Taxes – The Unavoidable Cost of Civilization

taxes

It is said that only 2 things are absolute in life: death and taxes. Taxes have been around for thousands of years. The purpose of taxes is to pay for the government, and various government expenditures, like police, fire, hospital, garbage collection, clean drinking water, education, food inspectors, military, and wars.

All these things cost money and various levels of government have been able to find ways to get more tax revenue every time someone discovers a new way to make money. Because taxes have been around for so long, everywhere, they are ingrained in the very fabric of society. You simply cannot avoid paying taxes in some way, which is why, along with inflation and fees, taxes are the 3rd and possibly most costly of the Unavoidable Trifecta of Investment Costs (UTIC)

Kinds of taxes include:

Consumer Taxes

In Canada, consumer taxes are:

  • Goods and Services Tax (GST), which is a federal tax (ie. national, run from Ottawa) and is spent across the country.
  • Provincial Sales Tax (PST), which is run at a provincial level, so the money is directly collected by Quebec City, Regina or Halifax and is not shared with other provinces. Only Alberta has no PST.
  • Or Harmonized Sales Tax (HST), which is a combination of PST and GST in one tax. Currently, only 5 provinces have HST instead of PST and GST:
    • Ontario
    • Nova Scotica
    • Prince Edward Island
    • Newfoundland
    • New Brunswick

As its name suggests, you will pay a lot more in consumer tax if you buy a lot of stuff, ie. consume.

Income Taxes

In Canada, both the federal government, ie. the Canada Revenue Agency (CRA), and provinces, eg. Fredericton, Regina will take a significant chunk of your paycheque before it even reaches you. Every year, you have until the end of April to complete your income tax return. Your income tax return is basically you telling the government how much money you made in a given year (including money from investments, foreign properties, and pretty much anything else you can make money on), and the government making sure you’ve paid your fair share of taxes on the income you claimed.

The CRA, ie. federal government, takes 15% of your income if you made less than $44,701, up to 29% on anything more than $138,586.

The provinces each take a different amount of your income. In Alberta, the provincial government in Edmonton simply takes 10% of your taxable income, no matter how much you made. In other provinces, your income tax will be determined by your income: the provincial government will take as little as 5% in BC and Ontario for low income earners, up to 21% in Nova Scotia for high income earners.

Property Taxes

Canadian cities and towns are all run by local governments and mayors, but the only taxes they are legally allowed to collect are property taxes. Because there are so many municipalities in Canada, there is a wide range of property taxes. Typically, your land will be assessed by the municipality you live in to determine the value of your property, taking into account renovations, the local housing market, amenities, proximity to good things like schools and transit. You will then pay an annual tax on the estimated value of your property that goes straight to city hall.

Capital Gains Taxes

This one is just for investors. If you make an investment, and sell it to collect a profit, you have to pay taxes on that. It doesn’t matter if it’s a house (as long as it’s not your only house) or stocks in your favorite company, the government wants you to give a share of the proceeds back to public coffers.

In Canada, you pay a capital gains tax on 50% of your investment profits. That means if you invest $10,000 in an unprotected fund (ie. outside of a TFSA or RRSP), and make a 40% profit, and then withdraw your $14,000, you would need to pay your current income tax rate on half your profit of $4000.

50% of $4000 (the income from your investment) is $2000. If your income tax rate is 37%, 37% of $2000 is $740 in capital gains taxes. The CRA has another example of calculating your capital gains here.

 

There are many other kinds of taxes and fees governments charge, like corporate taxes, inheritance taxes, carbon taxes, custom taxes, tariffs, etc. But there are also many kinds of tax deductions / breaks you can apply for to avoid paying a significant portion of your regular taxes.

It is controversial to say if tax payers get good value for the taxes they pay or not, but certainly, it is hard to argue that society would be better off without the kinds of services governments offer.

