This article is the fifth in a series on personal finance and investing at different stages of your life. As some issues may overlap the different stages of life, they could be covered in a prior or subsequent article. For the full series go here.
Here you are, in your thirties or thereabouts. You're in the work force, married with a young brood running about, a sizable loan on the car and an even bigger mortgage on the house. There are bills to pay. Money is tight.
But you can still get started with building a portfolio of financial assets through dollar-cost averaging, a technique for investing small dollar amounts over time. Here are 10 points that address whether or not this is the right course for you at this stage; and how to get your portfolio up and running if decide it's time to get investing.
1. Pay down debt first?
Not everyone will be interested in accumulating financial assets at this life stage. Many knowledgeable people say it's better to pay off debt first. "You are much better off to focus on buying a home and paying off all debt, including the home mortgage, before even starting to [invest]" recommends David Trahair, author of the book, Enough Bull .
Home equity can be used as collateral and the gains on selling a house are tax exempt, Mr. Trahair says. Moreover, a house can be turned into a retirement fund: seniors can downsize or go to renting and use the money left over to support their retirement. Or they (and homeowners whose jobs allow them to move around) can sell their house and buy in a cheaper region. For example, a Vancouverite moving from the average house in his city to the average house in a New Brunswick city would net close to $300,000 cash once the real-estate transactions settled.
Another argument in favour of paying off all debt first is that the risk-adjusted return is likely to be better than what can be earned on financial assets. When lending rates are at 5 per cent, for example, amortizing debt yields a certain and after-tax return of 6 per cent to 7 per cent. That return is near the upper limit of the average annual return historically earned by the best paying of financial assets - common stocks - and they provide such returns at higher risk levels.
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2. Pay off debt AND invest?
What if lending rates are below 5 per cent, like they are currently. Indeed, some mortgage rates are now as low as 2 per cent. The returns on financial assets have a greater chance of beating debt repayment.
"Another argument in support of caution when considering an investment in a home is that the investment is completely undiversified," cautions Moshe Milevsky, a York University professor and author of Wealth Logic . A portfolio of financial assets could provide diversification of wealth and offset risks such as:
- becoming unemployed and having to sell your home during a downturn in house prices (the plight of many Americans over the past two years)
- a job affected by the fortunes of the real-estate market, such as real-estate agents
- owning a home in an area dominated by one employer that could become insolvent or exit (for example, a one-industry town)
- various local risks to homeownership, such as rezoning of nearby properties for commercial use, the loss of beautiful trees gracing a street, or an uninsurable "act of God" that causes major structural damage
Homeownership is not everyone's cup of tea, either. Some people don't want to be saddled with household maintenance. Other people need to relocate frequently because of their jobs. Yet others may have an opinion that the housing market is too overvalued to be an owner at a certain time. In other words, people renting their shelter don't have to pay down a mortgage and have more latitude for getting an early start on the compounding of returns in the stock market.
3. The power of dollar-cost averaging
When you are married with kids and a mortgage, money can be scarce. But you can still invest in the stock market through dollar-cost averaging. This involves investing small dollar amounts at regular intervals. It is often set up through a systematic plan that transfers deductions from a paycheque or bank account into a mutual fund.
Dollar-cost averaging into exchange-traded funds (ETFs) and stocks is usually not as convenient or economical when carried out through brokerages. Some ETF companies, like Claymore Investment Inc. are trying to be the exception, but generally mutual funds are the places to go for dollar-cost averaging.
Many advisers recommend dollar-cost averaging to minimize the risk of investing at a market top. "Dollar-cost averaging is as close to infallible investing as you can get," says Roy Miller, in David Chilton's The Wealthy Barber . It can make downward fluctuations work for you by picking up more units when prices are lower. Consider $100 invested in three periods at prices of $10, $5, and $7.50. The number of units bought is 10, 20, and 13.3. Multiply the total number of units (43.3) by $7.50 to get the current value, $324.75. That's nearly $25 more than the $300 put in, even though prices are down.
4. Refinements to dollar-cost averaging
Another way to average in a position is value-cost averaging, as described by Michael Edleson in Value Averaging: The Safe and Easy Strategy for Higher Investment Returns. The basic idea is to adjust contributions to keep a targeted value constant. So, if the value of your holding has fallen 5 per cent below target, the deposit in the next period is increased by the same percentage to maintain the target. As a result, more units are acquired at low prices and fewer at high prices, compared to dollar-cost averaging.
If you have a lump sum to invest - a maturing guaranteed investment certificate or an inheritance - "dollar-cost averaging is an inferior strategy," suggests Mr. Milevsky. It's better to invest the sum all at once (and live with the volatility) because stocks rise over the long run. When money is averaged into a rising trend, it results in a higher cost base.
5. Index funds are the way to go
Mutual funds are one of the best places for investors interested in dollar-cost averaging, as noted above. They also have the advantaging of diversifying small dollar amounts over a portfolio of many stocks. But which of the thousands of mutual funds are best to own?
Warren Buffett, arguably the greatest investor of our time, has long said the best way for investors to own stocks is through index funds. As he wrote in his 1997 letter to Berkshire Hathaway Inc. shareholders: "Most investors will find that the best way to own common stocks is through an index fund that charges minimal fees." Many other investing greats such as Benjamin Graham and Peter Lynch say the same thing.
Index funds simply buy the stocks in a market index, which enables them to charge considerably lower annual management expense ratios (MERs) than mutual funds with portfolio managers who are paid to pick stocks. Empirical studies have shown that this cost advantage beats the stock-picking skills of professional money managers in the majority of cases. Among the lowest cost index funds are the TD e-Series Funds.
