Investing for Beginners: The Ultimate Guide
On my eighth birthday I received what seemed like one of the weirdest gifts an eight year old could get, but one that would also prove to be of the most life changing (and career defining) I would receive. It was a single share of McDonalds Corporation. My dad, the bearer of this seemingly worthless sheet of paper, went on to explain to me that what this stock represented was a small piece of ownership in the company, or more specifically ‘…a single floor tile in each restaurant’ (floor ownership is NOT actually the case when you own stock). For an eight year old to own part McDonalds is a pretty cool idea, and even at the time I loved it! But what I loved even more as the years passed by was the money I started making – as the stock doubled in value again and again, and again. As I went to school, watched movies and TV and slept at night the invested money kept on doing its growth thing with absolutely no effort on my part. Now 24 years later, I still own that share, and I am here to tell you that if an average middle class eight year old can understand and get excited by the idea of investing, I can almost guarantee that so can you.
It’s certainly not rocket science, and although investing is so often made out to be complex and difficult, I believe you’ll discover that it’s quite simple to do, and do well at. Specifically in this guide you’ll discover:
- The difference between saving and investing.
- Compounding – and how the rich keep on getting richer.
- Types of investments and which is the best to invest in.
- 3 Powerful Steps to start earning higher returns, without the stress.
These are fundamental topics to learn on investing, and I believe you’ll find that in the 10 minutes or so it takes to read this article – the lifetime of results will be as beneficial for you as it has been for me. But on a more serious note, in today’s age, learning about how to invest and then actually doing it is beyond a good idea. For most Canadians is 100% necessary.
Why do we need to invest?
While an entire article can be written on this question (and then some), the points below sum it up:
- For most people, the fat government and corporate retirement pension plans that once existed are quickly evaporating. For most Canadians, pension plans cannot be counted on to fully provide for retirement income. So investing is required to make up the shortfall.
- The government of Canada is paying out less and less for retirement income (CPP and OAS), and placing more emphasis on the individual to save for retirement through investments.
- With the baby boomer population moving through the government system, there will likely be major changes to the existing retirement systems over the next 10 – 20 years that will mean lower retirement benefits.
This guide will give you the information you need to know, to do investing right. It is information that has been distilled from dozens of books, hundreds of articles and years of experience working with clients. We will ‘cut through the fat’ and empower you with the foundational knowledge to make the most effective and profitable investment decisions.
The Difference between Saving and Investing
Most people are pretty familiar with the idea of saving. Saving simply involves withholding something (in this case money) for use at a later date. Saving money is very important: If the car breaks down tomorrow, we couldn’t want to go in to debt to pay for that. That special tropical or European vacation also likely requires the discipline to save. So saving is a critical part of our financial health – but investing goes a step further.
Investing means that you are putting your money to work, to grow and earn additional profits or income over time. So while you work to earn your regular employment income, prepare dinner, flip on a movie and then fall asleep – your investment money is growing away on its own.
For example, my investment in McDonalds happened in 1992, when the price of shares were $8.50 each. Now at the time of writing are worth $115. This represents well over 10 times growth on the invested money, without any new money added or work done on my part. This isn’t unique. It is a very common story for those investing with a long term time horizon (like 10 years or more). And it is exactly how the rich get rich, and keep on getting richer.
Compounding and How the Rich Keep on Getting Richer
The concept of compounding is commonly known to mathematicians and scientists (including Einstein) as one of the most powerful forces in the universe. Compounding is also directly tied to making money in investing, and therefore it is a central idea to understand.
Put simply, compounding means making money off of existing investment growth or profits. In other words, the profits or growth that you earn on an investment helps that investment grow even faster. It involves earning profits on profits. Growth on growth. Over longer periods of time, the effect of compounding gains momentum.
Think of a snowball starting small at the top of a mountain, and growing in size as in rumbles on down. The larger the snowball gets, the faster it continues to grow. This is compounding. Now instead of a snowball, picture a money ball. Its how the rich keep on getting richer while relaxing by the pool – and it’s what you’re learning to do here.
McCompounding in Action
We really want to reinforce this idea of compounding. It’s actually that important. So consider the following example: We have invested an initial sum of $10,000 at a 10% yearly return. So in 1 year we would have $11,000 without any additional investment ($10,000 + $1,000).
