What I'm Reading
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Tuesday, May 16. 2006
Here we go again with the next installment of the Newbies Guide To RRSPs. If you are just joining us, check out Part 1, Part 2, and Part 3. In this article, we will continue to build on our knowledge of mutual funds which was covered in Part 3.
For this installment, we will cover the different classes of mutual funds including: money market funds, fixed income funds, Canadian equity funds, international equity funds, and sector funds. I will then present a quiz that you can take which will determine how your money should be spread out amongst these funds since there are many to choose from. The quiz takes into account your current financial situation, your financial goals, and your tolerance to risk (pain). Based on the information you provide, the quiz will tell you what kind of investor you are. There are six major kinds of investors: very conservative, conservative, moderately conservative, balanced, growth, and aggressive growth.
Most of the examples and funds that I talk about will be from Royal Bank of Canada (RBC) since I'm fairly familiar with their funds. Full disclosure, I do hold a number of their funds. I will be referencing their mutual funds which can be found here. By clicking on the name of each fund that's listed at the RBC fund site, you'll get information about each fund. It should be noted that most of them have initial investment requirements which is how much you have to initially put in inorder to buy one of these funds. It's usually $500 if you're doing it through an RRSP account, and $1,000 if you're doing it outside of an RRSP. So lets dive in.
The average annual returns that I present below are based on RBC Funds. These numbers will vary across different banks since not all mutual funds are created equally. If a bank has a crappy mutual fund manager, then annual returns can suffer.
Money Market FundsRisk: Extremely Low
Average Annual Return Over 10 Years: 2.9%
The first class of mutual funds are money market funds. These are the safest mutual funds that you can buy, and there is close to no risk. It's practically impossible to lose money in these funds unless the government is overthrown and a revolution occurs. A money market fund makes its money by buying treasury bills (t-bills) from the government. A t-bill is essentially a short-term loan that the government issues. Think of it as an IOU from the government. A t-bill basically lends money to the government from 30 days to 91+ days, and they give you interest for the loan.
The annual return of these funds are dependent on the prime rate which the Bank of Canada controls. As interest rates rise, you'll make more money in money markets.
The advantage of money market funds is that you'll never lose money on them. They're an extremely defensive investment choice, and it's great for investing money that you can't risk losing or screw around with. Whether the stock markets go up or down, it is unlikely to affect these investments. The disadvantage of these funds is that the annual return is fairly low. Low risk means low returns. However, if the stock market crashes, you'll be laughing at everyone else if you're in money market funds. If you prefer to see a consistent +3% every year as opposed to -50% during the dot com bubble crash, this is for you.
Fixed Income FundsRisk: Below Average
Average Rate of Return Over 10 Years: 4% - 10%
Fixed income funds hold GICs and bonds. They're called fixed income funds because when we buy a GIC or bond, its interest rate is fixed, and the money comes in at predictable periods, ie interest payment once a year. We've already covered what GICs were in part 2, so I won't go over again.
Bonds are IOUs like t-bills except they're longer term, and they're not always issued by government. Corporations can issue bonds as well, and when you buy one of those bonds, you are essentially lending money to that corporation. A bond will pay interest for a certain amount of time, and we call that the time to maturity. A bond's time to maturity can range from 1 year to 30 years. In addition, bonds can be bought and sold like stock, so their value changes over time. As interest rates decrease, bond values increase. As interest rates increase, bond values decrease. Why is this? Lets take a look at Canadian Savings Bonds.
Ten years ago, one could buy a Canadian Savings Bond with a yield of 10% a year. If I had $1,000 in one of these bonds, I would be getting $100/year from the bond. Fast forward to now, and a Canadian Savings Bond yield is now at 1.75%. That would be $10.75/year. Quite a huge difference eh? So, someone might want a higher yield and buy your bond from you, and they'll pay you more than $1,000 for it. Clearly, your 10% yield bond is worth more than a 1.75% yield bond.
Now for the risks. I said the average return ranges from 4% to 10%, why is that? It turns out that not all bonds are created equally. If you lend money to a company, and they fall under tough times, they could potentially default on their interest payment, meaning they don't pay you interest. Another problem is, if the company goes bankrupt, you'll lose your bond. If you buy bonds issued by the Government of Canada, they're the lowest risk since it's highly unlikely that the government will go bankrupt or disappear. On the other hand, you might buy junk bonds from a sketchy company. Because the company is sketchy, they'll pay more interest because there's more risk.
Royal Bank offers a variety of fixed income funds, and they have different make ups in their portfolios. They'll have a blend of GICs, government bonds, and corporate bonds. It's up to you to choose which blend and potential return you're comfortable with.
Bonds are considered fairly defensive, as long as you stay away from the high risk junk bonds. When interest rates move up and then stop going up, bonds will be worth more money. This is what we saw in the 80s. For a while, the bond market kicked the stock market's butt. Generally speaking, whenever stocks do poorly, bonds will do very well.
