investments from taxation. Registered Retirement Savings Plans (RRSPs) and Tax Free Savings Accounts (TFSAs) are two examples.
RRSPs are a terrific way for Canadians to defer taxation of savings while at the same time reducing income taxes in the year of contribution. You can contribute up to 18% of your earned income to a limit of $22,000 in 2010. Maximizing your RRSP contributions is a great way to save for retirement and reduce your current income tax bill.
In 2009, the Federal Government brought out the TFSA. This is a new type of investment account that allows you to entirely eliminate taxation on the growth of your investments. Each calendar year, eligible Canadians can contribute up to $5,000. If you miss a year of contributions, you are allowed to carry the unused room forward – similar to an RRSP. Unlike an RRSP, TFSA contributions do not create a tax deduction. In addition, while RRSP withdrawals are taxable as income, TFSA withdrawals are completely tax-free.