What’s the Right Way to Invest? TFSA first? RRSP first? Pay down the Mortgage? Non-Registered Account? Gold? Real Estate? Help!

Posted on 2013 11 06 by BetCrooks

It fascinates me, like watching an unwary insect zig-zagging towards a waiting trap-door spider, to hear people asking what is the correct way to invest. Listening to and reading the answers to their frantic questions makes me even more uncomfortable. I don’t believe there is any one, correct way to invest. There are just too many variables. I think most people would be much better off in they could just relax a bit. There are many paths up the mountain and the view from 9,789 feet up is pretty close to that from 9,804.

Should I Max Out my TFSA First?

This is a common question. The answer though is a moving target.
TFSAs were only created 5 years ago. So the first year they were offered, you could max your TFSA with a $5000 contribution. When the “max” was that small, the consensus answer was yes, max out your TFSA first.

Even in 2014, the maximum someone who is 23 or older that year can contribute to a TFSA is $31,000 and that assumes they have contributed nothing ever (or have withdrawn everything from every TFSA they have in 2013).

$31,000 is still an achievable number, so it may be a good idea to max out a TFSA first.
But soon, that number will climb up to $50,000 or higher. At what point do you start to contribute to an RRSP as well as a TFSA?

Instead of a simple answer, it becomes necessary to consider a variety of factors:

What is your salary?
What is the expected change in your salary over the next 10-15 years?
Are you an impulsive spender?
Do you intend to buy a home (house or condo, etc.) soon?
Do you have debt? What kinds?
Are you planning to marry soon?
Do you have dependents (children, aged parents, disabled spouse, etc.)?
What income tax do you pay?

I’ll have to discuss some of these factors in a separate article. This one’s about the many paths up to that peak.

Should I Max Out my RRSP First?

This is probably the second most common question. It becomes the first during “RRSP Season” from January to February each year.

Many answers were written before the TFSA was invented and those answers have not been updated to account for this new investment possibility. Be wary and check the date of the information, especially in books.

One of the most common errors I see is people saying “Wait to contribute to your RRSP until you’re in a high tax bracket.”

They don’t seem to understand that contributing to your RRSP (and reporting your contributions on your annual tax return) and claiming the deduction for your contribution are two different things.

I could contribute to my RRSP in June 2013. I would have to report the contribution, with receipts, on my income tax forms for 2013. But I could wait till 2025 to claim the deduction to reduce my taxable income and to reduce my payable taxes (and maybe get a tax refund!). I just have to fill out Schedule 7. I could even wait till 2035!

One of the most common errors of omission I see is people not saying “If you are in a low tax bracket and you will probably be in a low tax bracket all your life, it’s better to save in your TFSA because it doesn’t affect your OAS and GIS eligibility and payments.”

That’s right: the real kicker is for very low income earners. If someone is going to have income of less than $15,000 (in 2013 dollars) in retirement from their pension, CPP, interest income on their investments, etc, they do not want to have a RRSP. Money coming out of the RRSP will reduce how much OAS or GIS they are entitled to receive. Money coming out of a TFSA will not reduce those payments. (At least it won’t as the rules are written right now. My cynical side expects that to change in the next 20 years.)

I need to explain these things in more detail in a separate article as well. But again, what I’m trying to say here is that there is no one simple, correct answer for everyone. Each person is unique and the best path for each person will vary.

Should I Pay Down My Mortgage First?

Again, this one used to be a no-brainer. People bought a house with a 50%+ down payment. They had a 25-year mortgage and they had 30 years till retirement. The interest rate on the mortgage was 7%+ and the interest rate on their GICs was 5%. There were no TFSAs. Their Pension Adjustments (PA’s) were so large because they had defined benefit pensions that they could only contribute $2,000 or less a year to a RRSP. They swore to everyone that they only planned to leave their home “when they were carried out in a box.”

In their cases, yes, paying down the mortgage made complete sense.

Now people are buying homes with tiny down payments. Some homes cost 5-10 times their owners’ annual gross salaries. They are buying them with a 25-year mortgage and 10 years till retirement. The interest rates, though, are low. They plan to down-size, right-size, convert to a rental property, flip or sell them to developers looking to drop a huge in-fill house on the super-sized lot.

It’s no longer a simple: “Yes. Pay off the mortgage first.” answer.

Real Estate? Gold? Non-Registered Accounts? RESPs?