Compound Interest – The Double Edged Sword

compound_interest

In my first post, I mentioned that I make decisions to buy certain things by weighing having something vs the value of that item in 20 years, with interest, for when I retire. I mentioned buying an Xbox One, let’s say that costs $500. If I spend $500 now, I have an Xbox One, but what if I instead put that money into my S&P 500 TFSA?

Well, it just so happens that I have a Google spreadsheet that tells you exactly what happens right here. The document assumes we invested $500 into the S&P 500, in our tax protected Tax Free Savings Account (TFSA), so we don’t have to pay taxes at all on this. It assumes the particular S&P 500 fund we want to invest in keeps its current fund fee of 0.08%, and inflation runs at 1.5% annually. You’ll see that our $500 investment grows to about $3900.

For me, $3900 can easily be enough to let me live comfortably for a month or two when I decide to retire. So Xbox One now, or 1-2 months of extra retirement in 20 years? As a PC gamer, the choice was easy.

I remember first hearing about compound interest, it sounded like you could turn on the ‘compound interest’ switch and start making serious money. Albert Einstein described compound interest as “The eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”

Compound interest is the growth of your principle investment, and collecting interest on that growth in the next year (or compound period).

To illustrate with another example, let’s assume you have $1000 invested and your investment grows by 10% a year. Here is how that would work over 5 years:

  1. At the end of year one, your $1000 will grow by $100 (10% of $1000) to $1100.
  2. At the end of year two, your $1100 will grow by $110 (10% of $1100) to $1210
  3. At the end of year three, your $1210 will grow by $121 (10% of $1210) to $1331
  4. At the end of year four, your $1331 will grow by $133 (10% of $1331) to $1464
  5. At the end of year five, your $1464 will grow by $146 (10% of $1464) to $1610

Compound interest is the interest that grows off interest you’ve already accumulated. Notice that after 5 years, your investment has grown to $1610, that is the base amount of your assets for year 6. Because of compound interest, it will take just over 7 years for your investment to double at a 10% annual rate of growth.

But compound interest can also work against you. Mortgages and credit card debt are good examples of that. If you have a credit card with an annual interest rate of 30% (the high end of interest rates in Canada currently), that 30% will be applied monthly or even daily by your credit card company. If it is monthly, you will be charged 2.5% (30% divided by 12 months) per month. As credit cards usually have a higher interest rate on overdue balances than most investments can return, this means that you can double your credit card debt in only a few years. This is one of the reasons why many financial advisers suggest paying off all your expensive debt before saving or investing your money.

If you are in the position of wanting to buy a house in Toronto or Vancouver, and happen to have an amazing down payment where you’d ‘only’ need a $500,000 mortgage, what would the (compound) interest be in 25 years? Using online mortgage calculators, at a historically average 7% interest rate the banks will charge you, you’re looking at $550,623 in interest charges alone over 25 years. That is more than double the amount you borrowed.

Compound interest is the only way you can grow your savings and investments, it truly is the engine that drives the value of your savings up. But if you have a tough time controlling your spending, it also has the potential to cripple you in debt and force you to waste your time working only to pay off interest.

Fees – The Unavoidable Cost of Service

fund fees

Fees are one of the Unavoidable Trifecta of Investment Costs (UTIC), taxes and inflation being the other 2. Fees are unavoidable because you really can’t even save your money, let alone grow it, without the services fees yield. Without banks, for example, you would have to store your paper money in a physical location in your house, which suddenly becomes vulnerable to fire, theft, and other bad things.

Types of fees to expect:

Bank fees / credit card fees – It is really hard to function in our economy without a bank account. In addition to the physical protection and government insurance that blanket your money, banks provide loans to people who would otherwise not be able to launch their business idea, or buy their first house. Banks have many annoying fees (ATM fees, having a savings account with little money in it), but provide a lot of services that make buying things easier and safer. Certainly a necessary cost.

