Types of InvestmentsLiam Hendrikse
Following on from my last installment on inflationary risk, it's time to get down to the nitty-gritty of proper financial planning. Let's face it - a good investment does not make a financial plan. A good investment can make you money, but with it can bring a myriad of problems that, if not properly identified and accounted for beforehand, can create a huge headache.
Generally speaking, there are 6 essential steps to developing a financial plan:
- Setting Goals and Objectives - if you're not sure where you're going, or what you want, how do you know when you're there, or figure out how to get there?
- Gathering Data - Irrespective of your goal, you need to understand where you are now, and what your current financial situation is. Keeping all your personal documents to hand, and ensuring you are up to date, is essential.
- Analysis and Solutions - this is essential to reach your goals; the solutions to get from A to B will provide you with a roadmap to your goals.
- Recommendations - Your financial plan should confirm that your goals are achievable, and appropriate recommendations will tell you what you need to do to ensure that you reach these goals.
- Implementing the Plan - now that you've determined an appropriate strategy, it's time to implement the plan to achieve your goals!
- Follow up and regular reviews - this is critical to ensure that you are on track, and if any adjustments need to be made to your plan in order to achieve your goals.
I'd like to share with you, a story about a friend of mine who approached his bank about 18 months ago. He had some money that he had saved up, and was looking to make it grow. Now, his recollection of what happened may be a little bit skewed, but the end result is the same: he invested all of his money in precious metals funds, based on the past year's performance and that fact that he is young and can "weather short term storms." What's wrong with the picture? Lack of proper diversification, a lack of understanding about investments, his investment profile, and a lack of understanding about risk vs return. In addition, there was no plan, no goals, other than the allure of "high returns."
He's not happy - the value of his investments have gone down about 70%. That's a bitter pill to swallow!
From a very basic standpoint, the greater the investment risk, the higher the potential return. The greater the security of an investment (less risk of loss), the lower the return. So investors who accept greater risk, do so in the anticipation of higher returns, and vice versa. Looking at the chart below, we see a myriad of investment vehicles, and their corresponding risk/return characteristics.
Across this spectrum, investment gains are dealt with by Canada Revenue in very different ways. Those gains, that are the result of "interest", are 100% taxable; "capital gains", are only 50% taxable; "dividends" are generally taxed a little more than capital gains, but much less than interest.
So, for example, let's compare an initial investment of $5,000, which doubles to $10,000, and assume a marginal tax rate of 21.55% (the lowest personal rate). If this gain of $5,000 was a result of interest, tax due would be the gain ($5,000) multiplied by the marginal tax rate (21.55%) i.e. 5,000 x .2155 = $1,077.50 is the government's cut. If this gain was a capital gain, tax due would be 50% of the gain ($2,500) multiplied by the marginal tax rate (21.55%) i.e. 2,500 x .2155 = $538.75.
So, with a capital gain, you pay ½ the tax! This is one of the reasons why people prefer to invest in equities (the "stock market"), as opposed to guaranteed investments. The highest marginal tax rate is currently 46.41%, so the tax paid on the $5,000 gain above, from interest, would be $2,320.50! So it's vital to undertake a thorough analysis of your situation, in order to determine what's best for you.
Amazingly, when you hold any investment inside of an RRSP, the investment loses its "identity." That is, everything in an RRSP is 100% taxable - interest, dividend or capital gain. It's something that the vast majority of people that I come into contact with, don't realize, and down the road to retirement, can actually cause some serious headaches.
I'll talk about that more next time, but for now I'll leave you with "The Rule of 72." That is, how long does it take for an investment to double in value? Well, take your rate of return (4%, 6%, 8% etc) and divide 72 by that number. That will give you the number of years, for your investment to double in value.
72/8 = 9 years
72/6 = 12 years
72/4 = 18 years
Long term planning, right? I like to take this approach. Working with the right planner cannot guarantee that you will become filthy rich (insert chorus of boos here!), but you can certainly expect to be better off.
It's about common sense, and being realistic. It's the exact opposite of a John Galliano show, without the pencil moustache!
Liam Hendrikse is an independent financial advisor, and a model with Sutherland Models. He provides 1st and 2nd opinions on new and existing personal financial plans. He's also a forensic scientist, but that's another story altogether...
email: liam_hendrikse@rogers.com
This is intended as a general source of information only and is not intended to provide any personalized tax, legal or investment advice, and is not intended as a solicitation to purchase securities. Liam Hendrikse is solely responsible for its content.
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