Last week I wrote about the risk of inflation. My solution to this risk is an investing method called Index or Passive Investing. (I recommend reading the website Canadian Couch Potato for all the little details.)
This method can provide a reasonable long term return on your investments (7-8%) with a variable risk of losing money. The chance of losing money is variable because it is related to your actions or inactions.
Today I’ll discuss some of the basic concepts of this method and provide some rules of passive investing to help minimize the risk.
Rule 1 – Pick an appropriate Asset Allocation for your situation.
A. Don’t invest heavily in the stock market if you need that money within 5-10 years.
B. Compare your short term monetary needs to your overall net worth.
C. Adjust your asset allocation depending on your time frame.
Asset allocation (or AA) refers to your general percentages of various investing methods. Often you’ll hear about the percentage of stocks vs bonds. Typically stocks are considered riskier investments as they are more volatile, but they have more growth potential in the long run. Bonds and bond funds are more stable, but the growth is lower, so they are considered less risky. Other instruments for stability, but not for growth, would be savings accounts and GICs.
Choosing an appropriate AA is too personal and complex for a website article, but some rules of thumb include:
- More risk if you have a long time horizon.
- More risk if you have a lot of money compared to your needs.
- Not so much risk that you can’t sleep at night.
Basically this means that if you are saving for a specific purchase in the near future – a down payment, your child’s education, a new car — be careful with using index investing for this purpose. In the long term stock prices will rise, but over a short term there can be significant volatility. However as the money you need becomes a smaller fraction of your overall portfolio the risk becomes less.
You think you will need a new car in three years. If you have $5,000 saved and want to spend $10,000 on the car. In this case index investing is probably not a good choice. However if you already have $30,000 in TFSAs there is no reason to keep all of his money in a savings account or GICs. You could put a portion of your money into the stock market, and still be able to purchase the car when you need to.
If your child is fifteen and you anticipate they will need $10,000 a year once they start university, now is not a good time to put all that money into index funds. But if your child is 2, there is lots of time for your money to grow and the market to fluctuate, before you actually need that money. Index investing would be a better choice here. As the time for your child’s schooling nears you may consider moving some of the money to investments with less volatility such as bond funds or GICs.
Rule 2 – Never sell anything unless you need the money.
Rule 3 – Rebalance appropriately.
This is usually annually or when you are buying. In the stock market what you want to avoid is buying high (when the prices are near the peak) or selling low. But no one can perfectly predict the peaks and valleys. Rebalancing helps you sell high and buy low.
Here is an illustration:
Rule 4 – Don’t try to time the market.
Just buy funds whenever you have money.
Rule 5 – Don’t panic sell.
Rule 6 – Don’t invest exclusively in stocks unless you are a very knowledgeable investor.
Rule 7 – When the news of the stock market is really bad and everyone around you is selling – don’t sell. Just keep buying.
Rule 8 – Don’t lock in your losses by selling in a down market.
You may have noticed that these rules get a little repetitive. Partly because repetition is fun, and I like repetition, but mostly because this is the most important rule. When you are investing in the stock market losses on paper aren’t realized losses until you sell and lock in that lower number. It is crucial to avoid this at all costs. If you can follow these rules this can be a very good way to invest your money and decrease your inflationary risk.