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Welcome to part 6 of the Investing 101 workshop.  In case you missed the previous posts, you can check those out here:

As you are probably aware, there are MANY ways you can invest your money.  Some are riskier than others.  Some require slightly more work than others.

There seems to be so much hub-bub about the terms 401k, IRA, CD, 529, etc in the States and TFSA, RRSP, GIC, RESP etc, which don’t get me wrong it’s great to be talking about these accounts, but once these accounts are open, now what?

We’ve already covered these different types of ACCOUNTS in previous posts of the Investing 101 Series.  This post is to inform you of the different types of FUNDS that you can fill up these different accounts with.

Different types of FUNDS include cash, stocks, bonds, mutual funds, index funds, ETFs, etc.

This post may be dry but it’s important to cover these definitions of the different FUNDS that you call fill your ACCOUNTS up with.  What’s the point of opening up an account if you’re not sure what to fill it up with? Note that all of the information below applies to both our Canadian and American readers – as well as world wide if there’s anyone out there tuning in!)

Cash

Holding onto cash is the simplest form of investing.  If you are able to create a gap from your earnings vs spending, you will find yourself with excess cash.  You can decide to do nothing with that cash, other than hoard it in your home in a jar or under your mattress. The issue here is that there’s this thing called inflation.  Inflation is the general increase in prices and the fall in purchasing value of money.  Can you recall an elder mentioning how “when I was young, a loaf of bread cost $0.05” and now a loaf costs closer to $3?  That’s inflation.  Let’s say you are hoarding $1,000 in your bedroom.  In 30 years from now, you may be lucky to purchase groceries for a week with that.  Don’t let inflation eat away at your hard earned pennies.

Same thought process goes for a checking or savings account with a bank.  As we covered before, have you ever checked to see what interest rate you are earning on your money in these accounts?  I’m going to guess that it’s VERY low.  Like below 0.5% low.  While this is better than 0% interest when the money is just stashed under your mattress, 0.5% is nothing to cheer about.

Yawn, we’ve already covered this in the past. So instead of just holding onto cash, what else can you invest in? Here we go!

Bonds

Grouped under the general category called fixed-income securities, the term bond is commonly used to refer to any securities that are founded on debt. When you purchase a bond, you are lending out your money to a company or government. In return, they agree to give you interest on your money and eventually pay you back the amount you lent out.  The main attraction of bonds is their relative safety. If you are buying bonds from a stable government, your investment is virtually guaranteed.  The safety and stability, however, come at a cost. Because there is little risk, there is little potential return. As a result, the rate of return on bonds is generally lower than other securities.

Some bonds provide zero risk, such as Treasury bonds held to maturity, money market accounts, and CDs (GICs for Canadians) where the federal government backs these types of investments.  Bond index funds are a bit more risky but you can expect to receive anywhere from 2-5% annual return each year (currently, we’re closer to the 2% side of things).  Even riskier would be to buy individual corporate bonds, emerging market bonds, or high yield bonds.  This last batch of bonds has the potential to provide higher returns but they also come with more volatility.  I’m not a fan of any of these latter bonds and this is that last you’ll hear from me on those particulars funds.

Stocks

At some point, just about every company needs to raise money, whether to open up a West Coast sales office, build a factory, or hire a crop of engineers.  In each case, they have two choices: 1) borrow the money, or 2) raise it from investors by selling them a stake (issuing shares of stock) in the company.  When you own a share of stock, you are a part owner in the company with a claim (however small it may be) on every asset and every penny in earnings. Woohoo, go you, business owner, you!

Stocks in general have been solid investments. That is, as the economy has grown, so too have corporate earnings, and so have stock prices. Since 1926 (note, including the Great Depression), the overall stock market has returned close to 10% a year.  (Yes, you read that average right.  Note this is NOT include inflation – mentioned above.)  If you’re saving for retirement, that’s a pretty good deal — much better than U.S. savings bonds, or stashing cash under your mattress as mentioned above. Personally, I use ~6-7% as my estimate of where to expect returns stocks going forward for the longer term. I sure hope I am shown up and the returns continue to come in the 10% range.