Next in year two, again at a 10% return, how much would we have? $12,000? Not quite…
Because after year 1 our investment had grown to $11,000, the 10 growth in year two is based off of the $11,000 value. So 10% of $11,000 is $1,100 which gives us $12,100. The extra $100 here isn’t a huge difference – but over time, and with larger amounts of money the difference can be substantial.
Let’s take a look at what would happen with $10,000 invested in my McDonald’s stock 24 years ago. The average rate of return has been 13.75% per year until the end of 2015.
Without compounding, the 13.75% investment growth would have made $1,375 per year. So if we sold $1,375 worth of shares ever year, for 24 years, we would have sold $33,000 worth of shares. We would also still have our original $10,000 for a total value of $43,000 ($33,000 profits + original $10,000).
With compounding, we leave the yearly earnings alone and allow them to continue to grow over time. Profits on profits, growth on growth. In this scenario, our same $10,000 investment with a 13.75% yearly compounded return would have become $220,208! This means we profited $210,208 over the same time period.
So with compounding we have ($220,208 – $43,000) $177,208 MORE MONEY than without. This is the power of compounding, and really makes me wish I owned more McDonalds shares in 1992.
Investment Tip: Start early, don’t procrastinate! You likely have more than 24 years to invest, especially considering how long and wonderful your retirement will be.
Types of Investments (and which one is probably best)
So far we have seen how investing is different from saving by harnessing the fundamental power of compounding. But, besides McDonalds, what investments are out there? And which one do we decide to invest in? Here we review the fundamental types of investments options, also known as ‘investment vehicles’.
If you buy a bond, you are lending money to a corporation or government, for a specific period of time, in return for a set amount of yearly interest. With bonds, the idea is that the interest rate is GAURANTEED to be paid yearly. Bonds are also generally a safer form of investment, because the bond will eventually expire, and the investor should get a full refund of the money lent (along with the yearly interst). Finally, if a company goes bankrupt, the bond holder will get paid out before any money is returned to a stock holder. So ultimately a bond, especially a government bond, is a very safe investment.
As you may have already gathered from my McDonalds share introduction, a stock or share of a company represents ownership in the company. This includes voting right on the direction of the company. But unlike bonds which guarantee the return you will receive, your return or growth of company stocks are not. This is why leading investors like Warren Buffet (the 3rd richest man alive at time of writing) only invest in stable companies, like Coca Cola, Gillette and yes, even McDonalds. The other way investors help to ensure the safety of returns is to buy more than one kind of stock – a fundamental investing practice known as diversification. You’ve probably heard the old saying, “Don’t put all your eggs in one basket”. This refers to diversification, and lowering risk.
Risk is not a type of investment, but the concept of risk is so important in investing that I felt it necessary to slip this note in here. While bonds are considered less risky than stocks, you are not likely to earn very high returns on your investment. Again, this is in exchange for the safety that bonds provide.
For stocks on the other hand, with the right company, the sky is the limit. But so is the basement floor. Fundamentally, if you are willing to (or able to) accept more risk in investing, you allow yourself the opportunity for higher returns over time. The key is to try and find the right balance of risk, and opportunity for high returns.
The main way to balance risk, as we have briefly touched on, is through diversification. Owing both stocks and bonds, stable companies and risky start-ups in the right mix is how to avoid catastrophic loss, and maximize returns within your overall investment portfolio. The time you have to invest also plays a very important role in how much risk you can take. You wouldn’t want to put all of your money in start-up companies if you are retiring in 1 year, but you might want to see what could happen with some start-ups if you have 30 years!
A mutual fund is a large, diversified portfolio of stocks, bonds, or both that is professionally managed. The idea behind the mutual fund is that you have access to a professionally managed, diverse portfolio of carefully picked stocks and bonds for as little as about $100 per month. A single unit of a mutual fund may represent holdings in 30 – 40 different companies. Alternatively to choose and invest in 30 – 40 different stocks on your own would probably cost thousands of dollars, and require hours to manage. So a mutual fund makes it easy.
In return for this investment management service, an annual management fee of 1.5% – 3% is typically charged on all money invested. This fee may seem small, but as we will see due to the effects of compounding, can be a really big deal.
Exchange Traded Funds
Before the 1980s people who wanted to invest would typically buy stocks, bonds and real estate. From the 1980s to the late 1990s/ early 2000s mutual funds made the most sense. Now as we make our way into 2017 and beyond, the ETF (Exchange Traded Fund) has emerged as the most efficient, effective and easiest to make money investing. So what is an ETF investment?
