Choose From The Best Products

Think of all the financial products you use: bank accounts, credit cards, investment products and so on. While the big, well-known players certainly have the most visibility, there is usually a wide range of alternatives to choose from. Considering you will probably stick with your choice for years (if not decades), it is worth taking the time to weigh the available choices before committing to a product. When I think of all the time I see people putting into choosing TVs, skis, golf clubs, and so forth, I often wonder how the financial industry would look if we also put as much care into evaluating our financial product choices.

While there is rarely a definitive "best" product for everyone, there is likely a group of "pretty good" products to choose from. I think it's worth the trouble to make sure you're using Pretty Good Products.

Here is what I would look at when comparing the following types of products

• Bank accounts: Fees. There's really no great reason to be paying fees for a basic personal bank account. You're depositing money that the bank will make use of and you shouldn't pay a fee for that. Start by looking at what restrictions are put on a no-fee account and see if that satisfies your typical usage. Also consider the smaller players like credit unions and online banks. They are typically set up so that you can use ATMs on The Exchange network.

• Credit cards: First of all, you really shouldn't be carrying a balance on any of your credit cards. The interest rate on balances is way too high and you'd be better off getting a line of credit from your bank if you want to borrow money. That said, assuming you are paying your bill in full every month, you probably most want to compare fees and rewards on credit cards. Again, start with a no-fee card. Just about every card issuer has a no-fee choice. For rewards, I consider cash-back to be best since you can do anything with cash. However, depending on your usage you may want to look at some more specialized rewards such as AirMiles. RedFlagDeals has a nice comparison tool.

• Discount Brokerages: Look at account fees and see what it takes to have them waived or lowered. Most brokerages will waive fees (account fees and trading commissions) if your assets deposited with them are over a certain amount. You may be able to consolidate your family's assets under one brokerage to meet those minimums. Many brokerages advertise additional tools like stock screeners or access to market research. If you don't use those tools (and I rarely have heard of people using them at their brokerage), then don't give them much weight in your comparison.

That's just a sample of some of the products you probably use. Others include your mortgage, and lines of credit. In all cases, the evaluation process is similar:

1. Check out the competition--the big players don't always have the best products, so include the smaller players as well. Get to know what is an average product so you can identify above-average products.
2. Understand the fee structure. Pay no fees if possible.
3. Don't pay for what you won't use.

Do consider the safety of using a product or company. If you highly value being with a big-name company because you think it less likely to close up shop than a small company, then you can make that part of your comparison criteria. However, most Canadian banks are CDIC members, and most Canadian brokerages are CIPF members.

Finally, don't fret over finding the Perfect Product. If it's taking too much time of your time to figure out the very best fit for you and the actual difference is small, it's no problem to chose a great product and get on with life.

US Non-Resident Withholding Taxes and Asset Location

Dividends and interest from US securities are subject to the US Non-Resident Withholding Tax (currently 15%). However, the US-Canada Tax Treaty grants an exemption for certain registered accounts like RRSPs. So if you hold those securities in an RRSP (or certain other accounts), you will not be subject to the withholding tax. (Your brokerage usually handles getting this information to your ETF company so that they do not withhold the tax.)

Now that TFSAs are available, many people are treating them as an extension of the RRSP. But you should be aware that TFSAs are not exempt from the Non-Resident Withholding Tax under the US-Canada Tax Treaty.

So, considering only that you want to minimize the US Non-Resident Withholding Tax, the RRSP is the preferred location for applicable holdings. No withholding tax is applied. The next-best place is in a taxable account, because you can claim a foreign tax credit on the withholding tax paid. The worst place is the TFSA, because it is not exempt from withholding tax and on top of that, since it is not a taxable account, you cannot even claim the foreign tax credit.

Earning, Saving, Spending, Investing: Toward a Common Goal

Have enough for today's necessities and save for retirement's necessities. Those are the basic personal financial goals, and while "necessities" is wide open for interpretation, the exact definition is not essential for this discussion. I'll define it as things required for a physically and mentally healthy life.

Earning, Saving, Spending, and Investing money are all contributors (that you have some control over) to your financial situation. They are all related, and it is worth looking at each one.

Commonly when we talk about saving money, we talk about not spending. Not buying unnecessary things is a great way to keep your money for other things later in life. But it's not the only way.