Of course, “over time” is a relative term. As any stock investor knows, prolonged bear markets can decimate a portfolio.  Since World War II, Wall Street has endured several bear markets — which is defined as a sustained decline of more than 20% in the value of the Dow Jones Industrial Average (which really only tracks 30 of the large publicly-owned companies trading on the New York Stock Exchange but it gives a rough guideline of how the overall market is performing).  Bull markets eventually follow these downturns, but again, the term “eventually” offers small sustenance in the midst of the downdraft. The main point to keep in mind, is that investing in stocks must be considered a long-term endeavor if it is to be successful.  Compared to bonds, stocks provide relatively high potential returns. Of course, there is a price for this potential: you must assume the risk of losing some or all of your investment.

This is why we prefer to stay away from all the buzz in the media.  If you cannot handle seeing your portfolio drop 20+% in one single day, we would recommend you avoid checking your accounts obsessively as I can almost guarantee a 20+% drop will occur at some point in your lifetime.  Likely even a 50% at some point.  When?  Who knows.

NO ONE can predict when this is going to happen.  No one.  People can do all the guessing they want, but that’s all it is, a lucky guess.

But it likely will happen.  You have to have the willpower to stay the course and not to overreact and sell when the market drops. Over the long term, the market always goes up.

If you can remember that the overall market has provided returns averaging 10% annually and you can continue to throw any extra savings monthly into the market, regardless what happened earlier this week, month, or year – you’re golden.

OK OK I Get It – Don’t Obsess Over The Market – Then What?

So investing in stocks allows you to grow your wealth.  But choosing the companies and industries that will deliver the best earnings is a real challenge.  There are some people in the FIRE community who are into dividend investing which is selecting individual stocks (or dividend index funds/ETFs) that pay a higher than average dividend to its shareholders in hopes of living off the dividend payouts rather than having to withdraw (aka sell) some of their investments which in early retirement.  Most people just don’t have the interest, time, or expertise to pick individual stocks well.  Team that up with the many individual stocks you’ll need for a well rounded portfolio and the complexity adds up quickly.  These higher dividend stocks also tend to have very slow growth over the long term so I personally do not invest in them.

Enter into the picture: mutual funds.

Mutual Funds

A mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are pooling your money with a number of other investors, which enables you (as part of a group) to pay a professional manager to select specific securities for you. Mutual funds are all set up with a specific strategy in mind, and their distinct focus can be nearly anything: large stocks, small stocks, bonds from governments, bonds from companies, stocks and bonds, stocks in certain industries, stocks in certain countries, etc.

Back in the day, all mutual funds were “actively managed” meaning some smart guy (because let’s be honest women probably weren’t hired for these jobs… eye roll) was paid to take all this money and buy a bunch of stocks with it at his discretion.  People who wanted to invest would put some money into the mutual fund and they would get a piece of all the stocks that smart guy decided to buy.  It was a nice way to diversify your portfolio without having to do all the research and trading yourself. The primary advantage of a mutual fund is that you can invest your money without the time or the experience that are often needed to choose a sound investment.  All mutual funds have expenses including commissions, redemption fees, and operational expenses.

These expense fees really can add up.  Most mutual funds charge 1.5-2% fees which may not sound like a lot but if you are making 6% returns (as it’s been proven mutual funds don’t perform as well as the overall market), the mutual fund company then keeps ~2% of that so in reality you are only see 4% returns.  That is 33.33% of your portfolio (2/6) that you don’t get to keep!!!  That’s in year 1.  And then the double whammy is that 33.33% earnings is now no longer allowing the magic of compounding to occur in your account!  THIS IS HUGE!!!! ABSOLUTELY HUGE. LIKE EAT AWAY MORE THAN HALF OF YOUR PORTFOLIO OVER THE LONG RUN HUGE.

Don’t believe it?  Check out this 20 year chart.  And note this is only for 20 years.  The percentages CONTINUE to grow the longer you invest.

If it wasn’t clear, understand the fees associated to any fund you invest in. Personally, I would steer away from anything over 0.25% these days.

Additionally, research shows how difficult it is for the pros to buy and sell individual stocks (that make up your mutual fund) to keep up with performance of the overall market. If you google “do mutual funds outperform an index fund” you will see time and time again, the resounding answer is NO.

To stress this point, because it needs to be stressed even more, let’s look at an example:

Let’s say Larry uses a mutual fund manager to oversee his investments whereas Lizzy invests in index funds (stay tuned for more on that).  Larry and Lizzy both contribute $1,000/month into their investments for a 20 year timeframe.  Let’s assume that Lizzy’s index funds averaged 7% whereas Larry’s mutual fund portfolio averaged 6% (because most actively managed funds don’t beat the market) but then also had that pesky 2% fee structure (mentioned above) built in.  20 years later, Lizzy would have $520,926 in her accounts whereas Larry would only have $366,744 in his account.  That’s a difference of $154,182!!!! That’s a 35% difference! Let’s say Larry’s mutual fund manager somehow managed to beat the market by 1% (very rare and unlikely), Larry is STILL worse off from Lizzy because of those added on fees!