The internet and the “celebrity-style” investment reporting on most news networks has just increased the confusion. The media is always buzzing about making millions in real estate, protecting yourself from world-wide-economic-collapse buy loading up on gold, avoiding the convoluted tax implications of registered accounts by keeping simple and investing only in non-registered accounts, and even using your kids’ RESPs as tax shelters for personal spending funds for their parents.

Argh!

So many choices, so much noise, so many ways to go wrong, lose money, not keep up with your peers, never get to retire, never get to travel, never succeed.

Enough.

I’ll repeat myself:

There isn’t any one correct way to invest. Many paths will lead to the same destination.
You don’t have to “get it right.” There is no wrong.
You don’t have to agonize and get paralyzed by all of the choices.
You will not be judged and found wanting.

Pick a path. Practically any path. Almost every one will lead you gradually up the mountain slope.

Don’t worry so much. The paths all criss-cross multiple times on the journey up. You can switch paths. You can even send some of your investments up one path while the rest of them follow another.

There are only a couple of choices that you must make:

Save money.
Don’t stay in debt.
Invest that money you save at a rate that exceeds inflation so it at least keeps today’s value.

Don’t worry about making the most possible profit from your money. No one knows how to do that successfully every time. Just try to make some profit and stop expecting perfection from yourself and your investments.

And try to tune out the endless stream of information that tells you “You’re doing it all wrong! Do it my way!” If you’re saving money, you’re doing it right.

Related Reading

Maximize your TFSA First

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Does it bother you to see people agonizing over whether to max their TFSA or buy a rental property? Please share your views with a comment.

How to Evaluate Mutual Funds and Choose which Funds to Buy

Posted on 2013 02 25 by BetCrooks

OK, I’ll admit my past investments in mutual funds are good examples of how NOT to evaluate and choose which funds to buy. However, by investing unwisely I have learned a few lessons that I will share with readers. I also encourage you to share your own mutual fund buying experiences, good or painful, with a comment. There’s always more to learn! This article describes some methods to help evaluate a mutual funds’ risk and performance before choosing which fund you want to buy.

Remember, while reading, that mutual funds are not only for investing in the stock market. They are great tools for investing in bonds, bullion and other types of assets. For more details, please skim The Types of Mutual Funds, Why They’re Good, and Quick Buying Tips.

Evaluating Mutual Funds

Take a Quick Look by Starting with the Fund Facts Sheets

Fund Facts are Your “Friend”

I’m never sure I trust employees of the government or of a financial institution when they say they want to be my friend. I mean it’s nice but I’m always a bit suspicious. I feel the same way about the required Fund Facts sheets provided by mutual fund issuers. It does provide a lot of useful information in a consistent format and in fairly readable English. However, I wouldn’t rely solely on the Fund Facts sheet when deciding whether to invest in a fund.

What Does the Fund Facts Sheet Identify?

Performance History
How did the fund fare in 2002 and 2008? The stock market as a whole did poorly those years. The TSX Composite fell about 35%. The S&P 500 in the US dropped about 32%. Bond and precious metals funds should have shown reasonably good results those years as investors fled from stocks into perceived security. Did the fund do better or worse than the market average?

Investments
The Fund Facts sheet should list the top investments of the fund and describe the types of investments held by the fund.

This can be a very important section to review!

For example, you might think a fund called the BMO Canadian Equity Class Series A Fund would be invested in Canadian Equities, right? Yet in the description of “What does the fund invest in?” BMO states “The fund may invest up to 30% of the purchase cost of the fund’s assets in foreign securities.” In other words, the fund could go and buy stocks in, say, businesses in Greece and Spain if it wanted to. Canadian, eh?

Costs
The costs section includes the cost to buy the fund including any commissions or fees. It also includes the ongoing costs of owning the fund including the MER and whether the MER pays trailer fees. (Trailer fees are often annual and are paid to the person who sold you the fund for as long as you hold the fund.) If there is a fee to sell the fund (called a deferred service charge or a declining sales charge) it should be reported here, too.

Risk
The sheet gives an approximation on a scale of 1 to 5 for how risky an investment in the fund is.

The problem is there is quite a difference between what the industry considers risky (hedging; options; leveraged investing; penny stocks) and what most investors like me consider risky (losing 20% of the funds value if the market sways). I think you shouldn’t put too much faith in this chart as I think most stock funds are going to be listed as “medium” risk.

Ellen Roseman of the Toronto Star wrote a great article on this called “Is a fund that drops 60% only ‘medium’ risk?”

