Investing 101 – Part 7: Terms to Know

I think we are finally on the last stretch of the Investing 101 Series.  In addition to what we previously covered (compound interest, financial institutions, accounts, funds, fees, etc.) there’s a bit more terminology I want to cover before wrapping this sucker up. For anyone new here, check out the entire Investing 101 Series here.

• Investing 101 – Part 1: Introduction
• Investing 101 – Part 2: Compound Interest
• Investing 101 – Part 3: Accounts You Can Invest In (US Edition) 
• Investing 101 – Part 4: Accounts You Can Invest In (Canada Edition)
• Investing 101 – Part 5: Tax Advantaged Accounts
• Investing 101 – Part 6: Funds You Can Fill Your Investment Accounts With

Asset Allocation

This is your breakdown of how your assets are allocated, meaning your split of stocks and bonds.  Which stocks?  Which bonds?

There is no right answer as to what your asset allocation should be.

Conventional wisdom is that if you are investing for the long term (10+ years) you should be aggressive and 90-100% in stocks and as you near retirement you would shift into more bonds, be it a 80/20 or 60/40 or 40/60 split etc.  Some people do not feel comfortable being 90-100% in stocks even if they aren’t planning to touch their portfolio for years and prefer to be 80/20 or 60/40 during their investing years.  Some people suggest to take 100 and subtract your age and that should be the percentage of stocks in your portfolio.

The point is, your asset allocation is personal and something you need to decide based off your risk tolerance level.

If you’re 100% in stocks and you see your entire portfolio drop by 20%, knowing it will very likely come back up in time (how long exactly? who knows), would you be comfortable with that? What about a 30% drop? Or even 40%?  These types are drops have happened in the past and likely will happen again in the future.  If you can’t stomach that, you may want some bonds.  However, if you understand that you are investing for the long term and a price drop in the middle of your investing time frame won’t impact you unless you actually sell it during that dip (noooooo), then you may feel more comfortable being heavily invested in stocks.

Again, it totally depends on both your risk appetite (can you stomach a drop and buy baby buy when the world is panicking?) and where you are time-wise in your journey (10+ years from retirement or less than 3 years from retirement).

Rebalancing

Rebalancing refers to aligning your stock and bond portfolio back to it’s designated asset allocation over time.

Say your goal is to be 80% in stocks and 20% in bonds so 80% of the time you buy stocks and the other 20% of the time you buy bonds.  If these two assets grew at the same rate, you would never need to rebalance.  However, that is likely not going to happen.  Some years your stocks may skyrocket and grow much faster than your bonds.  This may shift you from an 80/20 split to say a 90/10 split as your stocks are performing better and are now making up a larger portion of your portfolio.  Conversely, some years your stocks may tank and you end up seeing a better performance with your bonds.  This may shift you from an 80/20 split to say a 70/30 split.

Rebalancing allows you to get your asset allocation back in alignment with your goals.  If you are investing in tax advantaged accounts, rebalancing is quite easy.  You can sell your over performing funds and buy the under-performing funds to get you back to your desired allocation without facing any tax implications as long as the net amount is the same.  You simply sell the fund you are too heavy in, that will shift over to cash, and then with that cash you buy the fund you are looking for more of.  Or you may have a rebalancing option within your financial institution that shows your current breakdown (as a percentage) and you can tell the financial institution what you want the percentages to instead be and it will do the shift over for you.

If you are investing in taxable accounts and don’t want to rebalance using your tax-advantaged accounts to easily get you back to your desired allocation, then the best way to rebalance is to purchase future investments in the under-performing fund to slowly build it back up to the allocation you so desire.

Note that if you are comfortable investing 100% in one fund, rebalancing is not needed as you will always be 100% in that particular fund.

