Many of our clients have asked us to speak to their children about financial literacy. We are always happy to do so as the opportunity to start young with good wealth decisions can provide an outsized potential return over the long run. Good decisions made early compound over time. Before we start giving advice on finance and how to get ahead, and stay ahead, in this complicated and dynamic world of wealth management, it is important to acknowledge that everyone is different. We have observed over time that the way that individuals think of money and finance differ. Everyone has their unique risk tolerance and a different emotional relationship towards money, investments, and debt. As such, it is important to internalize and adapt the advice in this blog to best suit each person’s unique characteristics.
As Portfolio Managers and Financial Planners, our job is to guide individuals in building and preserving their wealth. In this blog, we highlight some guiding principles that we would share with teenagers if we were asked to introduce them to the world of financial planning.
1) Be true to yourself.
Financial success means different things to different people. It’s important to personalize the definition to what you need and want. Simply growing your net worth may not be a good enough definition of financial success for you. To dive into what this means, let’s do a quick comparison: On the one hand, we know an individual with a million dollars saved up for retirement, who lives within their means. Another individual we know has earned many million dollars, but lives a very lavish lifestyle. The first person will have a post-retirement income that will allow them to sustain their modest lifestyle. The second person is entering retirement with debt, three leased luxury vehicles, and an exotic lifestyle. With no more work income to pay these debts and a living-large lifestyle, they have unsustainably drained their retirement assets. In other words, although it seemed like they should have been well set for retirement, the multi-million-dollar well dried out quickly. Lifestyle and financial success are inevitably linked. Making decisions for one affects the other. There is a balancing act between living and enjoying life and investing for your future. You will have to find the right balance for your wants and needs – today and in the future. There are many resources that suggest a templated amount to save, but these may not take into consideration your unique needs and wants.
It is acceptable to have your own definition of financial success whether it be ambitious or modest. Know yourself, and save the amount you’ll truthfully need. Own your personal definition and ensure you are taking the necessary steps to reach your goals.
2) Know the risks.
Just like there are multiple definitions of financial success, there are many different roads to get there. Some individuals invest in real estate, some in stocks, some in growing their business. Some concentrate their investment in a single security and become immensely successful doing so. Others look for companies that will remain strong for many years and prefer a buy-and-hold strategy. With each plan comes risk. Knowing the risks you are willing to take, and the corresponding return you are targeting, will help you to chart out a route that maximizes your opportunity for success and minimizes your chance of failure. In and of itself, higher risk does not equate to higher returns. However, the willingness to take big, well-measured risk can present the potential for big returns. The opposite, however, is generally true: lower risk equates to lower returns. All things being equal, look for lower priced investments in relation to where you see them going. You can pay a lot for something if you have conviction that you can sell it for more later. As you chart out your route, research and understand opportunity and risk.
3) Debt is both good and bad.
Debt can be both your worst enemy and your best friend. Good debt is debt that will help you to earn more at a future date than the cost of borrowing. For example, student debt can be good debt as it is used to give you an education that will in turn give you the opportunity to find a higher paying career. Borrowing to invest can be good debt if the expectation of growth is higher than the cost of borrowing. Borrowing to invest in your business can be good debt if it helps to grow or preserve a successful business.
Bad debt, on the other hand, is when funds are borrowed to provide an otherwise unaffordable lifestyle. Purchasing material things or experiences that do not give you the opportunity to grow your wealth, and that you could not afford with your regular cashflow, puts you in a difficult position. Whenever you are borrowing money, it is a good idea to ask yourself if the use of the funds will help advance your financial future. If not, make sure you are able to pay it off in a very short time frame. Always know the cost of the debt you take on. The interest rates on credit cards are not the same as mortgage interest rates. The tax deductibility of interest should be taken advantage of, if possible, when borrowing to invest.
In good times, debt is readily available and it is easy to become overextended. But remember that for most, good times do not last forever. It is often in challenging times, when you need it most, that debt is harder to obtain and to carry. This is why it is important to borrow within your means – make sure you can carry the interest and that there is a realistic plan to pay it back at some point.
4) Do not ignore taxes.