Stock trade fees – As reviewed in my post about actually buying stocks, you will need a web broker that will execute your order. These typically cost from limited-time-free to $10 per trade. That means if you want to invest a bit of your money every month into the S&P 500, you might have to pay as much as $120 a year in web broker fees buying new shares.

Fund management fees – Every fund has a management fee that is charged to investors like us to pay for the management of the fund. This fee can include everything, include marketing and legal costs for the company that runs the fund. Generally, if the fund is human managed, you can expect fees of up to 1% – 2%.

1% – 2% may not sound like a lot, but it adds up to a lot over time. To illustrate, I’ve put together a spreadsheet in Google Docs that has a table with a breakdown in money invested, investment growth, and fees. You can’t edit it from your web browser, but if you go to the top right and click File -> Download as, you can download the spreadsheet as your own .xlsx to play around with.

The spreadsheet can be found here, in it you’ll clearly see how investing $200,000 over 20 years will result in a total take-home (before taxes) of $409,000 after $53,000 in a typical fund’s management fees are applied. If you play around with the spreadsheet, you’ll find that the more money you have invested, the more scary your fees will be.

Index funds, like Vanguards S&P 500, also have fees, but because index funds are run by a fairly straight forward computer program, humans generally aren’t involved. That makes index funds comparatively inexpensive, Vanguards S&P 500 has a Management Expense Ratio of 0.13%.

Financial adviser

Not everyone has a financial adviser, most don’t. But those who do will need to pay for them. Lots of large financial institutions will typically pay their financial advisers commission. Your financial adviser will probably take a fraction of that 1-2% fund management fee, or they might take a cut of any mortgage or other financial service they are providing you.

I personally don’t like this payment model, it is one of the reasons why I decided to manage my finances myself. The problem is that obfuscating how your financial adviser is paid will hide the fact that they are paid (and thus, motivated) more for selling you more profitable services, like insurance. And obviously, a financial adviser working and ABC Bank will only be able to help you with funds and services that ABC Bank provides, meaning you’re only getting the best products and services from ABC Bank, not the best products and services available.

Doing Taxes – It’s a Dirty Job

homer

There are few things on this planet more confusing and divisive than taxes. In Canada alone, there are federal, provincial, and municipal taxes (municipality taxes are mainly limited to property taxes). Depending on the province you live in, your tax rate will vary. In fact, there are so many factors that ultimately influence what you pay in taxes that there are probably as many variations in tax returns as there are people; everyone’s different.

Taxes have been around for thousands of years and come in many colors and flavors. Tax laws and tax deductions (aka. tax breaks) change all the time. Every year governments across Canada adjust how different things are taxed. Tax deductions are generally meant to reward people doing what the sitting government thinks is good for the nation, things like taking transit, saving for retirement, renovating your home, giving to charity or a political party, living in the far north, paying for tuition or text books, putting your child in little league soccer, doing artistic activities, etc. All these are current federal tax deductions everyone is eligible for, in fact there are hundreds of tax deductions that offer something for everyone.

The onus to do taxes is completely on you. If you do not file your taxes and owe the government money, they will hunt you down. You will also be subject for any interest fees due for any delays in payment, or a fine, or jail time. The Canada Revenue Agency (CRA) takes this stuff very seriously and expects you to also take it seriously.

There are generally 2 ways to do taxes in Canada: get an accountant / tax adviser to do them for you, or do them yourself with software like ufile.ca or turbotax.ca. There are pros and cons to both, but no matter what you chose, make sure you have all your tax documents together. All your receipts you want to claim tax deductions for, all documents the CRA has sent you. For me, my taxes aren’t that complicated, I don’t claim that many things. But I can see things getting out of hand quickly if you are an average family of 4, run your own business, own your house and spend lots of money improving it.

If you don’t really have it in you to go through the complete list of federal tax deductions, I don’t blame you. If you think your taxes might be complicated, get an accountant to do your taxes for you.

Tax adviser pros:

  • The biggest advantage to a human tax adviser is that they are better at tying your personal situation to any tax deductions you are eligible for, but not aware of.
  • They are usually accessible. If you have any questions, you can call them up.
  • If there are any complications, they can help take care of them.