Get Under the Hood: Look at the Core Holdings

The names of mutual funds often seem to have been selected by a random phrase generator pre-loaded with words like “performance; high; income; dividend; yield; growth; security; guaranteed“ The names often don’t actually reflect what is held by the fund. The only way to know what you’re really buying a share of is to look at the holdings of the mutual fund.

For Canadian funds, the top holdings are usually easy to find in the Fund Facts summary for the product.

Be Careful because Fund Names Don’t Match Fund Holdings
For example, the RBC Global Dividend Growth Fund Series A is actually invested 63% in American equities. [UPDATE: In February 2014 it was down to 35.6%.] If you bought this fund assuming it was investing primarily outside of North America you’d be wrong. Look at the details, not at the name.

In another example, the RBC Asian Equity Fund Series A is 15% invested in Australia. [Update: In February 2014, still 14.1% in Australia.] Now I don’t know for sure what they teach now, but when I went to school Australia was NOT part of Asia. Names can be misleading.

How Will You Make Money from the Mutual Fund?

One thing I didn’t consider well enough before buying a mutual fund was how I would make money from owning that fund. I was used to funds that paid distributions that were re-invested as additional units. I honestly didn’t look closely at that aspect of this fund before I bought it.

The fund, like many of my investments, promptly tanked as the price of oil halved. I sighed. The oil patch and I have a long history and I knew that given enough time and patience, petroleum stocks rebound. I’d just have to wait since I still considered the companies the fund was invested in were good choices for the long term.

Imagine my shock when I realized, though, that this particular fund is purely a capital gains play. It doesn’t make any distributions, ever. You buy it, wait till it appreciates in value, then sell it. The only money you make is the difference between your buy and sell prices.

I *hate* having money invested that shows no annual return. If a stock pays at least a small dividend, I feel better if I have to wait for a market rebound. With this fund I had to either sell and eat the capital loss or hold and lose the opportunity value of that money while I waited for a rebound (and hopefully an eventual uptick.)

I learned my lesson that time. I don’t buy anything now that doesn’t have some form of annual distribution. I’m just not wired to handle dead weight investing.

Look at the Fees and Commissions Including the MER

Almost all mutual funds have a Management Expense Ratio or MER. The MER tells you what percentage of the fund is used to pay costs each year. A typical MER might be anywhere from 0.35 to 2.5%. That’s quite a difference. It means you are paying $17.5 to $125 per year in fees to own $5000 of a fund.

In a good year, the MER is subtracted from the earnings of the fund before the profits are distributed to the fund owners. Profits may be distributed as income or as an increased value per unit of the fund or as an increased number of units in the fund.

In a bad year, however, the fund may lose money. then the MER is subtracted from the actual value of the fund. That’s right; you have to pay the MER even if the fund loses money.

If the markets go down and a fund loses 15% in value and the fund has a 2.5% MER, then the real loss passed on to the fund’s holders is 17.5%!

According to various studies, Canada has some of the highest MERs for mutual funds in the world. Check closely how much you would be paying before purchasing a fund.

Some companies offer funds with comparatively very low MERs. These include the TD e-series funds available only to investors with an online TD Canada Trust EasyWeb account or a TD Waterhouse Discount Brokerage account. (Vanguard is now offering some very low MER ETFs in Canada, too.)

Look at the Redemption Terms

For many mutual funds you are locked in to your purchase for 90 days. If you try to redeem (sell) your fund holdings before 90 days you may have to pay a very large fee. Check the prospectus for information on early redemption.

However, funds may have longer or shorter holding requirements. For example, at the time this was written, there was no minimum holding period required for the Renaissance High Interest Savings Account mutual fund, ATL5000. This fund is encouraging investors to “deposit” cash like in a daily interest savings account while waiting to invest elsewhere.

Look at the “Loads” Front End, Back End, Deferred Sales Charges or Declining Sales Charges

Some mutual funds still charge you a fee to buy them (a front load) or to sell them (a back end load or DSC.) It really should not be necessary to pay a fee just to buy or sell a mutual fund. Check whether there are any loads or DSCs and don’t buy if there are.

Look at the Trailer Fees for Mutual Funds

This fee is trickier to assess. A trailer fee is paid to the person who sold a mutual fund to a customer. The trailer is often paid annually for as long as that customer holds the fund.
This is not great, but it wouldn’t be so bad if the trailer fee was identical for every mutual fund. It’s not. Some funds pay larger trailer fees.