Earnings: It's a time consuming process to increase your earnings. You can re-train for a different job, earn a raise, or do extra work on the side. It must be earned and involves work, so most people will not pursue this avenue after finishing school, but achieving this will put you in a better financial position that will likely stick for the rest of your career. Note that increasing your earnings does not mean an increase the cost of your necessities.

Investing: Is related to saving. What do you do with the money you save? Investing idle cash is a smart move. Learn how to do it properly!

Spending: Spending smartly makes sense. Realize that although advertising can be funny, entertaining, and/or carry a meaningful message, the real goal is to push your buttons and convince you to part with your cash. Learn how to make smart decisions on what products you buy. Consider the price, the relative quality (diminishing returns is probably in effect), and the cost versus how much you will actually use the product. Too many times, we convince ourselves to buy something based on how much it can potentially do instead of thinking about how we will actually end up using it.

Suggested Schedule For Lazy Investing

There are many blogs, news outlets, and advice channels providing the average Joe with a constant stream of financial news, opinions, and noise. What is a good way for a normal person to deal with all this information?

As horrible as it may sound, I would recommend that anyone who is serious about managing his own investments start by ignoring it all until he understands the subject matter. If you take the matter seriously, you can educate yourself quite thoroughly in 6 months to a year. Maybe that sounds like a long time, but it's a huge money-saver if your alternative is to pay someone 1% of your assets to manage your investments for the next 30+ years of your life.

How do you know that you've gotten to a point where you understand your investments? A test is to ask yourself whether you understand how a product is priced, what different parts make up the cost of owning that product, who issues the product and why, how liquid is it, what are the risk factors and how risky is it compared to other products, what is the expected return, what do you actually own, how can the product be taken away from you other than your selling it?

Understanding your investments is one part of freeing yourself from the constant barrage of questionable financial advice. Have a scan through some financial articles. You will find them peppered with non-committal words like "could", "maybe", and "looks like" with regards to current events. This is not really a knock against the articles themselves, since nobody knows for sure how things will pan out. However, once you understand your investments, you will be able to read these articles as opinion pieces instead of concrete tips.

Next, learn about investing history. Learn about the mass hysteria that has gripped investors in the past. Most people don't bother to learn about history and we find ourselves getting tripped up by similar problems later on. Our memories are so short that we even manage to crash the markets twice in the same lifetime.

[The above two points are very well covered and expanded upon in William Bernstein's book, "The Four Pillars of Investing". His four pillars are:

1. Theory of Investing
2. History of investing (how did people handle things before)
3. Behaviour of Investing (how your can emotions ruin your chance for success)
4. Business of Investing (how the mutual fund / brokerage / middleman industry bleeds you dry).]

Read books that are based on scientific research. "Educating" yourself by reading about hot investing methods that have no repeatable success is a waste of time.

So you understand investment products, you know how the markets can act, and you know how you should behave. Now is the time to form a plan. Spend some time to make it a good plan based on your researched knowledge, and then implement your plan. Just as it's not a good idea to invest without a plan that you understand, it's also not worth it to hold off executing a good plan because you are searching for the perfect one. Except in hindsight, there is no perfect plan.

You now have a plan, probably for your retirement that is many years away. If you've done a good job educating yourself, and you have confidence in your plan, you're free to let your plan run. If you want to continue learning more, by all means go ahead. If you like reading blogs and keeping up with the news, you now know enough to separate the good stuff from the noise. Tweak your plan every 6 or 12 months, and use the rest of your time to do something that will bring you better returns in some other area of your life.

Expert Opinions and Market Timing

Research into investor performance has shown quite convincingly that for the average investor, market timing does not work. I don't think that this statement is so controversial that I should spend time providing supporting information on this blog. (Search engines will provide plenty of reading on the topic.)

If this is such a well-known fact, why do we so enthusiastically consume speculative commentary on the markets? Or rather, why do we believe that we can make the jump from "expert speculation" to successfully timed investment?

The field of behavioural finance strives to answer questions like these with a scientific approach. On an individual level, we can also perform a thought exercise to find our personal stumbling blocks. Here's my list. I encourage you to think about your own, and share them in the comments.