Tax adviser cons:

  • The only real drawback is that they are going to be more expensive than DIY tax software.

I used to think tax software was gangling and cumbersome. But I used turbotax.ca to file my taxes for the 2014 tax year, and was impressed with how intuitive it was, and how everything was broken down into small steps. The website was also good at suggesting tax deductions I may be eligible for. It reminded me of my TTC transit passes that I forgot to claim.

Tax software adviser pros:

  • Inexpensive. It cost me $35 to do taxes for both my wife and I (H&R Block has a website that will do it for free)
  • Easy and instant. See how each change affects your tax return amount.
  • Getting better at advising on potential tax deductions.

Tax software adviser cons:

  • Though they’ve come a long way in a short amount of time, the software isn’t yet smart enough to cater to everyone’s squeaky wheel, though they do have a 1-800 number for anyone looking for a helping hand.

Having a human tax adviser is great, they can take a lot of the stress out of doing taxes. But with the tax deadline only days away, if you haven’t found someone to do your taxes, try out turbotax.ca.

Taking Action – Buying Stock

taking action - buying stock

Tired of savings accounts that lose you money? Want more growth and less fees than your bank’s mutual funds can offer? Thinking about giving the S&P 500 a whirl, but don’t know where to start? This post is for you!

Last week, we looked at stock markets and how their purpose is to let the public buy and sell shares in publicly traded companies. I mentioned that to invest in the S&P 500, you’ll need to buy an Exchange Traded Fund (ETF), like Vanguard’s S&P 500 index fund.

In order to buy and sell shares on a stock market, you need an stock broker, someone who has gone through various training programs and is regulated by the stock exchanged they work on. A stock broker is traditionally a person who takes buy/sell orders from individuals and fulfills those orders on the stock market floor by yelling and screaming at other stock brokers. Stock brokers usually charge a commission on every trade, that means if you want to buy some shares in company A and sell shares in companies B, that would be 2 separate trades, and your broker will charge you for each.

These days, the job of stock broker has been largely replaced by computers. So what we really need is a web broker. For you and I, a web broker is a website where we fill out a form specifying how many shares to buy or sell, at what price, etc. We then hit ‘Enter’ to buy and sell stocks. The web broker then trades your money with another web broker. The whole transaction could take seconds.

There are dozens of web brokers to chose from and every major bank in Canada has one, they are cheap and easy to use. How cheap are they? Well, that depends on what kind of investing you’re going to be doing and how often. As I mentioned, they will typically charge you per trade and web broker prices currently range from limited-time-free to $10 per trade.

The cost of a web broker is a fee, the third prong in the trident of costs (taxes and inflation being the other 2) and means that if you want to invest money every month, that could be $120 per year, which won’t be that big in the grand scheme of things, especially compared to some mutual fund fees. But I suggest planning on buying shares of TSE:VFV every 3 or 4 months to cut down on fees. Some web brokers can set up automated buying so all you need to worry about is having money in the bank.

Finding and opening a web broker account is easy. I would go to whoever your current bank is and tell them you’d like to open a web broker account. Here is a list of the 5 big banks and their web brokers:

If you aren’t with any of the above banks, you can still open a web broker account with them, or google around for another one. As long as the web broker allows you to trade on the Toronto Stock Exchange (TSE or TSX), you should be fine.

To open a web broker account, I would suggest physically walking into your bank and telling them that you want to open a web broker account, and someone will meet you to go over whatever steps are needed to setup an account. The banks do all the work for you, but there are quite a few forms they have to fill out, the process can easily take 30 minutes.

I would open up a web broker account for your TFSA, and a second web broker account for your RRSP. This will allow you to transfer money into your tax sheltered accounts, and buy and sell as much as you want without incurring any taxes. You would only pay taxes when you withdraw money from your RRSP web broker account. You will never pay any taxes on money withdrawn from any TFSA account, and you are able to withdraw money from your TFSA whenever you want.