To go one step further, lets assume after 20 years both Larry and Lizzy stop contributing to their respective accounts and let them sit and grow for another 20 years before withdrawing any money from them.  It get’s worse the further out you look.  Assuming Lizzy’s portfolio of $520,926 continues to average 7% annually, in 20 years it will then be worth $2,103,884 without putting in a single penny more (thanks to compound interest).  Larry, on the other hand, still has his portfolio with his mutual fund manager making 4% net returns after fees (6% returns – 2% fees).  After 20 additional years, Larry’s portfolio of $366,744 will be worth $815,118 without adding another penny in.  This is definitely a sizable portfolio, no doubt about that, but we’re talking a difference of $1,288,766 compared to Lizzy’s portfolio!! That’s a 61% haircut!

So how do you be Lizzy and NOT Larry?

Enter in: index funds.

Index Funds

Building a well-rounded portfolio of individual stocks is complex. That’s why people pay mutual fund managers to try and create a portfolio to outperform the market. However, as noted above, research shows most pros find it difficult to outperform the market let alone match the overall market performance.  Additionally, there’s the other problem that we stressed above that these smart guys charge a high fee for their services. So individual investors are paying these smart guys a lot of money to trade stocks back and forth and end up with less money than those stocks actually would provide.

There has to be a better way!  How do you get the best chances of building a portfolio that is designed to grow and to get invested in as many different companies in as many different sectors as you need to be as well diversified?

Index funds!!

An index fund is a mutual fund or ETF which follows a certain preset of rules so that the fund can track a specified basket of underlying investments. Back in the day, if you wanted to mimic the performance of an index, you’d have to buy shares of each individual company listed in the index in the exact amount specified by the index.  That can really start to add up when you take into account the costs of commissions and having to buy whole shares of each stock.  There are many index funds that have over 3,000 individual stocks listed.

Essentially, an index fund is an easy way to invest in every company in an index (think of it as a list). Instead of paying some smart guy a high fee, an index fund is a type of mutual fund that buys EVERY equity in a list.

Index mutual funds are just a special type of mutual fund.  Mutual funds have a portfolio manager who determines which stocks and bonds to buy and sell.  If you are in an actively managed fund, you are putting faith in that particular portfolio manager to make buy and sell decisions with the expectation that they will outperform their benchmark market index over time.  Index mutual funds are passively managed.  The holdings within the index fund will not change unless the index (list of companies) changes.  In that way, the goal of the index fund is simply to try to meet the index’s performance.

You’re probably already familiar with indexes.  Ever heard of the S&P 500, the Dow Jones, or the Nasdaq? When people are talking about the stock market, they are usually talking about an index.

You can find an mutual fund or ETF (more on these below) that tracks these indexes along with MANY other indexes out there.  So for example, an S&P 500 index fund owns the 500 biggest stocks in the US. This means with that one purchase of that one single index fund, you are now investing in a tiny piece of the pie of the top 500 companies. In any given day, there will be some industries that will go up (say utilities for instance) and some industries that will go down (say tech) – the point is you have an investment in every major sector of the economy.

There are index funds that track the Canadian TSX 60 (Canada’s top 60 companies), or Ex-North American stocks, or Emerging Markets, or High Dividend Yield companies, etc.  There are also bond index funds too that may track the overall Canadian Short-Term Bonds, or US Long-Term Bonds, or Global bonds.  You get the picture.

Simply put, you get the advantage of broad diversification.  You are investing in MANY stocks or bonds all under one stock symbol.

On top of all of that, index funds are offered at MUCH lower fees than actively managed mutual funds. And I mean much lower.  Index fund fees are typically 10-50 times lower than actively managed mutual funds, and their performance is almost always better.  In fact, there are now some index funds with 0% fees, pretty mind blowing.

For example, in the US you can invest in the index fund with the stock symbol VTSAX.  This is the Vanguard Total Stock Market Index Fund Admirals Shares.  It’s fee is 0.04%.  That is INSANELY low!  Buying this one simple stock symbol means you are now investing in ~3,6000 different US companies.  Talk about diversification at a LOW cost.  Fidelity recently came out with two index funds (FZROX and FZILX) at 0.0% fees, crazy!  And more and more companies seem to be following suit with zero fee index funds.