Now if you are the person who sells mutual funds and you could sell either of two funds and one will pay you 1% of the sale price per year forever, and the other will pay you 0.25% of the sale price for three years, which one will you naturally feel inclined to sell?

The problem is that as the customer we want to buy a fund with low or no trailer fees. So it’s up to us to check various fund choices and be aware that the salesperson might have a bias towards a fund with a higher trailer fee.

Ask yourself: who am I trying to make money for, myself or my salesperson?

Did you know that you pay trailer fees to your brokerage even if you have a self-directed brokerage account? That’s right, even though YOU are the person analyzing and recommending to yourself which mutual funds you should buy, you are paying your brokerage a trailer fee. There have been a few attempts to change this but at most brokerages the practice stands.

Comparing Apples and Cows

Two funds may sound the same and have nothing in common. This is where it’s important, yet again, to look at what the fund is actually investing in.

For example, in early 2013, the BMO Monthly Income Fund is invested (at this time) 1% in cash and 51% in Canadian equities. The Fidelity Monthly Income Fund is invested 10% in cash, 24% in Canadian equities and 16% in foreign equities. Despite the very similar names they are not invested in comparable ways. Differences in their earnings could be due to differences in the risks they take and in the types of assets they hold.

Get Independent Advice Before Buying Mutual Funds

If you’re going to invest in mutual funds you should be looking for impartial, third party advice on which funds to buy. If you go to a bank, they are almost sure to only try to sell you their own line of mutual funds.

Where can you find impartial advice? For years, Gordon Pape used to write an annual book comparing funds. He only made money from you buying the book whether or not you ever bought any funds. Now, his business runs an online newsletter called the Mutual Funds Update. (http://www.gordonpape.com/ )There are probably other newsletters out there too. Again, the newsletter publishers do not get a trailer fee because you don’t buy anything from them.

Other sources include reading financial newspapers and magazines.

You can also hire a fee-only financial planner. They get paid by the hour or project and do not receive any commission for what you purchase, because they do not actually sell it to you. It may be hard to find a fee-only planner, though, that is interested in helping clients with a low value portfolio.

When are Mutual Funds Worth Buying and Which Ones Should You Pick

Bond Funds

Buying units in a bond fund requires less capital investment for more diversification with lower purchase commissions than buying individual bonds yourself. It also provides active management. What’s not to like?

Compare the fees for ETFs vs mutual fund bond funds. Also compare the performance, though.

I’d take a close look at the PH&N bond funds, including their total return bond fund. There may be equally good bond funds out there elsewhere, too. I’m not an expert.

Disclosure: I do own some holdings in a PH&N bond fund but it is not one available through discount brokerages only through company pension plans. And yes, in 2013 it lost money.

High Interest Savings Account Funds

The daily interest savings account mutual funds provide a convenient place to park cash in some discount brokerage accounts. For example, at CIBC Investor’s Edge you can put cash into ATL5000 with a minimum $1000 deposit. At other brokerages it isn’t as easy. For example at BMO InvestorLine there is a minimum deposit of $~~25,000!~~ [UPDATE: As of April 11, 2013, BMO InvestorLine is offering a BMO HISA with a minimum deposit of $5,000.]

I have used ATL5000 at Investor’s Edge, RBF2010 at RBC Direct Investing and AAT770 ~~DYN500~~ at InvestorLine successfully.

Precious Metals Funds

It’s difficult to buy and hold precious metals safely. If you want precious metals in your portfolio, it’s worth considering buying them through a mutual fund or ETF. Some funds like the BMG Bullion fund (BMG 100) hold real physical metals for you in secure storage.

Personally, I don’t own any precious metals and I have no idea in which fund it would be best to invest.

Index Funds

If I was investing in equities, I personally would choose a fund that matches a large comprehensive index, such as the TSX Composite for Canadian equities, the S&P500 for US Equities and something equally broad for other international equities. Any analysis of which fund to pick needs to look closely at the fees (especially the MER) and at the actual holdings to make sure it is replicating the index. You must compare the ETFs and the mutual funds to ensure you are getting the best options.

Remember, at many brokerages you will pay each time you purchase or sell an ETF, but you will not pay a commission to purchase or sell a mutual fund. You generally can also reinvest mutual fund distributions in fractional units, but you usually cannot hold fractional units of an ETF. Ideally you’d like to find a mutual fund that holds the same index as an ETF for the same or lesser MER. Then you could have the lowest fees and the best re-investment policy.