In no particular order:

1. It's comforting to believe that someone has an expert handle on this stuff. In many parts of our lives, we make use of products and services that we do not fully understand. In many ways this requires a leap of faith. For instance, that cell phones are safe and are not causing us brain tumors, that the formula we feed our babies is a good substitute for breastmilk, or perhaps that the water filter we just bought makes the water more fit for drinking (how many people know what those filters actually do?). We assume that somewhere along the way, some experts have proved that the products we use do what they say the do (and don't do anything else). In financial matters, where are our experts, and where is their proof?
2. We're all above average (the Lake Wobegon Effect). Since I'm smarter than the average person, I can make use of information to formulate and execute a superior plan.
3. Spectacular stories of people who have made it big. Is it luck? Is it skill? I don't know, but every once in a while, we'll hear about someone who bet it all and made a fortune. We all want to be that person.
4. Market timing is fun and exciting. Feel the thrill of a money-making trade! Quickly forget the rest.
   
5. Not tracking personal portfolio after-tax performance against a representative benchmark. You might think that you did a great job earning a 10% return, but if your benchmark (not a benchmark of your choosing, but a representative benchmark) returned 12%, you actually did poorly.
6. Lack of understanding of the investment products. Sure, you could read about bonds, stocks and other investment instruments so that you could judge investments for yourself, but isn't it easier to just take the recommendations of experts? They're experts, after all.
7. We don't know the track record of experts' opinions. This is a complicated issue:
1. We need to separate a commentator's own advertised performance (maybe through the fund he/she manages) from the performance of the expert's recommendations that we hear or read about.
2. The "experts" may make frequent recommendations. Make enough guesses frequently enough and you'll eventually get it right. Maybe we should count each recommendation as a buy or sell execution in our tracking system.
3. Recommendations on an investment does not make a portfolio. Did Mr. Expert recommend buying ABC 5 years ago? Has he said anything about it since then for those who added it to their portfolio? Maybe your expert concentrates only on tech stocks and consequently a portfolio of his recommendations would be unbalanced.
   
4. No indication of investment horizon. This is linked to (b) and (c) above. Maybe you buy something based on a recommendation. How long is that recommendation supposed to stand for? Maybe a new recommendation (based on better information, of course) will be made soon (b). Or perhaps your expert will become bored with that particular security and you'll never hear about it again (c).
   
5. There are lots of other issues I invite you to think about, but the point is that until we have a good way of tracking the experts' opinions, we don't have a basis for taking their recommendations.
   

When it's so easy to make very close to benchmark earnings, and study after study shows that the average investor is making less than that, it is really an interesting exercise to think about your own situation and decide how average you want to be.

Preparing To Invest: Read Some Books!

For many of us, the web has become an important learning tool. Search engines have made it wonderfully easy to find information on specific topics. But to me, the web, with no promise that content has been edited or is correct and complete, is not a great tool for getting comprehensive information on broad topics, which is exactly what you want as you prepare to invest.

There is also the question of how the site stays in business. For most, it means selling advertising, which raises issues of conflict of interest. For instance, can I trust a review of credit cards to be fair if the site also runs ads for certain credit card companies? How do I know that a comparison of brokerages is not biased when I see ads for banks running on the site?

The use of hyperlinks on web sites, while at the very core of what makes the web great, means that users can read about whatever pages they like on a site. But it also means that they will probably read only what they like. So structuring information on a broad topic is very difficult.

Newspapers and magazines have similar issues, and also need to constantly generate new content. It does not matter if there are not any new and useful ideas to write about--staying in business for them means writing new articles.

There are plenty of other learning methods, each with their own issues, like learning from chats with friends, or from TV.

To me, the best learning tools are books. Here's why I think so:

• Content is structured: Unless this book was written and edited carelessly, the content is presented in a logical progression. Focus is given to points that are important in the context of the broader topic. Articles on the web and in magazines and newspapers lose this context.
  
• Content is comprehensive: To many people, investing means buying stocks. I'm always surprised by how many people do not understand or consider bonds or other asset classes like real estate. A good investing book will teach you about the different asset classes and how they may (or may not) fit into your portfolio. Articles from other sources mainly focus on one point (usually stocks) and are not as able as books to present information in the context of the full spectrum of investing options.
  
• Once the book is in your hands, the sale is complete. Unless you've picked up a book that is trying to sell you another product, the content is not as influenced by advertisers.

To be sure, there are some books out there that are real stinkers--books written to evangelize the latest mania, to sell another product, short-sighted books, and just plain bad advice books. But all these problems also exist in the pages of non-books, without the positive points that books enjoy.

