The Bare Necessities: Chapter One

Chapter One: The Real First Step Most people who start investing get their information from pamphlets, the television, and the Internet. These are great sources of information, but people often do not understand that investing is more than just dollars. The first step is determining your current and future objectives through risk tolerances, needs, age, employment conditions, and even capital. A small difference in any of these variables may produce an entirely different portfolio. Sadly, for most people who want to start investing, they can not afford an advisor to determine this, so here are some textbook ways to do this yourself. Risk Tolerance Being able to handle risk will ultimately shape your account. However, it can be quite difficult determining your risk tolerance. One suggestion is to sign up for a free mock trading account. These mock accounts allow you to trade and invest using pretend money with real-life quotes. It is not as effective as using your own money, but it is a great way to figure out if you can handle losing a few hundred dollars over night. It is also a great way to get real-life experience without risking a cent. Once an individual's level of tolerance is fully understood, advisors can build an appropriate account. Those with a low risk profile should have little exposure to stocks, allowing them to maintain their capital with limited exposure to the market, however keeping enough to create some growth. Traditionally, low risk vehicles are money markets, treasury bills (t-bills), guaranteed investment certificates (GIC), commercial deposits (CD), and bankers' acceptances (BA). These products are usually backed by an issuer, the government, or the CDIC (FDIC in US), therefore have almost no risk. Medium-risk vehicles may include mutual funds and bonds. These products are not backed by an issuer, and the risk of losing all your money is possible, but due to its features, is quite unlikely. We will discuss this more in-depth later on. High-risk vehicles are considered to be stocks, real estate, options, commodities, and foreign exchange. These vehicles provide no guarantee on your capital and losing it all is very possible. The adage higher risk, higher rewards runs true historically. The high-risk vehicles average over 8 per cent annually, but with volatility, that is, years of ups and downs. Needs What is the difference between a 40-year married male with two children and a 25-year old single male? That was rhetorical by the way, but these life needs can factor into a portfolio as well. There are a multitude of options each of these have. The man with children may have less capital to invest, but could also open up education accounts for their children, could pool funds with his spouse and open a joint account, or may be able to make spousal contributions into an RSP. The single male will also have many options because of his needs. Lower expenses could mean more can be contributed to RSPs and TFSAs (sorry to my American readers. I believe it's 401K's), investing in more products, and potentially taking on more risk. Other needs may include liquidity. Many people may invest the majority of their savings in their investment account, but what if there is an emergency or an opportunity arises outside of the market? The ability to release funds in a timely manner is also a factor. A person who may have a large savings account will not need to access their investments, therefore, has the ability to lock in to long-term products for better returns. Age A person's age can be an influence when building a portfolio because of its inverse relationship with risk tolerance. The younger somebody is, the higher the appetite and fit for risk. A 20 year old will have ten more years to save and recover from high risk losses compared to a 30 year old. For most, this means investing a little more in high-risk ventures like penny stocks, new companies, and even companies nearing bankruptcy. The opportunity for huge returns outweighs the potential for losses. Employment An investor's source of income can also have a factor on the portfolio. Those employed with a fixed salary have more stability and therefore can build an account with more risk. The certainty of a paycheque next week provides for this basis. Another option with fixed salary workers is their ability to make periodic investments into mutual funds or registered accounts. Mutual funds allow investors to put in just a few dollars, usually just $100 a month at no additional cost. This dollar-cost averaging allows investors to stabilize their purchases instead of going in all at once. This strategy would not be practical for stocks, with the exception of Dividend Re-Investment Programs (DRIPs). The purchase of stocks will always have a commission, which can eat away at returns. Therefore, those who plan on making periodic payments should consider mutual funds appropriate with their risk apetite. Again, we will discuss mutual funds in a future chapter. Those that may be free lancer or have unstable sources of income may want to consider a more stable account filled with preferred shares, bonds, and risk-free assets. Preferred shares and bonds generally are less volatile and do not move up and down with the market. They provide higher returns on dividends and coupons because of their lower risk profile. The inclusion of the risk-free assets (money markets) provide the liquidity required during times void of income. These products clear within one business day, meaning access to the cash is available in 24 business hours. Capital The final variable an advisor may look at is start-up capital. Those that head to a broker typically have half a million dollars and want a professional to maintain their wealth, but in reality, most of us start with just a few thousand dollars. For those that have less than $3,000, I would suggest mutual fund investments, which I will discuss in the coming chapters. The larger the account is today, the more options one has. Those that want to avoid fixed income or mutual funds should stick to large blue-chip companies that are expected to be around for a few decades. Historically, these are banks, utilities, energy, technology, and consumer staples that pay dividends. Again, consider your risk factors, needs, etc. to determine what are appropriate for you.