In Canada, index fund fees are a bit higher but still very low comparatively speaking to other Canadian mutual funds.  A similar comparison would be the stock symbols VUN.TO or XUU.TO.  VUN.TO is Vanguard’s version of the US Total Stock Market Index ETF that is offered to the Canadian market and it’s MER (management expense ratio) is 0.15%.  While 0.15% may sound high, it’s MUCH lower than the ~2% you’d be paying for an actively managed mutual fund.  Another great option for Canadians looking to hold onto a total US stock index fund is XUU.TO which is iShares Core S&P US Total Market Index ETF whose MER is slightly lower at 0.07%.  Another option is VFV which is Vanguard’s S&P 500 Index Fund ETF which has a MER of 0.08%. Or XAW which is BlackRock’s iShare Core MSCA All Country World ex Canada Index ETF with a 0.22% MER.  These funds are are slightly different in that VUN holds 3,630 holdings whereas XUU holds 3,470 companies and VFV hold the top 500.  Either way, you can’t go wrong in my books.

Personally, I am a loyal Vanguard fan because Jack Bogle (the founder of Vanguard) was the one who created the world’s first index mutual fund.  Other companies have realized how amazing this concept is (and how it consistently outperforms managed funds) so you can now find MANY companies offering index funds (and like Fidelity and iShares, some at a better cost).  Vanguard also has the first-mover advantage not just in being the ones to have created index funds in the first place but they also seem to come up with the next latest and greatest index funds and the other companies tend to copy cat what they do. I am just loyal to Vanguard as they greatly changed the playing field for us everyday investors and for that I am thankful and show my thanks by investing with them.  By no means am I telling you what to do, I am in no way shape or form get paid for anything I write here about Vanguard, I’m just voicing my opinion.

The other great thing about Vanguard is that they have a fairly unique structure in  that the company is owned by its funds and the companies different funds are then owned by you and me, the shareholders.  Thus the shareholders are the true owners of Vanguard.

Please do your own reading and research and feel comfortable with whatever decision you end up making. If you’re interested in learning more about index funds, read about it from the legend himself by reading The Little Book of Common Sense Investing by John (Jack) Bogle.

To summarize, the two main pros of index funds are diversification and minimizing costs.

Exchange Traded Funds (ETFs)

ETFs have several similarities to mutual funds. Like a mutual fund, an ETF is a pool or basket of investments which can contain stocks, commodities, bonds; some offer US only holdings, others are international.  The main difference between an ETF and a mutual fund is that an ETF trades on an exchange, just like a stock. This means that an ETF doesn’t trade at the end of the day like a mutual fund. The price of the ETF is determined by investor demand at any given time during the trading day.

ETFs are also a great investment suggestion as well, especially ETF index funds. ETF’s tend to have lower expenses then a similar index mutual fund (in Canada at least) and so that is why we invest in the ETF VUN.TO (as mentioned above). Most Canadian index mutual funds have an MER around 1% whereas ETFs tend to have an MER around 0.2%. (Note Canada has some of the highest fees overall of all the first-world countries out there.) ETFs also tend to have lower investment minimums so the barrier to enter is lower (i.e. if you don’t have a ton of cash but you want to start investing, you may meet the minimum requirement to open an ETF but not an index tracking mutual fund).

But investing small amounts or set dollar amounts into an ETF is a little trickier since you are required to buy whole shares making the process a bit more difficult and leaving some cash unused with each transaction. Don’t let that steer you away.

What do we mean by that?

As of today, one share of the ETF VUN.TO is valued at $59.13.  This means that if I want to buy into this ETF, I have to do so in increments of $59.13.  So if I had $100 to invest, I could only buy 1 share at $59.13 as two shares would cost $118.26 and I only have $100 and you cannot buy partial shares.  Thus I would have the difference of $100-59.13=$40.87 sitting in cash in my account (be it TFSA, RRSP, etc) and I would have to wait until I had more cash saved up in that account to buy that second share.  Mutual funds do not work in this manner.  You can select to invest any dollar amount into an indexed mutual fund and you can purchase partial shares of these funds.

In my books, if you’re investing in an index (whether it’s tracking the overall US stock market, overall international market, overall bond market, target retirement date, you name it – it totally depends on your risk profile) that’s a win in my books. Whether the index is within an ETF or mutual fund doesn’t carry much weight to me as long as you’re minimizing fees. You can find ETFs that track the very same indices as an indexed mutual fund.