So, the advantage of bonds is that they're low risk investments, with greater returns than money market funds. They also make excellent defensive positions if the stock market crash.
The disadvantage is that bond performance is somewhat inconsistent compared to stocks. If you take a look at any 20 year period in modern history, stocks outperform ALL asset classes. In addition, in the current market where interest rates are slowly moving up, and the stock market is in bull mode, bond funds are slowly losing value. Currently in the last 6 months, most bond funds have been giving -0.8% to -1.0% returns. Yes, there is potential downside for these funds, but more potential upside over time.
Balanced FundsRisk: Below Average to Average
Average Rate of Return Over 10 Years: 7% - 8%
A balanced fund takes the middle of the road approach to investing. It invests in both bonds and stocks. The hope is that you get the best of both worlds. Part of the portfolio is anchored in safer investments like bonds, and part of the portfolio has exposure to stocks which are riskier, but yield better returns. This is why the average rate of return is higher than a pure play on bond funds.
Canadian Equity FundsRisk: Average to High
Average Rate of Return Over 10 Years: 9% - 12%
When you hear the word equity, think stocks. A quick run down of what stocks are. When you buy stock in a company, you become an owner or shareholder of that company. When the company does well, you do well. Shares of these companies are publically traded on stock markets, and the value of the shares are determined by the market, therefore the price of stock fluctuates.
Normally, investing in the stock market by yourself is tricky. Say you had $1,000 to invest in the stock market. Lets say you bought some Royal Bank shares which is part of the financial sector. The problem is, you now have all your eggs in one basket. If the company is hit by some bad news, then the stock drops like a stone. How do we minimize our risk? We can have more baskets by buying other stocks in this sector. Okay, lets say we buy some CIBC shares and TD Bank shares. Now we're fine now right? Nope, a lot of times, bad news can hit an entire sector, and everything in that sector goes down. How do we minimize our risk furthermore? Easy, by buying things in many different sectors. The hope is at any given point in time, we'll have some good sectors and some bad sectors, but that way we limit our downside. An equity fund does this essentially. When you buy into an equity fund, you're diversified because the fund usually holds many many stocks.
There are a few kinds of equity funds. We have dividend funds which primarily invests in mature companies. We have value funds where we try to look for underpriced stocks. Mid-cap funds focus primarily on medium sized companies which are destined to grow into large companies.
One of the most diversified types of equity funds are index funds. The theory behind this is: if I buy every single stock in a stock exchange, then my return should match the average return of ALL the stocks in that exchange. So, if the Toronto Stock Exchange increased in value by 20% this year, then the index fund should have grown by 20% as well. Obviously though, we want to beat the market, so index funds typically try to buy all stocks except the crappy ones. If we remove the crappy ones, then we should in theory have a higher return than the market.
Bottom line, the advantage of equity funds is that you get a diversified serving of stocks. The returns are much higher but that's because you're taking on more risk. If you're considering equity funds, know that it can be a rollercoaster ride. Returns can vary from -25% to +25% from year to year. However, if you're a long-term investor, then your average return is going to be pretty good. If you're a short-term investor, then equity funds may not be appropriate.
International Equity FundsRisk: Average to Extremely High
The idea of an international equity fund is pretty straightforward. The fund will invest in stocks from foreign countries. I didn't write down the average return because it varies from region to region. Equity funds which invest in the American markets will have returns similar to Canadian markets. Funds that invest in more volatile regions like Latin America will have very high returns and high losses because the whole region is scary to investors since the whole continent seems to be going communist/socialist.
However, a certain portion of your portfolio should be invested outside of North America. This helps diversify your risk furthermore. If the North American economy slows down, you can harness growth in other markets. Most of these funds will show you which countries they're invested in, and you'll have to choose which regions you're familiar with and comfortable with, and how much pain you're willing to take.
Sector FundsRisk: Extremely High
So, we said that equity funds usually invest in multiple sectors in order to diversify. It'll usually hold some really hot sectors, and some awful sectors. The awful sectors end up reducing your annual return. Wouldn't it be nice if you could invest in the hot sectors and get rid of those bad sectors? Well, that's what a sector fund allows you to do. You can target your investments in tech, healthcare, financials, retail, manufacturing, natural resources, etc. Some sectors are more risky than others. The financial sector for example is fairly stable and defensive. The natural resources sector is a wild rollercoaster ride.
If you feel like you're ready to blow away all the numbers and bag a huge return, then these funds are for you. If you can stomach -50% to +136% from year to year, then this is for you. Depending on the kind of investor you are, your mutual fund advisor may caution you about buying these, or even refusing to sell them to you because it can be a house of pain (based on your investor profile and risk tolerance).