Once your account is open, and you have a trading password, you are ready to buy a stock! The stock we want to buy is Vanguard’s S&P 500 ETF I mentioned earlier. It trades under the symbol: TSE:VFV.

This means <stock exchange>:<company stock symbol>, so TSE is the stock exchange, VFV is the symbol of the fund or company we want to invest in.

Things you’ll need to know to buy stock on any exchange:

  • The account the funds to make the purchase are coming from.
  • The action you wish to take (buy, sell, other stuff we don’t care about).
  • The company symbol.
  • How many shares you want to buy.

When deciding how many shares to buy, remember to factor in any web broker fees. If you have $1000, you can only buy 9 shares that cost $100 (9 x $100 = $900, + $6 (web broker fee) = $906)

You can buy VFV from your web broker’s website, or you can phone up the web broker directly and have a human to actually make the trade for you. Note that web brokers are neutral parties when buying/selling shares. They will not give you investment advice, so don’t bother asking them if buying particular shares is a good idea.

Don’t bother trying to time when you buy the S&P 500, in the long run, that won’t matter. Once you’ve bought your shares, hold them. Literally do nothing for decades and watch the value of your investment grow.

Stock Exchanges – The First Sharing Economy Market

exchange

A stock exchange is really a large auction, like ebay, but for company shares. Stock exchanges allow anyone with a bank account to buy shares in companies and Exchange Traded Funds (ETFs). Companies sell small amounts of themselves to the public in exchange for ownership shares in an Initial Public Offering (IPO).

For example, Acme Inc might try and sell 1,000,000 shares of itself for $50 per share in order to raise $50,000,000, or more if investors think Acme Inc is going places. If things go well for Acme Inc, they will have traded tiny slices of ownership for at least $50,000,000. This would be called Acme Inc’s IPO, they can then use the new money to invest in their business (maybe acquire a rival, update their factories, etc).

IPOs also allow founding shareholders the chance to sell some of their shares to the public for what can be a small fortune.

For Acme Inc, raising money on a stock exchange might be better than borrowing money from a bank, or raising $50,000,000 from one person or small group of people who would then be able to exert control over the inner workings of a company.

Companies that have shares on a public exchange, like the TSE or the New York Stock Exchange (NYSE), are called ‘public companies‘ because any member of the public can own a part of these companies by buying shares on a stock exchange. Companies on exchanges are subject to various rules and restrictions though. For example, they have to publicly announce the status of their operations and finances every 3 months (quarterly reports), they have to publicly declare who is on their board of directors, which typically represents the biggest share holders of a company. Also, their finances have to be in good shape, or they will kicked off the exchange.

Most of the time, when you buy shares on a stock exchange, you are not buying them from the company you wish to invest in, but from another investor. You are only buying shares from a company directly if it has an IPO, or secondary public offering, or third, etc. Otherwise, you are buying from another investor. It is important to know that people will sell shares for many reasons, but will generally only buy shares in a company if they feel that the worth of the company will go up.

And the worth of the company is often described as its market capitalization: the number of available shares it has, multiplied by the value of each share. So Apple, the largest company in the world currently, has a market capitalization of $740 billion, and a current share price of $127.09, making the number of Apple shares available at 5.8 billion. Market capitalization is generally considered how much it would cost to buy a publicly traded company, if you wanted to completely buy Apple, the company, that would cost you $740 billion today.

But we’re not looking to buy a company, only the S&P 500. Our next step is setting up a self directed investment account.

In order to invest your money with the S&P 500 you need to open a special kind of bank account, a self directed investment account. Because the specific S&P 500 investment we want to make takes the form of an ETF, we need access to the Toronto Stock Exchange (TSE).

The S&P 500 itself is an index, an index that can be easily duplicated with a basic formula. Other financial companies have created funds using this simple formula, and made these funds available on the TSE, Canada’s main stock exchange.