There is still a place for non-books, especially for doing quick research into specific topics or getting the beat of current trends. But while you are building a foundation of knowledge as you prepare to invest, go read some books!

Get All The Benefits That You Qualify For

When we enter the various stages of our lives, we are often so busy adjusting to the changes that we don't look into benefits that we should be getting. Since you must apply for many of the benefits available, a lot of us miss out on those benefits for some time while we sort out our lives. Some of the significant events that can qualify you for benefits that you were not previously collecting are:

• Marriage
• The birth of a child
• Change in income or employment status
  
• Health changes and deaths in the family
  
• Retirement

For instance, with the birth of a child, here are some of the things you can do:

• Set up an RESP for the child's education
• Collect the Universal Child Care Benefit
• Collect the Canada Child Tax Benefit

It is hard to keep track of all the programs that are available, both from the federal government as well as from your province, but the government has set up a handy web site to help you find all the benefits that you qualify for at CanadaBenefits.gc.ca. Tell it your province of residence, and head over to the Benefits Finder. You'll be asked a few questions and then be given a nice list of applicable benefits. Each benefit is marked as either federal or provincial.

Using this site, you can make sure that you are getting all the benefits for your current situation, and you can also use it see what you may be qualified to receive in hypothetical situations. Use the tool to plan ahead for events like the birth of a child so that when that event happens and you're busy waking up at 3am to change diapers, you won't need to also scramble to learn about and apply for (or put off for a few years) the benefits that you are entitled to.

Tax Terminology for Beginners

In conversations amongst my colleagues and friends, I've found that many people are not really aware of some of the basic terminology used in a tax return. While it's certainly not required to know all the terms used in the tax code, having basic knowledge of the meaning of the numbers you are calculating can clear up what is actually going on in your tax return. So here's my short list of tax terminology for beginners:

Total Income - Your gross income, before any deductions. Includes income from employment, investments, pensions, and government benefits.
Net Income - Your total income, after certain deductions have been applied. This number is used for determining eligibility for income-tested benefits, but is not used to calculate your personal income tax since it still contains some non-taxable income.
Taxable Income - Your net income, minus non-taxable income. Used to calculate your personal income tax.
Deduction - An expense that you declare (claim) on your tax return that is subtracted from your income when calculating your net income and taxable income. By reducing your taxable income, you reduce your tax paid.
Tax credit - A tax credit is applied directly to tax owing, reducing the amount you owe. This differs from a deduction in that a deduction reduces your taxable income.
Non-refundable tax credit - A tax credit that is not paid out as cash to you if it reduces your taxes owing to below zero.
RRSP - A plan provided by the government under which you can place investments that will grow tax-free. An RRSP is not a specific investment, or account, but acts like an umbrella. The size of your umbrella (contribution limit) is set by the CRA and anything (that is RRSP-eligible) that you put under it that fits in your contribution limit grows tax-free.
Adjusted Cost Base (ACB) - The cost of an item. This includes your purchase price, and costs related to the purchase. If you purchase the same item on more than one occasion, add the additional purchase prices and costs for those purchases. In a mutual fund (or ETF), if you receive distributions that are a Return of Capital, this will reduce your ACB, since your money is effectively being returned to you. Use the ACB to calculate your capital gains or losses when you sell the item.

How Often Should You Rebalance Your Portfolio?

It is often suggested that you should rebalance your portfolio every year. But you might ask yourself, "why every year"?

I think it makes sense to think about why you rebalance and what is happening to your portfolio when you do or do not rebalance. I believe that the top 2 reasons for rebalancing are:

• Control the risk profile of your portfolio
• Capture reasonable gains when they occur (buy low, and/or sell high)
  

How does rebalancing on a timed schedule (quarterly, yearly, etc) help with either of these goals? For example in a volatile market, with wild swings up and down in short time frames, we optimally want to rebalance frequently at market tops and bottoms. This would achieve both goals. In a stagnant market, we might not need to rebalance for many years. This would also achieve both goals.

However, if we agree that we cannot time the market, then we have no way of knowing where those tops and bottoms are, so most of us need some rules of thumb so that we don't forget to rebalance altogether (or rebalance too often--think about transaction costs and taxes on capital gains).

The rule of thumb that is easiest to remember is a timed schedule. This is also probably why it is the most frequently suggested rebalancing strategy. Maybe it's on your birthday, or after you receive your notice of assessment from the CRA. If you will forget to rebalance without a timed schedule, it makes sense to use calendar dates for rebalancing, whether you decide it is every quarter, every year, every 2 years, or whatever is convenient for you. The once-a-year suggestion appears to be historically sound and also keeps transaction costs within reason.

