Now that we have fought through the “boring” but necessary parts of investing we’re going to begin to look at just how you get to make money while you sleep, watch TV and live your life. I am still amazed at how effectively capitalism can work for the people who choose to be capitalists (as opposed to those who sell their labour for luxury goods).
If you are looking for the next great stock tip I am definitely not your man. We will look at stocks in general a little later on, but first I want to take a brief “big picture” look at the different ways the majority of people invest their money, and what to expect from each. The buzzword that the financial industry uses to discuss the different kinds of investments is “Asset Classes.” Basically, asset classes can be organized according to the principle that the more risk an investment has, the more return you can expect over an extended period of time. Investments are usually judged by their rate of return. This is essentially how much money they will make you per year as a percentage of the principal you invested. For example, you will often hear people say, “I have a savings bond at 3%.” That 3% would be the rate of return for that investment.
Most investment professionals have now come to the common conclusion that if you save 10% of what you earn, and properly allocate your savings amongst appropriate asset classes, you will do fine in the long run no matter what specific bonds or stocks you choose. Many advocate for spreading out your investments across multiple asset classes to take advantage of diversifying your money making opportunities and not putting all your eggs in one basket so to speak. The idea is that if one asset class is performing badly another will be earning you money. Here is a brief introduction to the major asset classes.
The first and most basic asset class is cash. Most people still gravitate to cash because of the simplicity of it. The idea that you can never lose your money if it is in your mattress is based on apparent common sense. The problem with this idea is that prices naturally go up over time. This devalues the cost of each dollar in your mattress and is known as inflation. In other words, if your money is just sitting, not earning a rate of return, then it is actually losing ground over time and your wealth is bleeding away. Many people will look to cash when other asset classes get into trouble.
GICs or CODs
Next to stuffing your money in a mattress Guaranteed Investment Certificates (GICs) or Certiticates of Deposit (CODs) are the safest investments you can make. The basic idea is that you are lending the bank your money for a guaranteed interest rate (the rate of return). The bank of course will turn around and lend it out at a higher rate and that is one of the ways they make their profit. GICs and CODs can be had for nearly any length of time, and are sometimes preferred to bonds because of the option for short time periods.
Bonds are one of the most commonly recommended asset classes. They are perfect for people looking for dependable investments that provide a decent rate of return over the long term. The common knock against bonds is that you have to pay penalties for taking your money out before the end of the agreement. The end date is called the maturity date of the bond. Bonds are another way to lend money to an institution and get paid to do it. There are a huge variety of bonds to choose from. The most popular are government bonds. Lending to a federal government is considered the least risky bond (it used to be thought impossible for a government to not pay their bonds, but with recent events in Greece one has to wonder) and consequently provides the lowest rate of return. Provinces (or states) and municipalities (counties) also have bonds for sale. They offer slightly higher rates and are considered more of a risk. Finally, there are corporate bonds (sometimes referred to as “junk bonds”) which of course are more risky than any sort of government bonds, and thus have to offer higher rates of interest if they hope to attract investors. Many people have been moving money into this type of bond to generate income lately.
Stocks and Equities
As a young person with a very long investment time horizon stocks are my preferred class, and the one I devote the most time to getting informed about. There are plenty of ways to get into stocks (financial analysts would say there are multiple options for getting “exposure” to this asset class). The difference between bonds and stocks is that with bonds you are lending your money, with stocks you are actually buying a piece of a company (or a unit if your talking about mutual funds). Stocks are the most risky asset class, and there is a huge range of risk one can take within the class. They also provide by far the largest returns overtime. Since its inception the American stock market has returned over 10% per year. Even if some pessimistic investment advisors are correct, there is little doubt that the stock market will continue to rise by at least 7-8% a year on average (the key to remember is that this average will encompass some large ups and downs). We will go further in-depth in the weeks to come on my favourite asset class and the different options you have within it.
Commodities, Real Estate and Precious Metals
Some financial analysts do not count commodities, real estate and precious metals (gold, silver etc.) as true asset classes, but they have undoubtedly become more popular lately as the stock market has suffered from some harsh downturns. I won’t go too in-depth describing each one except to say that specialists dominate in each field. Many people I have talked to recommend investing a small amount of an investment portfolio in these classes simply to diversify to the max. My personal response is that I can get plenty of exposure to these through stocks. For example I can own a Real Estate Investment Trust (more commonly known as Canadian REITs) if I want to invest in real estate, or a mining Exchange Traded Fund (usually called an ETF) if I believe precious metals are the way to go. We will talk more in depth about these investment vehicles next week.
For now it is important to remember the concepts of spreading out your risk through asset allocation, and the relationship between risk and return. As someone looking to invest for the extreme long term I am looking to be fully invested in stocks right now. For those approaching retirement a more diversified mix of asset classes is definitely appropriate.