I have to put in this disclaimer. I'm a fairly aggressive investor, but even I stay away from these funds. A hot sector can become a crappy sector in a matter of weeks. Since mutual funds shouldn't be bought/sold like stocks, you usually have to hold on to them for 3 months before you can sell them or risk a certain penalty. 3 months is a long time, and a sector could turn on you very quickly. Inconsistent annual returns are no good either. You have been warned. HERE BE DRAGONS!
Which Class Of Mutual Fund Should I Be In?This depends completely on the type of investor you are, what your desired return is, how much pain can you take, and the amount of time you want to be invested in one of these funds.
As promised, here is the Risk Tolerance Quiz provided by Royal Bank. It's a quick 9 question quiz that will determine what kind of investor you are. When you go open an RRSP account, your institution will give you a similar quiz. Anyway, take the quiz now, and be honest about it. It doesn't matter if you're a conservative investor or an aggressive investor because there's no best way to invest. All methods are valid. If you invest in something that doesn't fit your profile, you're going to stress out, panick, sell, and lose a lot of money.
The best quote I heard about investment risk was this, "you'll know that the level of risk you've taken with your investments is right if you can sleep soundly at night." I live by this rule.
Generally speaking for an RRSP, you'll start off with higher risk, and as you near retirement, you'll take less and less risk because at end game, you don't want to mess with your money.
Also, be aware that your investor type changes over time. I started off being a balanced investor, and as I got the hang of things, I moved into the growth camp, and now I'm almost in the aggressive growth camp.
Anyway, now that you know what type of investor you are, Royal Bank has suggestions on what type of funds you should have in your portfolio. Check out Royal Bank's model portfolios for different investor types. If you're a very conservative investor, then look at the secure portfolio. If you're a conservative investor, look at the income portfolio. Moderate conservatives should check out the balanced column, and the rest should explain itself. The funds that they recommend isn't as important as the types of fund they recommend. So, if you're at a different bank, don't worry, they'll have funds that are similar to RBC's funds.
People typically ask me what my mutual fund portfolio looks like, so here it is in all its glory. This portfolio was built up over 5 years, and I've been moving from a balanced portfolio to an aggressive portfolio. The transition isn't done yet, so it doesn't look like a full blown aggressive portfolio yet. So, here's my portfolio:
0% - Money Market Funds
17.6% - Fixed Income Funds
21.8% - Balanced Funds
25.9% - Canadian Equity Funds
22.9% - US Equity Funds
11.8% - International Equity Funds
0% - Sector Funds
This mixture has given me an average annual return of 13.7% for the last 3 years.
(Note: you can assume that half of the balanced fund can count as fixed income, and the other half can count as Canadian equity. US equity funds can be grouped with international equity funds.)
Which Specific Mutual Fund Should I Be In Right Now?If you're reading this, that means you managed to get through all this boring backgrounder stuff about mutual funds, and you will be rewarded for your efforts. I have to go through all this backgrounder so you don't lose money and get mad at me. People that buy high risk mutual funds, become impatient when they lose money, and sell in a few weeks will most likely get slaughtered. People that invest like an aggressive investor when they really should be more conservative are going to freak out when they start losing money. That's why we have to understand each other before I go on to my recommendations.
So, if you were to hold a gun to my head and demand for a specific fund to buy, I would have to recommend the RBC Canadian Equity Fund. Many banks will have equivalent funds, like there's the TD Canadian Equity Fund, CIBC Canadian Equity Fund, etc. Anyway, these funds are closely tied to the Toronto Stock Exchange (TSE). The TSE has pulled back a lot. In the last 4 trading days, the exchange has lost over 560 points or -4.6% and this is a good entry point into Canadian equity funds. I don't think we've seen the market bottom quite yet, but it's near. The reason why the markets have gone down so much lately is because commodity stocks (zinc, copper, gold, steel, etc) have come crashing down. People are selling them off because they feel these stocks have moved up too much and people are taking profits by selling them. People who chase momentum bought these stocks high and when the stocks starting dropping, they panicked and they're unloading shares on the market.
This means only one thing, THE STOCK MARKET IS THROWING A SALE! We should be seeing a reversal in about a week. That's why I need you getting in on these equity funds while the sale is on.
ConclusionsWe now know the different mutual fund classes that are available, and we understand at a high level what the potential risks and returns are. We also know that different mutual funds consists of different assets which includes T-bills, GICs, bonds, and stocks.
Lastly, we talked about how important it was to invest in funds that match our investment style and our risk tolerance. Based on the quiz that we took, we found out which types of mutual funds were appropriate, and how our money should be spread across these mutual funds.
In our next installment, I'll discuss how to read a mutual fund prospectus. Furthermore, I'll discuss two different strategies for buying/selling mutual funds.
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"A wise man in times of peace prepares for war."
--Quintus Horatius Flaccus (65BC - 8BC), Roman Poet
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