I recently began volunteering with an organization called Girls Inc., one of whose valuable programs that teaches teen girls the basics of investing and money management. By the end of the program, the girls will be competently managing a full-blown investment portfolio. Sadly, that’s something that most adults are unable to do. Most novice investors who come to me for advice have usually been burned badly by trying to trade penny stocks in an online brokerage account – something my teen protégés would never do. Here’s why...
Don’t start with a marathon
Even before you start researching stocks as potential investments, you have to start with the basics. First, remember that there is no free lunch. If you are serious about investing, then you will need to start from ground zero and build from there.
First rule: Apply money basics
It’s all about getting a grip on your income and your outgo. Live within your means, and do not spend more than you earn. Simple advice, and something you’ve probably heard a thousand times. Yet, many people just seem unable to follow it. That’s where planning comes in. Most people benefit from a written plan – somehow that makes your goals seem more real. You do not need to make a six-figure salary to become a successful investor, but you do need to set out a diligent savings goal and investment plan that will span decades.
Second rule: Make it grow
Understand the power of compounding. This is the principle that any earnings from an asset will in turn generate their own earnings. Compounding allows your original investment amount to grow faster when earnings are reinvested than when earnings are paid out. Most people will have heard about compound interest, which is simply the principle of compounding applied to interest-bearing assets, like Guaranteed Investment Certificates, where the interest earns interest.
Third rule: Start early
The more years you have to invest, the more manageable your plan becomes. For example, let’s say you are 30 years old today and make $50,000 a year. You have $10,000 in a non-registered investment account that pays, say, 8% annually. Let’s also assume you can contribute $5,000 at the start of each and every year until you stop working at age 65.
At the end of 35 years, you would have accumulated $728,226…but you’ve paid an eye-popping $271,774 to the Canada Revenue Agency along the way. This is because the growth on your investments is taxed annually at your marginal tax rate (in this case, using a 31.15% tax rate), leaving you an after-tax rate of return of 6.4%. The CRA has collected $270,000 from you for absolutely no reason! That’s why Rule Number Four is so important.
Fourth rule: Cut taxes
Make full use of tax-free, tax-deferred, and tax-efficient investment plans and products. It’s what I call the 'The Wealth Effect'. While the type of securities you hold (asset mix) and the choice of securities (security selection) are important, research has shown that tax-efficiency is absolutely critical for building wealth, because great performance is useless if the taxman takes most of it away.
To see what I mean, take the same example I used in Rule Number Three above, except apply it to a Tax-Free Savings Account (TFSA). This is a federal government registered account that lets investments within the account grow completely tax-free. In addition, there is no tax when you withdraw funds from the account. Using the same investment plan described above, when you reach age 65, you will have accumulated $1,067 412 in your TFSA. Yes, read that again- over one million dollars from a $5,000-a-year investment! It’s all yours- and all without paying a cent of tax on that growth…ever.
You get the same type of effect from contributing to a Registered Retirement Savings Plan (RRSP). With an RRSP, your annual contribution limits may be much larger than for a TFSA, based on your earned income. Contributions are also tax deductible, a feature that could earn you a tax refund every year. However, investments grow in the plan on a tax-deferred basis- in other words, you won’t have to pay tax on interest, dividends, or capital gains on investments in an RRSP until you withdraw funds from the plan- at which time withdrawals are treated as ordinary income and taxed at your full marginal rate. Still, there are various maturity options and strategies you can take advantage of to mitigate the tax impact when it comes time to collapse your RRSP.
Fifth rule: Pay off expensive debt
Always pay high interest debt off (like credit cards) first, before investing. If your credit card charges you 19% in interest and your expected market return on investments is 7% to 9%, it only makes sense to pay the higher rate off first.
Sixth rule: Be flexible
Your life will change and evolve, and your savings and investment plan must grow with you.
Once you understand the rules, the rest falls into place. Create an investment plan that matches your risk-tolerance level. For example, it makes absolutely no sense to say you’re a conservative investor and then jump into trading penny mines on the TSX Venture Exchange. Once you’ve set your investment plan in motion, track it weekly or monthly. You’ll be surprised how fast your investable assets can grow when you take control. If my teen investors can do it, so can you!