If you have more discipline and follow your portfolio more closely, a more direct approach to achieving the goals of rebalancing is to set limits on how much an asset is allowed to deviate from your target allocation. For instance if you have a 60/40 portfolio and you decide that a 10% deviation is when you are out of your comfort zone, you would rebalance if your portfolio became 70/30 or 50/50. The number you choose as your deviation limit depends on your risk tolerance and what you think are fair gains to cash out on. Using this method, you would be rebalancing whenever it is necessary according to your rules for achieving the rebalancing goals.

While I think that the timed schedule is a fine rebalancing strategy, it does seem to me to be an indirect way to achieving the ultimate goals of rebalancing. If you have the discipline and energy, setting deviation limits is probably a more direct approach.

Consider All Sources of Income When Forming a Portfolio

When you think about your portfolio, take into consideration more than just the assets sitting in your brokerage or mutual fund account. For instance if both you and your spouse work in the high tech industry, maybe you don't need to have so many high tech stocks. Or if you work in real estate and have a couple of investment properties, it might not make sense to invest in REITs since a real estate crash would affect your job, as well as your investments.

Similarly, although you may really like your employer, holding substantial assets in company stock is dangerous. The classic example of this is the Enron case, where employees not only lost their jobs, but many also lost their retirement savings. Either one of these would be terrible on its own. Having both happen is devastating.

Consider your entire financial situation when creating your portfolio so you won't have any unexpected surprises.

Tax Refunds Cost You Money

Around this time of year, most people look forward to a nice big tax refund cheque from the CRA. The average refund for 2007 was $1440, a pretty substantial amount. Plenty of people (including financial advisors) will suggest treating yourself to something nice. $1440 will buy you a pretty nice TV, for example. But let's think about where that money came from first.

The government is not giving you free money. It's actually returning your money. Money that you overpaid through the year. In fact, because you overpaid, you've given the government a free loan and you didn't even get to earn any interest on it. So getting a big refund is actually to the government's advantage, because they certainly are getting a better-than-zero return on the cash you've graciously lent them.

One argument in defense of tax refunds is that they are like a forced savings, taking money out of your hands that you might otherwise have spent. Well, if you need to be on a forced savings plan, why not set one up yourself that sends regular deposits from your chequing account over to a high interest savings account or a money market fund. At least that way the money is working for YOU, and is way more liquid (should you really need it) than waiting for a cheque once a year.

It's probably to your advantage to actually owe a little bit on your tax return. However, you will need to budget for the amount owing at tax time. In the end, though, the fairest result would be to have no refund and no amount owing.

If you find yourself regularly getting a large refund, you can fill out form T1213 to request to have tax deductions reduced.

So if you get a refund this year, before you go and spend it, remember that it's not free money, and it's not a bonus. It's cash that you should have had in your hands already. Cash that you should have been able to put to work for yourself. Use the money like it was already yours, except that it was put away in an account earning you 0% and locked up until a few weeks after you file your return.

Preparing to Invest: Practice

So you've got your finances in order, and after paying for living expenses, insurance, and funding your emergency fund, you find you have some money left over to invest. Great! Now you're itching to get your account opened so that you can place your first trades and make tons of cash! Well, before you do that, it's probably a good idea to do some practice trades. There are plenty of stock simulator sites out there for you to get your feet wet.

While you probably have an idea of what you want to buy, you may not be familiar with the types of orders you can enter, or how to enter the order at all. Having a trial run of this using play money will save you from the frustration and embarrassment of entering an incorrect trade with your real money. Market orders and Limit orders will probably be your most common order types, so try entering a few on a simulator. If you have enough time (a few months at least), try joining a game and see how you do.

If you're going to make mistakes while you learn how to enter orders, better to do it with fake cash!