Index mutual funds and ETFs do the legwork for you, purchasing exactly the number of shares of each company it takes to recreate the indexes weighting. They also use scale to minimize the costs with buying and selling stocks.  Whenever an investor buys a share of an index mutual fund or an ETF, they are buying a portion of the underlying portfolio. That way investors can get by with owning partial shares of each individual security, making it much more affordable than trying to match an index on your own.

A note to add regardless which type of investment fund you choose to go with – while you are in your wealth accumulation phase, ensure that your dividends/earning are being reinvested back into your account as they are paid out by the companies that you are investing in.  The other option is to get paid out in cash from these dividends.  But you want all of the earnings to continue working for you and compounding in the market!  For most financial institutions, this is a simple check of the box when you are setting up your account.

Real Estate

The last investing strategy I will briefly touch on is real estate.  Just like investing in the market, real estate can come in MANY forms.  You can start off small by shifting back to living with roommates instead of on your own if you’re renting to cut your rental costs in half. Or you can house hack like us where we purchased a townhouse and rented out 3 of the 4 bedrooms to pay off our mortgage in 2.5 years. Or you can buy a duplex and live on one side and rent out the other. Or you can rent out a home entirely. Or go to the big leagues with owning and renting entire apartment complexes.  Or you can invest in commercial real estate.  Or you can invest in storage facilities.  I’m sure there are MANY other ways to invest in real estate – point is, there’s no one set way to invest in real estate so again it’s important to read and research if this is something that interests you.

Even though we house hacked our first townhouse and then rented it out for 2 years to a great family, and then sold it for a profit, by no means would I say I’m close to an expert in real estate.  There are other members of the FIRE community who solely focus on real estate and are making a living off of that passive income alone.

If you’d like to learn more from some FIRE real estate experts, I recommend checking out:

Afford Anything and Bigger Pockets also have podcasts of their own if you prefer learning through that medium.

If you like the idea of investing in real estate, but don’t want to physically own one property in particular (or you don’t have enough for a down payment), you could invest in REITs.  A REIT (Real Estate Investment Trust) owns, and in most cases operates, income producing real estate.  REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels, etc.

And you guessed it, you can find a REIT index fund if you’d like.  VGSLX is Vanguard’s Real Estate Index Fund Admirals Shares that is offered in the states.  For Canadian’s, Vanguard offers VRE which is their Canadian Capped REIT Index ETF.  Of course, Vanguard isn’t the only player in town.  Canadians, click here to read a Canadian specific post for REITs. Americans, click here for an example of some other real estate ETFs.

That’s a Wrap

You now know about bonds, stocks, mutual funds, index funds, ETFs, and real estate (including REITs).  Hopefully this gives you a solid understanding of the TYPES of FUNDS that you can invest in.  Remember, don’t get these confused with the TYPES of ACCOUNTS you can invest in.

Investing really is pretty simple when you think of it.

Find a financial institution, pick an account, and fill it up with funds.

I know there are some reasons why you’d want to pick account A over account B which requires some reading and research.  Similarly, once you decided on the account, then you’ll want to do some reading and research as to which funds to fill that account up with.  Honestly, the harder part really is to grow your gap between your income and your expenses so you can maximize the amount that you can invest. Having money to invest is the hard part.

Personally, I feel it’s best to keep your investment strategy short and sweet.  Maximize your tax advantage accounts (401k and Traditional/Roth IRA in the States and RRSP and TFSA in Canada) with index funds tracking the overall market.  Once you’re reached your max contribution room in your tax deferred accounts (kudos to you), then see if there are other tax advantaged accounts worth investing in (HSA and 529 in the States and RESP in Canada – I’d argue an HSA should be up there with your 401k and IRA if you’re in the States).  Once all of your tax advantaged accounts have been maxed out, open a taxable account and fill it up with more index funds.

Sure, there are alternative investments but they are generally high-risk/high-reward securities that are much more speculative than plain old stocks and bonds. Don’t get me started on crypto! But hey, if you want to invest less than 5% of your portfolio into one-off accounts, go for it!  I call this your fun money bucket.

Did this weeks post help explain the different types of funds you can select to invest in?  Are you enjoying our Investing 101 Series? Any questions? We will have one last post as part of this series to summarize everything we’ve learned.  Thanks for tuning in and feel free to comment below.

Want to check out the rest of the Investing 101 Series?

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