RRSPs – The Taxman Giveth A Bone

taxtreat

Deciding to invest your retirement money in something like the S&P 500 is an important step in setting up your personal finances. Being able to safely grow your money is important, but so is avoiding paying as much tax as possible when it’s time to retire and begin withdrawing from your savings.

Taxes are one of the three main agents of money corrosion (fees and inflation are the other two). If you follow the law, you will always pay some taxes. The trick is to figure out how to pay as little as possible.

Because the Canadian Pension Plan (CPP) pays out so little (currently $640 – $1060 per month), the government has given Canadians an incentive to take care of their own retirements by introducing Registered Retirement Savings Plan (RRSP).

RRSPs are a type of investment account that is registered with the government, they are designed to defer tax payments until you retire. They are not themselves accounts, but an account designation. That means that many types of bank accounts can be used as an RRSP: savings accounts, web broker accounts and mutual funds can all be designated as RRSPs.

The idea behind RRSPs is this:

When you are working, you are making much more money than when you retire. That means you are also paying more income tax too. By putting your money into an RRSP, you get a tax break next time you file your income taxes. If you make $100,000 per year, and you invest $18,000 into RRSPs, the tax break you get is the difference in tax you would pay if you made $82,000 instead of $100,000. The government lets you pay less income tax when you put money into your RRSP.

But later in life, when you retire and start tapping into your RRSPs, you pay regular income tax on whatever you withdraw. Because what you withdraw when you retire is likely to be less than what you made while you were working, you would be paying less income tax on that retirement income. Withdrawing $50,000 a year (for example) will still require you to pay income tax as though you had a regular income of $50,000. But a $50,000 income is in a significantly lower tax bracket than $100,000, you would end up paying far less tax overall.

Not only are you paying less tax when you invest in an RRSP, the money you get back allows you to immediately invest it so that you have even more money that can grow over the years.

Some RRSP facts:

  • The maximum amount you can contribute for 2015 is $24,930, or 18% of your income, whichever is lowest.
  • You can buy and sell equities (stocks) and take a profit in an RRSP without paying any taxes.
  • You cannot contribute if you are 71 or older.
  • You can withdraw up to $25,000 to help with the down payment on your first home, but you have to pay that amount back within 15 years.
  • If you can’t contribute the maximum amount, the difference will be carried over to the next year.
  • You will be charged 1% per month if you contributed more than your contribution limit.
  • When you are ready to retire, you need to convert your RRSP into a Registered Retirement Income Fund (RRIF). You can do that at any time.

Because the money you get back from the government when you contribute to your RRSPs is based on what income tax bracket you are in, the higher the tax bracket, the greater the tax break. But if you are in a lower income tax bracket, the benefits of contributing diminish. You can use an RRSP contribution calculator to see what you would get back from the government if you contributed to your RRSPs.

Using an RRSP calculator, you will notice that if you live in Ontario, make $40,000 per year and contribute $5,000 you will get a return of $1003. But if you make a salary of $100,000 and contribute $5,000 your return more than doubles to $2170.

RRSPs are a great way to help grow your money tax-free, but they are designed for average to above average income earners or households. If that’s not you, that’s OK, because Tax Free Savings Accounts (TFSAs) offer an even better way to save your money, and the benefits of TFSAs apply equally to everyone, as I will explain next week.

 

The S&P 500 – The Best Way To Save Your Money

s500

Last week, I talked about mutual funds and how they are able to grow your money much better than savings accounts. One of the problems with mutual funds is that there are so many to choose from. Personally, I just don’t have the time or desire to really hunker down and maul over financial details of funds, what they are invested in, and how much.

And that’s a real problem. When I didn’t know any better, simply being shown an impressive graph of a fund with a name like ‘Mackenzie Ivy Foreign Equity-A’ by a financial adviser with a reassuring smile was all I needed to invest.