6. Directly sold mutual funds
Some mutual-fund companies sell their wares without huge advertising budgets and don't pay monetary incentives (trailer fees) to financial advisers and planners. This means they can charge low MERs on even their actively managed funds. Some examples of fund families in this category are Beutel Goodman and Co. Ltd, Steadyhand Investment Funds and Leith Wheeler Investment Counsel.
Their MERs are still higher than index funds but they come with extra services that some investors may find makes up for the extra cost. Front-line staff can assist (at no charge) with asset allocation, rebalancing and other investing tasks related to funds offered by the company. Margot Bai, author of Spend Smarter, Save Bigger , observes: "You get the best of both worlds: low fees and unbiased, professional investment advice."
7. Dividend Reinvestment Plans (DRiPs)
Small dollar amounts can also be invested over time through the Dividend Reinvestment Plans (DRiPs) offered by companies paying dividends. Dividends are the lowest taxed form of income. Dividend growth (resulting from companies raising their dividends over time) provides an additional boost - a feature that particularly appeals to dividend bloggers such as The Dividend Guy . A gathering spot for DRiP investors is www.dripinvesting.org.
DRiPs allow registrants to reinvest dividends without charge and often come with Share Purchase Plans (SPPs) that permit the purchase of shares directly from the company, without charge and frequently at a discount from the market price. DRiPs don't have MERs and so are even cheaper than index funds, although there is a bit more work in having to chose and manage a diversified basket of DRiP stocks. Selected issues of the Investor's Digest of Canada contain lists of DRiPs in Canada.
Bob Gibb converted to the DRiP approach after reading Cemil Otar's Commission Free Investing . "Over 15 years with strategic small monthly investments in DRiPs, I've built up a sizable tax-advantaged, dividend-yielding portfolio," he reports. "The dividend income is now well into five figures and will replace my wife's income from her part-time job when she retires."
8. Asset allocation and location
Asset allocation is about spreading savings over stocks, bonds and other assets. See Tips 3-6 in "Having kids? Here are 10 money tips to guide you" for several aspects of this topic. One point to expand upon relates to life-cycle funds (which automate the shift from growth to conservative assets as you get closer to retirement). In addition to the fees and the fact the asset allocation may not align with the one you prefer, such funds might not be a good fit for people who like to have flexibility when they take retirement, the timing of the shift out of growth funds and other variables.
Asset location is about spreading assets over non-registered and registered accounts. A general rule is to at least have the highest taxed investments, notably interest-paying ones, in the registered (tax-deferred) accounts. Contributions to RRSPs are best made when employment income is in the high-tax brackets (if made while in the low-tax brackets, consider delaying the claim tax deduction to a period when income will be in a higher bracket). RESPs might be a good first choice for young families because of the grants and ability to transfer funds (minus the grant) into an RRSP at the end of the plan. If you're unsure where to put savings, TFSAs are good holding places until a decision is made.
Another registered plan is employer-sponsored pensions. A defined-benefit pension may render it unnecessary to divert funds away from debt repayment into financial assets if the goal is to create a conventional retirement fund. But you might still create your own portfolio if you have other goals such as early retirement, want to hedge the risk of employer insolvency, or augment your employer's plan. A defined-contribution plan leaves investing decisions in the hands of the employee and this vehicle may be the better location for a portfolio, especially if the employer matches employee contributions.
9. Do you need a financial adviser?
In Canada, there is a strong case to be made for educating yourself and becoming a self-reliant investor - if only to be in a solid position for selecting and evaluating advisers. "My best investment move was to realize no one will look after my money better than I will myself," declares Mr. Gibb.
First, most financial advisers are not interested in accounts under $100,000. Some may take smaller investors, but don't expect a high level of personalized service. "I bought my first mutual funds from a bank teller," says the author of the Thicken My Wallet blog.
"We picked funds based on the best named funds." In short, you may be better off on your own using a passive approach such as the Couch Potato portfolio. The amount of time required is about 15 minutes a year, according to MoneySense magazine. Yet, the approach will outperform the majority of financial advisers, thanks to lower fees.
Second, many financial advisers are paid by commissions embedded in financial products. There is an ever-present risk that products will be recommended on the basis of the highest commissions instead of the client's interests. At many firms, if advisers don't meet their sales targets, they could be dismissed or denied bonuses. Don't be beguiled by a charming personality of a top-performing adviser. "The financial adviser who fleeced me the most was also the one I found most likeable," remarks Michael J. Wiener, now a do-it-yourself investor and author of the blog Michael James on Money.
10. Family matters - parents
During the life stage of marriage, children and mortgage, your own parents are typically approaching old age. As Bernie Madoff, Earl Jones, the Institute for Financial Learning and other alleged or actual Ponzi schemes have recently highlighted, elderly persons are predominantly the victims of these scams.
Some seniors are more susceptible to financial predators, which seem to abound in Canada judging from the fourth-worse ranking assigned to Canada (worse than Nigeria) in the 5th Global Economic Crime Survey recently conducted by PricewaterhouseCoopers LLP. Adult children in Canada should not dismiss lightly their moral obligation to watch out for mom and dad.
But they also have a legal obligation. "In most jurisdictions in Canada, adult children are legally liable for caring for their parents. Generally, adult children are liable to pay parental support if their parents supported them financially when they were minor," writes tax and estate lawyer Christine Van Cauwenberghe in her book, Wealth Planning Strategies for Canadians 2010 .Report Typo/Error
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