Preparing to Invest: Have a Plan

Before you deploy your investment dollars, have an investment plan. Get it down on paper along with your reasons so that when things get scary, you will stick to your plan. For asset allocators using index funds, this might look something like:

What	Why
Stock/bond split	Risk control
Asset allocation	Diversification, opportunities for capturing benefits during re-balancing
Re-balancing strategy	Systematic method of capturing diversification benefit (buying low, selling high), Risk control

Reasons to revisit your plan include changes in the following:

• marital status or family
• job
• tax laws
• life changes affecting your income/expenses
• life goals (eg. you no longer want to sail around the world--helping to raise the grand kids is what you really want)
• periodic adjustment for age/investment horizon (this is a risk adjustment done maybe every 5 years)
• financial system (should be pretty rare--these are not economic or political events)

Poor reasons to revise your plan are usually predictive and short term issues such as:

• hot tips forecasting the next growth opportunity
• trying to predict the effect of an economic or political event
• predictions of interest rates and monetary policy

If you have a reasonable plan, it's important to stick to it. Getting spooked during a downturn (are you investing within your risk comfort zone?) or jealous when others appear to be doing better than you (don't chase past performance!) will lead you down the road of buying high and selling low.

Preparing to Invest: Get To Know The Available Account Types

RRSP, RDSP, RESP, TFSA, RRIF, DPSP! There are many types of accounts/plans available to help you grow your money faster. Get to know how they work, so you can make the best use of them and allocate your investments to the proper accounts from the get go.

Let's look at the RRSP and TFSA since they are probably the most common. The main benefit for both of the accounts is that growth in the accounts are not taxed while they stay in the plan. How about some of the differences?

• Contributions to an RRSP are tax deductible while TFSA contributions are not.
• Withdrawals from an RRSP are taxed as income while TFSA withdrawals are not taxed at all.

These two points mean that if you expect your tax rate to be lower after retirement, you will pay less tax using the RRSP. If the opposite is true and you expect your tax rate to be higher after retirement (not as likely), then the TFSA is more advantageous in this respect.

But that's not all! RRSP withdrawals before retirement incur an early withdrawal penalty while TFSAs do not. Check out the withholding tax chart for early RRSP withdrawals. (Note these are not exactly your final tax rates on these withdrawals. You might think that if you make 3 withdrawals of $5000 that you will be taxed only 10% instead of 30% on a lump sum withdrawal of $15,000, but since these withholding taxes are estimates, you will end up with a huge tax liability at tax filing time when your final tax rates are calculated.)

As you can tell, there are many rules and eligibility requirements. Get to know the different account types so that you can make good use of the benefits available!

In the general case (and remember, none of us is average, so adjust for your own situation!), for someone saving for retirement, I would recommend filling up an RRSP first. Of course, top up both accounts every year if you can!

Preparing to Invest: Be a Saver

You can't build real wealth and financial security if you are not regularly saving money. Yes, you can "own" a really nice car and a big house by the water by borrowing, but that debt is a liability that you'll never pay off if you are not saving.

Borrowing money to invest is a risky prospect too. Suppose your lender is going to charge you around 5% in interest. This is payable no matter how your investment does. Lose money, and you still have to pay interest on your loan (and eventually pay back the principle as well). And when you make money, considering that stocks average 8 to 10% annual gains in the long run, a 5% bite for interest payments is substantial.

Controlling your costs and spending is key to saving. Contrary to what advertisers imply, you do not automatically deserve to have the latest and greatest just because people around you are getting one. It does not serve you to envy them. If you can afford it, by all means, go ahead. But recognize when you cannot afford it (hint: if you can't pay for it with cash, you probably can't afford it. If you have to dip into your emergency fund, you probably can't afford it.) You don't need to keep up with the Joneses when chances are, under the nice shiny exterior, the Joneses are broke.

So how can you save? If you have the will, you can set a percentage (I suggest at least 10%, but the more the better) of your income to try and set aside as savings. Then look at your spending patterns and separate your needs and wants. Cut down on your wants to achieve your savings goal. Adjust what you spend on your needs (are there lower cost alternatives?) If you need a bit of help, try a "forced" savings plan by automatically depositing your savings goal into a savings account (like a high interest savings account). Places like ING Direct offer such a service (ING calls theirs the Automatic Savings Program).

Preparing to Invest: Protect Yourself, Your Dependents, and Your Belongings

Personal finance is about more than just your stock picks or your carefully selected asset allocation. A holistic view of your finances also includes your ability to handle financial surprises, and protection against financial catastrophe. These come in the form of your emergency fund and various types of insurance.

Emergency Fund: It is usually recommended to have 3 to 6 months worth of living expenses (not salary) in your emergency fund. Tally up your rent/mortgage, food, bills, fuel costs, monthly insurance premiums, etc. and set aside 3 to 6 times that value in your emergency fund. Keep this money liquid, so that you can access it relatively quickly. For example, put it in a savings account, money market mutual fund, or cashable GIC.