It could well be that Mackenzie Ivy Foreign Equity-A is a great place to invest your money, but I personally don’t know. And I don’t really care either because I don’t have the time to research mutual funds, and quite frankly, I find it really boring.

As I mentioned in my first blog post, I have things I want to do with my one life. I have ambitions and passions to pursue, and the sooner I can stop having to work for the Man, the sooner I can really focus on doing the things I want to do. This means that my free time now is also valuable, too valuable to waste researching boring things.

Like many before me, I thought to myself, “Surely, someone has figured out the best place to put money, this must be a solved problem.”

After a short search, it was revealed to me that the Standard & Poor’s (S&P) 500 was such a place and that it was actually a well known solution amoungst investor types. Indeed, Even Warren Buffett, the most successful investor of the 20th century, where he amassed most of his staggering 72 billion dollar fortune, has very publicly endorsed the S&P 500 as the best place for the average person to put their money.

The S&P 500 itself isn’t a fund, it is an index: a list of 500 large companies publicly traded in America that basically make the world work. Companies are put on or taken off the list based on specific criteria by a committee.

In its current form, the S&P 500 has been around since 1957. The way the index is calculated is pretty simple: Add up the capitalization (number of company shares multiplied by the share price) of all 500 companies in the index, and divide by ‘the Divisor’. The Divisor is technically proprietary info owned by the people who manage the S&P 500, but it is approximately 8.9 billion.

The math behind the S&P 500 is basic: the sum of the capitalization of the companies in the S&P 500 index is something close to $18.8 trillion, divide that by 8.9 billion and you get 2108.10, the S&P 500 index as of March 20, 2015.

Because the index is based on the stock market share price of each of the 500 companies, the better individual companies do, the higher the S&P 500 index goes. Over the last 5 years, the S&P 500 index has gone up an average of nearly 16% per year. Over the last 20 years, 11% per year. Over the last 100 years, 12% per year. At 12%, you are doubling your money every 6 years, $100 with the S&P 500 could become $200 in 6 years.

Of course, it’s not quite that straight forward. The S&P 500 is not a fund, but and index. There are several funds, however, whose sole purpose is to emulate the index for as cheaply as possible. But there are still three largely unavoidable costs that will effect all investments: taxes, inflation, and fees. These costs will chip away at what you actually end up taking home on any investment.

But as far as investments that require the least amount of energy go, it’s hard to beat the S&P 500. There are all kinds of companies in that index that you use every day: Disney, Visa, Apple, Starbucks, Black & Decker. Other well known companies like Boeing, P&G, Gap, Staples, Ford, Whirlpool and Google are also included.

The S&P 500 is a very diverse investment. The individual companies that make up the index make your world go round: they mine natural resources, build all the stuff you use, move goods, grow food, make the internet useful, provide electricity, entertain you, cloth you, etc. It is a single investment in 500 companies that gives you a little part of every industry. And it is good to be diversified, because unseen things always happen. I sure wouldn’t want all my life savings tied up in only Starbucks if a mold that killed the worlds coffee crop broke out (god help us…).

Fees are another strength of the S&P 500. Because the index is easily calculated and publicly available, software can easily do the job of fund managers, significantly reducing fund fees. My preferred S&P 500 ETF (Exchange Traded Fund) is Vanguard’s, its management fee is only 0.08%.

So how does one put their money in the S&P 500? To answer that, we must first consider some new realities, namely, the incredible amounts of money one can make. Consider having $100k in the S&P 500, it is possible to double that in 6 years. That’s an average of more than $15k per year of investment income. Imagine having $10 million in the S&P 500?

The government is fully aware of the massive potential for income on investments, and has taxes in place to rain on a good investors parade.

Taxes are a problem well known by Canada’s wealthy, where solving the problem of having to amass a fortune becomes the problem of finding the best way to avoid taxes when withdrawing from said fortune. But for anyone who plans to someday live off interest from investments, knowing how to avoid taxes from the start is key.