Everyone should have a base knowledge of how we are taxed. Taxes serve their purpose in Canada. We are fortunate to live in this great country and should not want to eliminate paying taxes. Those who earn more should help to pay for our free access to education and medical care. We should help to pay for our roads and also to help those that are less fortunate. However, understanding and managing your tax rate is very important to ensure you pay a fair rate but not more than you need to. Taxes erode your cash flow and investment returns very quickly. This is especially true for higher income earners. Be aware of the different tax rates on different investments. Start by investing in your TFSAs and RRSPs, both of which offer favourable tax situations. Be aware of the tax benefits of different structures such as corporations. You do not need to study the Canadian Income Tax Act; however, you should educate yourself on the basics of taxes so that you are able to have a dialogue with your accountant.
5) Spending more is easy. Spending less is incredibly hard.
In 1997, fresh out of university, I took my first job in the financial services industry making $26,000/year. It was an excellent entry-level job where I cut my teeth and was exposed to one of the greatest organizations in the industry at that time. With student debt and living in the GTA, I was happy to have a job but realized quickly that this income was not enough to get ahead. If only I could make $30,000 – I would definitely be able to make higher payments against my debt and start to get ahead. But as my income creeped up, so did my taxes and expenses. When I made $30,000, I thought if only I could make $50,000 – my life would be set, and I would be able to save a great deal. But at $50,000, expenses simply got higher. It was difficult to see how expenses continued to increase because my lifestyle did not feel very different; yet every additional dollar I made was spent. The magic number I thought had to be $100,000… The story continues. The moral? No matter how much you make, taxes and spending increase easily, keeping up or even outpacing income increases to the point where it can be difficult to feel like you are actually making progress.
It’s easy to think, when I have more, I’ll be able to save or invest more – but not easy to do. Investing a percentage of your income, one that stays fixed even as your income increases, is a great place to start. To determine what that percentage is, start by creating a budget. It helps to know where you are spending today so you can be deliberate about investing in your future.
6) Consider diversification versus ‘deworsification’.
Looking in the rear-view mirror at any point in time, the answer to what you should have invested in is clear. The challenge, however, is not whether you are able to look back and see winners and losers, but whether you can look forward and see opportunity and risk. If you have conviction that a stock, a rental property, or a business will do well, you could take a bigger bet on that opportunity with the expectation of an outsized return. However, if you are wrong – and you will be wrong at times – well… let’s just say it’s important not to have all your eggs in one basket.
By owning a basket of potential winners, across different assets, you protect your wealth portfolio from making single poor investments. In a perfect world, the assets you hold will not all go up at the same time. If they do move in tandem on the way up, they likely will move in tandem on the way down. Good investments do not always do well at the same time. If investments underperform but you still have a positive outlook on them, do not be hasty to discard them. When building a portfolio, look for investments that have low or inversed relationships. By building a portfolio of such investments, you will minimize your risk while still allowing for good long-term growth. This process is called diversification. However, too much diversification, or we like to call it ‘deworsification’, will mute your potential returns over time. For example, with the proliferation of exchange traded funds (baskets where you tend to own all the stocks in a particular index), it is important to understand that by owning too many stocks, you will reduce your potential for growth. When you own everything, you own good and bad stocks at the same time. There is value in improving your wealth portfolio by owning well researched good investments rather than owning everything.
The following advice can help improve your investment outcomes.
It is important to start learning and investing early. Good investment habits that are formed early and maintained throughout your working life will improve your financial wealth. Trying to play catchup later in life can be difficult and can force you to make choices you would not otherwise want to make with your investments. Mistakes are part of the process and you should not fear them, but it is better to make your mistakes early. Mistakes later in your investment life can have much larger consequences, as you have a larger portfolio, and it is much harder to recover from losses, as you don’t have the luxury of time.