Why do you want to have this set up before you invest? Since the markets are volatile and emergencies and financial surprises can happen at any time, you really don't want to be forced to cash your investments when the markets have taken a nosedive, as they do from time to time.

Insurance: Protect yourself from financial ruin. The types of insurance you need will vary based on your situation, and in some cases your employer may provide some coverage for you. Some of the more common types of insurance you need are:

• Disability Insurance (protect your ability to earn)
• Health Insurance (protect from possibly huge medical bills)
• Life Insurance (protect your family's income)
• Home Insurance (protect your property and possessions)
• Vehicle Insurance (protect your vehicle and get coverage for liability)

I would strongly urge you to adjust your policies to get the best coverage for those cases that would truly bring financial hardship. Paying a couple hundred deductible for a broken windshield is annoying, but won't wipe you out like a court order for $1 million will. All insurance brokers have a default policy. It will work for the average situation, but nobody is average, so take the time to examine it and make adjustments that fit your situation.

The Cost of Doing Nothing

In today's extreme bear market, the urge to hide all your cash under the mattress can be pretty strong. Why invest in a market that can produce such horrible losses?

Inflation is the nasty phenomenon that will eat at the purchasing power of your cash year after year. The Consumer Price Index (CPI) is tracked by Statistics Canada and shows the rate at which the prices of goods and services has changed. An inflation rate of 2% means that in general, something that costs $100 in one year will cost $102 by the next year, reducing the purchasing power of your 100 dollars. The Bank of Canada targets an inflation rate of 1% to 3%, but we have seen double-digit inflation as recently as the 1980s.

What does this mean for your $100 if you stash it under your mattress and take it out again when you retire in say 30 years? Let's say you put $100 away 30 years ago in 1979. The average annual rate of inflation over those 30 years was 3.69%. According to the Bank of Canada Inflation Calculator, something that cost $100 in 1979 would cost $296.59 today. Another way to look at it is that the value of your initial $100 would be $33.72 after the effects of inflation. That's a 2/3 reduction in the value of your money!

So in order to preserve the purchasing power of your hard earned cash, you simply must invest and at least keep up with inflation (after paying taxes on your earnings).

An Example of Allocating Holdings to Minimize Taxation

As a follow-up to yesterday's post on taxation of different income types, I want to go through an example so that you can see how one might think about where (RRSP, TFSA or taxable accounts) to hold different funds in your portfolio.

Let's consider what happens if you decide on an asset allocation of 25% each in the following types of index funds:

• Bonds
• Canadian Equities
• US Equities
• EAFE Equities

Let's also say that you have RRSP room for 50% of your portfolio, and the other 50% will have to go into your taxable account. Where would you put each of your funds? Let's look at the general income characteristics for each of these funds. Again, I am thinking in terms of index funds. Actively managed funds will have different tax profiles.

Bonds count as interest income and are fully taxed at your marginal rate.

Canadian Equities, when in an index fund, generally produce dividends and small capital gains. (In an actively managed fund, expect higher realized capital gains for which the tax liability is passed on to you.)

Similarly, the US Equity fund also generates dividends and some small capital gains, but these are considered to be from foreign sources.

Finally, the EAFE (roughly the rest of the developed world) Equity fund, since it covers a (generally) more volatile index, will probably generate more capital gains, as well as some dividend income. As with the US Equity fund, this income is considered to come from foreign sources.

In my opinion, and I'm no tax specialist, I would definitely put the Bond fund into the RRSP since its interest income would otherwise be taxed at your full marginal rate. The Canadian Equity fund would go into the taxable account to take advantage of the reduced tax rates on Canadian dividends and capital gains.

It's a bit of a toss-up between the US Equity fund and the EAFE fund, but I would put the US Equity fund into the taxable account and the EAFE fund into the RRSP since I believe that the US Equity fund will trade less and therefore generate fewer realized capital gains tax liabilities.

RRSP: Bond fund, EAFE fund
Taxable account: Canadian Equity fund, US Equity fund

Strategically allocating your holdings in your taxable and tax-sheltered accounts will help ensure that no matter what earnings you make, you actually keep the highest percentage for yourself as possible.