 

Mutual Funds – A Better Way To Save

mutualfunds

Despite their name, savings accounts don’t really save your money. Because the rate of inflation is almost always higher than the rate your money grows in a savings account, you are effectively losing money in any savings account each year.

Mutual funds, however, can offer a much better Return On Investment (ROI) than a savings account. A top performing savings account will grow your money by around 1% a year, a typical mutual fund might grow your money by 5% a year.

To emphasize the importance of a mutual fund’s higher growth potential, consider the difference between 1% savings growth and 5%. Ignoring inflation, at 1% a year, you will double your savings every 70 years, thanks to compound interest.

At 5%, you double your savings every 14 years.

A mutual fund is basically a pool of money a group of investors use to purchase various stocks, currencies, bonds or a mixture thereof. They can be focused on investing in one geographical region, like Asia or Western Canada, and they can also target specific industries or sub-industries, like mining or small-scale banking.

Mutual funds buy and sell assets based on the discretion of the fund manager. Fund managers are typically going to be your Bay Street types who are constantly reviewing individual assets, like a particular company they may buy into and introduce to their fund, or perhaps shares of a company already in the fund that are underpreforming and needs to be cut.

One of the problems I found with my own experience with mutual funds is knowing what exactly your money is being invested in. There are two angles to this:

  • Simply knowing where your money is going. You wouldn’t buy a car without knowing as many details about it as possible. Why invest your life savings into a Canadian mid-cap fund without knowing what a mid-cap is, or what specific companies are included?
  • There are other reasons for wanting to know what specific companies your money is being invested in: Do you only want to invest in companies that are environmentally friendly? Do you want to invest in Asia, but not China? Maybe only small US-based tech stocks?

Every major financial institution has their own set of mutual funds, and naturally, every financial institution will say they have a mutual fund perfect for you. According to fundlibrary.com, there are around 36,000 mutual funds in Canada. With so many, how are you going to find the right one?

Here are a few things I learned to be aware of when shopping for mutual funds:

  • Fees. Those Bay Street-types aren’t cheap, and it’s you, the investor who pays their wages. The biggest complaint against mutual funds is the fees. Many funds have a Management Expense Ratio (MER) of 2%, where every year 2% of your investment will be taken by the fund to pay for itself. The fees include management fees, advertising/marketing fees, legal fees, transaction costs in acquiring assets, etc.
  • There are many re-sellers of mutual funds who are paid a commission. And some funds pay better commission to sales people than others. Remember to ask how the person encouraging you to invest in any mutual funds is being paid. Investing in something because a sales person gets a cut is a bad reason.
  • Because mutual funds are more risky than savings accounts, you want to avoid putting all your eggs in one basket. If your only mutual fund targets small tech stocks, that is a traditionally risky investment. Be just as prepared to lose a sizable chunk of your savings on bad years as you are to reap the rewards of a risky investment paying off in the good years. If you have mutual funds that invest in very specific things, I would strongly suggest diversifying and looking at a broader range of funds.
    • The agony of losing your life savings on a bad bet will always elicit a much stronger emotion than the joy that comes from doubling the value of your life savings.

In comparing mutual funds, you could use a comparison tool such as Van Guards fund comparison page. But I find it difficult making sense out of fund-to-fund comparisons. Instead, I prefer to compare my investments to the bellwether of benchmarks, the S&P 500.

The S&P 500 is an index of the 500 biggest companies in the US. This includes Disney, Apple, Verizon, Citibank, Walmart, Google, etc. The index is calculated by looking at every company’s balance sheets, and regularly ejecting poor preforming companies from the list in favor of up-and-coming companies with excellent balance sheets.

The S&P is also what almost every fund manager uses as their benchmark in determining how well their investment acumen is doing. At an average annual rate of return of 12.65% over the last 40 years, there are virtually no mutual fund managers who have been able to consistently beat the S&P over that period of time.

Which begs the question, can’t you just invest in the S&P 500 index yourself?

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