There are some funds out there that do a bit of this legwork for you, but at a cost of a slightly higher fee compared if you did a more DIY investing approach.  A lot of Robo Advisors are essentially doing the rebalancing for you.  Essentially, robo advisors have you fill out a questionnaire to try to help determine your desired asset allocation and will rebalance your portfolio to stay at that targeted amount.  Same idea for a target date retirement fund in the states except without the robo assistant, you select your fund based off your target retirement date.  Or in Canada you could invest in VEQT (100% stocks, 0% bonds), VGRO (80% stocks, 20% bonds), VBAL (60% stocks, 40% bonds). VCNS (40% stocks, 60% bonds), or VCIP (20% stocks, 80% bonds).  These are much more hands off and take a lot of the thinking out of the equation for you.  But again, at a slightly higher cost of course. Do the math to see if you would rather do it hands-on yourself or if you are willing to give up some of your gains to let it be handled for you by someone else.  For a new investor looking to get their feet wet, these could be a great starting point.

Nominal vs Real

In finance and economics, “nominal” refers to an UNADJUSTED rate or the change in value where as the term “real” expresses the value of something after making adjustments for various factors to create a more ACCURATE measure.

The rate of return is the amount an investor earns on an investment. The NOMINAL rate of return reflects the investor’s earnings as a percentage of the initial investment, whereas the REAL rate takes inflation into account. As a result, the real rate gives a more accurate assessment of the actual buying power of the investor’s earnings.

For example, if we say “the stock market has grown ~10% on average annually over the past 100 years” – that is a true statement but it’s the NOMINAL rate of return (10%). However, inflation has also existed over this timeframe and has averaged 3% annually over the past 100 years. So 7% is the REAL rate of return.

Another example is if we say ‘hey if you invest $10,000 today and assume the stock market grows at 10% on average annually, then in 40 years you’ll have $537,006 thanks to compounding interest’. This is not a false statement but it’s just missing another feature. Inflation. That $537,006 is the nominal value. That $537,006 in 40 years will NOT be worth what $537,006 is worth today. If you include say 3% annual inflation then you’ll get the real terms of $163,114. This means that original $10,000 will show as $537,006 in your account in 40 years but it will be worth $163,114 in TODAYS dollars (aka what you can actually buy today with $163,114). So maybe a smaller older home in the Midwest? Not a larger home on the coast like $537,006 may imply.

Similar example would be how your grandparents would say “back in my day bread cost 10 cents” and now there is no way you can find a loaf of bread for $0.10. All commodities have increased in cost over time. Inflation eats at your buying power and when you talk in terms of REAL you take that into consideration.

Fees/MERs

As we’ve harped on in the past already, fees matter.  A LOT!  Understand how much you are loosing in fees each year.  MER stands for Management Expense Ratio and is essentially another name for fees. The sad part about fees is that these are not explained well to the every day investor.  And why would the banks explain these?  This is how THEY get paid.  Instead they are misconstrued to seem like a small menial number (1-2%) which doesn’t sound too bad on paper but when you look at the math of what 2% does to your portfolio over a 40+ year time horizon you’d want to punch your banker in the face trying to take that much money away from you. It’s honestly highway robbery.

Don’t believe me STILL?  Check out all of these articles:

• Investment Fees Art Eating Your Returns – Money Sense
• The “tyranny” of fees: How costs kill investment returns – The Globe and Mail
• Don’t Let Fees Destroy Your Investment Return – The Motley Fool
• Investment Fees Will Cost You Millions – Physician on FIRE
• How Taxes and Trading Costs Kill Investment Returns – Forbes
• Give Fees an Inch, And They Will Take a Mile – New York Times
• How Much Of Your Total Returns Are Lost To Fees? – Wall Street Physician

The list goes on and on.  Sure, some portfolios with higher fees may out perform the ones with lower fees.  But consistently, year over year over year over your entire investing time horizon?  Likely not.  And that’s what matters.  Go read Beat the Bank by Larry Bates or The Little Book of Common Sense Investing by John Bogle if you want to read entire books about how fees will impact your portfolio in the long run.