Managing Taxes on Your Investments

If you're new to investing or taxes, or have never done your own taxes, you may not know that different types of income are taxed at different rates. Your salary is taxed at your regular income rate (which is a progressive system in Canada--the first X dollars are taxed at a certain percentage, and the next Y dollars are taxed at a higher percentage, and so on). The tax rate on your last dollar (i.e. the highest tax level that you hit) is your marginal tax rate.

How does this relate to your investments? Investment income can be grouped into 3 basic categories:

• Interest
• Capital Gains
• Dividends

Interest is taxed at your marginal tax rate. Capital gains and dividends, on the other hand, have some advantages in that they are taxed at less than your marginal rate. TaxTips.ca has charts of this information, which varies by province. Here is the chart for Ontario and British Columbia.

Capital gains tax is calculated by taking half of the taxable amount, and then applying your marginal tax rate. In other words, capital gains are taxed at half the rate of interest income.

Dividends are a bit trickier since there is a tax credit involved, but as you can see from the chart on TaxTips.ca, they are taxed generally at the lowest rate.

Keep in mind that income from foreign sources is generally taxed as regular income. The type of income--interest, capital gains, or dividends--does not matter for foreign sources. You may want to check for tax treaties with other countries to see if there are exceptions in your case.

I won't go through the exact rates or methods of calculation since they change from time to time, but you can see that some income is tax advantaged, and some (interest and foreign) is not. For example, suppose you could earn 3% interest income in a high interest savings account, or earn 3% dividend yield on a stock (both in a taxable account). You will get to keep more of your earnings from dividends than from the interest income. It is important to keep in mind that it doesn't really matter how much you earn on your investments. What matters is how much you keep.

For those of you who have all of your investments sheltered in an RRSP (or TFSA), this discussion does not really matter--all of your earnings are tax-free (and able to compound tax-free). If, however, you have your investments split between tax sheltered accounts and taxable accounts, you can maximize the money you keep by strategically placing certain types of investments in the RRSP, and leaving the rest in your taxable account. We'll look at an example of this tomorrow.

What Do You Do With Your Cash Savings?

There are many reasons to hold some amount of cash, and not put 100% of it into other investments. Emergency funds, and savings for near future purchases are examples.

Cash savings is one area where the rate that you earn makes all the difference. The products offered are for the most part very similar, so it really does pay to find the best rate of return possible.

My personal preference is for high interest savings accounts. For short term cash holdings, it's hard to beat their liquidity, principle protection, and CDIC coverage.

Let's consider some of the other options:

• Keeping it in your chequing or savings account at your bank: While letting cash sit in your account after your pay cheque is deposited may be the easiest option, and probably as safe as a high interest savings account (assuming you can resist the urge to spend it), moving money to a high interest savings account really only takes a few minutes on the internet, or over the phone. You'll earn many times more interest (in the range of 2 to 3 times more over a traditional big bank savings account) for your few minutes of work. Remember, the premium you earn over these accounts are guaranteed earnings. It's free money for a small amount of extra work.
  
• Money market mutual funds: This is a possible option, but it is not as liquid as a high interest savings account, and earns very close to what a high interest savings account would earn. If you choose this route, check for loads on the fund (you definitely want a no load fund for short term savings), and check for short term redemption penalties. Many funds also have minimum initial investment restrictions.
• Money market ETFs: For short term savings, the commissions you pay on a money market ETF will kill your return.

So if I've convinced you to use a high interest savings account, which one do you choose? Although advertising is a great way to get introduced to a product (ING Direct, for example), you really owe it to yourself to find out about as many other competitors as you can. Luckily, Peter has a great web site for comparing the rates offered for some of the leading institutions. Check out his site, especially the handy comparison chart.

Aside from picking the highest interest rate, you want to also check out the history of that bank's relative rate versus the competition, in case you're just catching one that has adjusted its rate. You also want to consider how convenient it is to move money back and forth between it and your regular chequing account. Do you have to send cheques? Or can you do it over the internet? Finally, make sure you check for any fees they may charge.

If you decide to open a TFSA account at one of these institutions, also note that some banks are offering a different TFSA rate than their non-registered accounts.

I realize that opening a new account can be a hassle, but consider that once your account is open, you can use it for the rest of your life (or the life of the institution). If you can earn a guaranteed one or two percent more on your short term savings for the rest of your life, I think it's well worth the time you put in now to get that account opened.

So, what do you do with your cash savings?