The Ultimate Investment Challenge

In the world of investing, there are numerous options and places to put your money, some riskier than others. You can pay into an RRSP fund and immediately get a tax break. Fixed-income and equity options look appealing if you can manoeuvre the complexities. And then there’s the garden-variety mutual funds – equity funds, bond funds, index funds, segregated funds, hedge funds – and exchange traded funds or ETFs.

Regardless of which vehicle you go with, investing basically boils down to making a choice between “loanership” and “ownership.” Once you learn the advantages of lending money to people and financial institutions (less risk) versus buying a stake in a company or other property (greater rewards but more volatility), you’ll be well on your way to financing your future.
Here are 10 investment tips, some basic and others somewhat complex.

1. The magic of compounding

One of the simple rules of investing is one of the most amazing. The Rule of 72 dictates that dividing the number 72 by your yearly rate of return on an investment will tell you how many years it takes for the investment to double. For instance, if an investment returns 6% a year, the principal will double in 12 years. If you can get 8% a year, your investment doubles in nine years.

The rule shows the importance of investing early in life. Making small contributions early can produce better results than making large contributions late. In his book The Automatic Millionaire, David Bach uses the example of Billy and Kim. Billy starts investing $3,000 a year at age 15 for five years, then never invests another penny. If he has a 10% return compounded annually, by age 65 his $15,000 investment will be worth $1,615,363.40. By contrast, Bill starts investing $3,000 a year at age 27, and does so each year until he turns 65. If he also has a 10% return compounded annually, at age 65 his $117,000 investment will be worth $1,324,777.67.

While it’s never too late to build up a retirement nest egg, it takes a lot less money to do so if you start young.

2. Fishing in foreign waters

People seldom stray beyond their borders when investing, a phenomenon called “home country bias.” They tend to play it safe, investing in Canadian companies they know about and are most familiar with and avoiding the additional complexities caused by ever-changing foreign-exchange rates. But Canada’s TSX-listed companies make up a fraction of the world’s stock market capitalization, only 3%.

In the spring of 2005, the federal government eliminated the 30% foreign content limit within registered retirement savings plans and other tax-deferred savings plans, making it easier for Canadian investors to take advantage of emerging world markets.

“When you take a chunk of the world that has not consumed before and bring them into the consumer market, you create tremendous opportunities and challenges,” says Warren Jestin, chief economist with Scotiabank. “It’s China, Brazil and India. You’re getting consumers moving into the consuming market vigorously, and businesses starting up where there were no businesses – so all of a sudden you have demand for energy and industrial commodities such as nickel, zinc, copper and uranium.”

Proof that the foreign markets should not be overlooked, the Morgan Stanley Capital International World Index neared the end of 2006 up 16.8%, compared to 13.2% for the MSCI North American index. Moreover, the total market capitalization of the Shanghai Stock Exchange increased by 120% in 2006 over the previous year.

3. Don’t believe the hype

The saying in investment circles is that once your cab driver starts giving you stock market tips, it’s time to get out. The explosion in communications – the Internet, investment newsletters, blogs and financial TV channels like ROB-TV in Canada and CNBC in the United States – has educated people about investing beyond anything imagined even a decade ago. But amid this information overload, it’s often hard to distinguish between unbiased research and “market noise,” what Investopedia.com, the online investment dictionary, defines as stock market activity that is not reflective of overall market sentiment.

Buying shares of XYZ Explorations Ltd. based on a brother-in-law’s hot tip is gambling. Doing your due diligence by researching earnings and profits and debt and management and market forces is called investing.

4. The difference between a good company and a good stock

Two major types of investment styles are value and growth, and there is point in every investment cycle when one does better than the other.

Value companies tend to be mature firms whose stock prices may not vary much, but whose low expenses result in large profits that often mean continually increasing dividends. Growth companies reinvest most of their income back in the company to increase production, often resulting in rising share prices but little if any profit left for dividends.

Ben Graham, the father of value investing, had a protégé named Warren Buffett. Value investors like Buffett, who became one of the world’s richest people largely by investing in common stocks, try to find companies whose shares have fallen for a variety of reasons – too much debt, bad management, bad products – and patiently wait for things to turn around. Factors that can change for the better, such as economic conditions, new management, solving legal problems and reducing debt levels, can represent hidden value in the stock of a company that seems down and out. The adage is that these investors “try to buy a two-dollar share for one dollar” by investing in a bad company that may be a good stock.

Emulating Warren Buffett, of course, takes painstaking research, but you can share the workload by pooling knowledge with fellow investors. Popping up all across the country, investment clubs represent a safe environment to learn about the ins and outs of financial markets. John Bart, founder of the Canadian ShareOwner investment club, regularly publishes research on “great stocks” and “grief stocks.” He charts each company’s revenue and earnings per share over a period of time. His members look for companies that have both lines moving steadily upwards.

5. Investing in real estate

Despite a slight cooling of the Canadian real estate market, there are many investors eager to make their fortune in real estate because the housing reports make it sound like an easy-peasy investment. Yet many of these reports don’t mention that owning rental property can be a full-time job, managing tenants and maintaining property.

Don Campbell, a real-estate investor and instructor with the Calgary-based Real Estate Investment Network, says there are four mistakes home buyers make: not having a real goal; not doing their homework or asking critical questions; creating a confrontational relationship with tenants; and signing documents that are not true.

To avoid the headache of managing the property yourself, consider buying stock in a real estate company or investing in real estate income trusts (REITs), which will continue to be exempt from taxation under new rules proposed to tax income trusts. Calgary-based Boardwalk REIT, which builds, manages and owns apartments and condos in the Alberta and Quebec markets, saw its unit price more than double during 2006. RioCan REIT, Canada’s largest REIT with $8 billion in market capitalization, saw its unit price shoot up nearly 35% during the last half of 2006.

6. How bonds work

Bonds usually increase in value when interest rates are falling and vice versa. If you buy a $1,000 bond with a 4% coupon or interest rate, and the rates move up and a new $1,000 bond yields 5%, you have to reduce the asking price to sell the bond. For this reason, bonds are often considered a defensive holding, going up when stock prices are falling.

In the ’80s, North America experienced a two-year recession, the longest in the last half of the century. The prime interest rate, which hit a record high of 22.5% in 1981, began a 20-year decline that eventually took it to 3.75%. During this period, long-term bonds earned a compounded average of 13.8% a year.

But since August of 2004, the prime interest rate has been rising, and for 12 months through July 2006, the average bond fund had a 12-month gain of only 0.65%. The U.S. now has an inverted yield curve – where short-term bonds actually pay more than long-term bonds – and that usually foreshadows a recession. However, with the Bank of Canada and the U.S. Federal Reserve on the verge of reducing interest rates again, many analysts feel bonds could outperform equities during the next 12 months.

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