In investing, it is advisable to pay attention to longer term trends and investment philosophies. While you might be tempted to chase new ideas and ways of looking at the investment world, know that this time will not be different. New trends are tempting to jump into but unless you build a strong fundamental rationale for investing, you should tread lightly. When your neighbour is giving you investment advice on a particular stock, it is usually time to sell that stock. There is a difference between investing and gambling. Many novice investors fail to understand that distinction and so they follow the crowd. They take advantage of soaring prices on the way up; they are also often caught with no understanding of the potential losses on the way down. This does not mean that you should not be adaptable and forward thinking when investing. New technologies will disrupt and replace older technologies. Markets lead economies on average by six months. You need to be nimble when investing, but also always respect tried and tested sound investment principles.
“Don’t let the tax tail wag the investment dog”. This is an expression that is fundamental in investing. Do not choose investments based on their tax merit first. Always consider investments for their opportunity for future growth or income first. Then think about taxes. This is not to say you should ignore taxes, but if you focus first on taxes, you will miss many opportunities that would otherwise improve your investment portfolio. Remember taxes are paid on gains and income. All things being equal, do look for ways to reduce or eliminate taxes that are available to you. For example, you should consider investing in a Tax-Free Savings Account (TFSA) earlier on in life when you have a lower income and consider saving your RSP contribution room for later years when your tax refund will be more significant.
Be cautious and take risk. Both caution and risk apply to you whether you are a conservative investor or an aggressive investor. Often cautious investors do not take sufficient risk. This does not mean that you should throw caution to the wind, but by being overly cautious, you may lose significant opportunity for growth. Understand the rule of 72, which states that investments will double when a time frame multiplied by the investment return equals 72.
For example, your investment will double after 10 years if you experience a 7.2% return (7.2*10 = 72). Or an investment will double after 20 years, if you experience a 3.6% return, and so forth. The less risk, you take the less your funds will grow. Having said that, you should always know yourself and invest within an acceptable risk tolerance. If you are overly aggressive, you should still have the ability to consider risk protections in your portfolio – like diversification. Having a sell discipline, where if a stock falls below a predetermined level, you will sell the stock, can also help to protect a portfolio.
Understand the fees you are paying. If you were offered a 0.50% fee instead of 0.90% on your investments, you would be inclined to jump at this opportunity. However, lower fees with lower after-fee returns, do not trump higher fees with higher after-fee returns. Investment fee comparisons need to take into consideration four things:
1. Return expectation
3. Tax Efficiency
Knowing how investments are managed, what risk management strategies are employed, and whether they are tax efficient, should all factor in to how much you are willing to pay for investments. Many lower fee options often come at the expense of financial planning, service and advice. On the other hand, when assessing comparable investments and value, lower fees can certainly benefit your longer-term wealth outcome. Most investment professionals (including Tall Oak Private Wealth) would group you together with your parents and other family member and offer a consolidated lower fee. They will help educate you on financial services and be a sounding board for making sound financial decisions.
Finally, know that emotions impede good investment decisions. The most successful investors can separate emotions from their investment decisions. If you are not able to do so, you should hire a professional money manager to assist you in doing so. Emotions destroy portfolios. Financial markets are fully driven by fear and greed. Those who make consistently good decisions understand that others will invest driven by these emotions and will take advantage by making methodical well-rationalized decisions rather than blindly following the crowds.
It is hard to distill decades of observations into a blog. The world will continue to adapt and change. And so should you. However, remember that there are certain actions, behaviours and emotions that can help you to get ahead, and stay ahead, in this complicated and dynamic world of wealth management. A plethora of opportunities and incessant information has become more and more available to investors. The key to investing, however, is not in access, but more so in knowing what to choose. Choice should always weigh opportunities against risks.
We hope this blog helps in providing a framework to be used in conversations with your teenagers. We remain available to sit down with yours, if you would like to schedule time for us to go through these principles with them. Contact us today for a complimentary call.
This material is provided for general information and is subject to change without notice. Although every effort has been made to compile this material from reliable sources; no warranty can be made as to its accuracy or completeness, and we assume no responsibility for any reliance upon it. Before acting on any of the above, please contact Tall Oak Private Wealth of Raymond James Ltd., for individual financial advice based on your personal circumstances. Raymond James Ltd. – Member – Canadian Investor Protection Fund. Insurance offered through Raymond James Financial Planning Ltd., not a member – Canadian Investor Protection Fund.