A single share of an exchange traded fund represents all the companies in a particular stock index. The TSX (Toronto Stock Exchange) index for example includes all the largest Canadian companies. The S&P 500 index represents the 500 largest US based companies. With one share of an ETF, you gain total diversification between all of the companies in an index. There is no professional money manager at the helm of an ETF – all companies in an index are automatically owned. There is absolutely no ‘stock picking’. Therefore if an index (like the Toronto Stock Exchange index) goes up by 2%, the ETF goes up by exactly the same amount.
The main benefit here, that cannot be understated, is that the cost of owning an ETF is about 90% less than the cost owning a mutual fund. The ETF typically costs 0.15% to 0.30% per year to ‘manage’, in comparison to 1.5% to 3% per year in a mutual fund. This means you, as the investor, get to keep the rest of the returns. Your investment returns are not gobbled up by management fees. But professionally managed mutual funds perform better than ETFs right? We get what we pay for, right!?! Well, not exactly…
As counter intuitive as it may sound, somewhere around 90% of mutual fund managers cannot beat the stock market indexes, or ETFs, over the long term. This fact has been proven again and again, in hundreds of analyses and publications. As a proud young stock picker, I myself had a difficult time coming to grips with this fact.
The problem is that picking one of the 10% of mutual funds that can beat the market over time is exceedingly difficult. Try comparing the long term performance of any existing mutual fund to its most closely related index at www.morningstar.ca (or any service that allows this comparison). The mutual fund probably didn’t beat the index.
Try thinking about it like this: How can the average of all investors (invested in the stock market average), beat the average of all investors? It’s mathematically impossible over the long term. You are part of that average. So why pay upwards of 3% in fees in a mutual fund, for long term performance that doesn’t beat the market averages? Ill leave that one with you.
An Optimal Investment Strategy: 3 Easy Steps
With a foundational understanding of investing, its time for the rubber to hit the road. Knowing about how investing works means nothing if you don’t put this knowledge to practice and start reaping the rewards.
The three steps below in this ‘guide within a guide’ will show you an excellent way to do this on your own. Each step will provide you with additional resources if you’d like to expand your knowledge in this area or that.
Ultimately, if you are just not comfortable investing on your own, or would like someone to help answer questions, keep things on track and in perspective of a bigger picture financial plan – consider hiring a financial planner or financial coach.
The following three steps can be completed by anyone willing just to move forward. Don’t worry about perfection for now. You’re learning. But you will likely outperform most Canadian investors if this is adhered to over time.
The 10% rule.
In his book, the Wealthy Barber, David Chilton does a masterfully entertaining job in explaining the basics of investing and growing wealth. The book is actually the top selling Canadian publication of all time. But it pretty much can be summed up in three words: Invest ten percent. The idea here is simple as it sounds. Set up an automatic withdrawal from your bi weekly or monthly pay check, and pay yourself first. Even if your income is as little as $30,000 to $40,000 per year, with enough time you will likely become a millionaire my doing this.
Read: How to Earn 20% per year gauranteed on your investment.
If you read the ‘Types of Investments’ section of this guide, you probably understand that I am more than partial towards Exchange Traded Fund Investing. Make no mistake – I am not getting paid to recommend this and have no interest in recommending this other than to see you do well. There are several different kinds of ETFs out there that you can help you diversify your holdings. Also, if you are interested in picking stocks or mutual funds – try the ‘Core and Explore’ approach. 75% – 80% of your portfolio is invested in ETFs, and the rest of your money is used to try and strategically beat the market with individual stocks or mutual funds.
Read: How to Improve Investment Returns
Use a Robo Investor
A ‘Robo Investor’ is a relatively new concept in Canadian investing that is rapidly gaining popularity. A robo investor (short for Robotic Invetor) builds diversified portfolios of different ETFs based on your risk tolerance of conservative, balanced or aggressive growth. As little as $100 dollars per month can be automatically invested into a portfolio of your selection, and everything else is taken care of for you from here. You get all the benefits of a well balanced portfolio of ETFs at a very reasonable management fee.
So with these three steps, and the knowledge contained in the ‘additional learning’ here you should be set. The big exception for this strategy is if you have an investment matching programme through work. Usually part of a pension or retirement benefits package, many Canadian employers will match a certain % (in many cases 100% of your contributions are matched) of the money you withdraw from your pay check every two weeks or month.
There’s no money like free money, even with higher mutual fund fees involved. So consider applying the 10% rule seen in step one to this programme if you are able to take advantage of one of these types of retirement benefits.