Net Worth vs Income

So many people focus on their income.  I’m not saying it’s not important, it definitely is, but what’s more important?  Your net worth.

What do I mean by that?  Someone making $40,000 and saving $5,000 per year is in much better shape than someone making $100,000 and spending all $100,000 – or even worse, spending even more than $100,000.

If you aren’t tracking your net worth you should be.  At least annually.

Keep striving for that bump in pay, but don’t forget to pay yourself first and put that extra income to use.

Savings Rate

Your savings rate refers to what proportion of your income are you saving.  It’s a pretty simple concept, yet there seems to be many ways to calculate your savings rate.  Big ERN wrote an extensive post on the different ways so I will send you over to his post rather than recreate the wheel.

My thought is, to each’s own.  There is no right way.  What’s important is that whichever way you calculate it, you track it.  Month over month.  Year over year.  This really is the most important figure for you to optimize on your journey.

Try and optimize this and boost it a few percentages each year until you are saving over 50% with a goal to be in the 70+% club (if that’s your thang).  Once your savings rate is 45%, you’re looking at less than 20 years to retirement.  The math really is simple. But again, don’t do this if it means you are depriving yourself along the way.  Instead make money a game and gamify (sp?) your spending to figure out how to enjoy life by spending less.  As you go along, you’ll figure out that a happy life does not need to be that expensive.

Personally, to calculate my savings rate I use my after tax income and add back in any pre-tax contributions I’m making towards my retirement accounts (i.e. 401k or Group RRSP that comes out of your paycheck) and I also add in any company match as that is essentially part of your pay from your employer.  Any investments I am making counts towards savings.  Any expenditures that depletes my net worth is an expense.  Some people argue weather or not paying off debt (mortgage, student loans, consumer debt, etc.) counts towards your savings rate.  You can argue all day of what counts and doesn’t – again what really matters is that you use the same consistent formula and see your savings rate go up.

Sequence of Returns Risk

Sequence of Returns Risk refers to the risk an early retiree faces at the beginning of their retirement when they start to withdraw from their portfolio.

The idea behind it is:

• Assumptions (based off the 4 Percent Rule):
  • You have 25 x your annual expenses in passive income.
  • Your passive income should return 7% returns on average.
  • You aim to withdraw 4% of your portfolio year over year once you retire.
  • You assume inflation will grow 3% on average.
  • Thus earning 7% returns annually and withdrawing 4% annually should be a net neutral (since another 3% is being eroded away from inflation) and keep your portfolio (and spending power) in tact.

The problem is, these are averages.  We all know that the market does not grow 7% every single year. Nor does inflation increase by 3% every single year.  Some years the stock market may grow by 15%, others years it may only be 1%, or worse off there may be a 20% drop.  Same goes for inflation but likely to a lesser degree.  The stock market may average 7% returns annually and inflation may eat away 3% of your portfolio annually over the course of your withdrawal time-frame, but what happens in those first 5-10 years is really important. The order in which you earn your returns matters – A LOT.

Again, I am not the first to dig into this topic, so here’s a list of posts specific just to sequence of returns risk when it comes to financial independence:

• Understanding Sequence of Returns Risk – Safe Withdrawal Rates, Bull Market Crashes, And Bad Decades – Michael Kitces
• The Ultimate Guide to Safe Withdrawal Rates – Part 14: Sequence of Return Risk – Early Retirement Now
• The Ultimate Guide to Safe Withdrawal Rates – Part 15: More Thoughts on Sequence of Return Risk – Early Retirement Now
• Protect Your Early Retirement from Sequence of Returns Risk – Our Next Life
• Sequence Risk: How To Protect Your Nest Egg From Going Belly Up Before You Do – Bigger Pockets   
• How to Eliminate Sequence of Returns Risk – Retire By 40

I suppose we should write an entire post on our withdrawal strategy… luckily for you, dear reader, our amazing friends Ali and Alison from All Options Considered are working on an AMAZING case study analysis on our portfolio which covers in SO much detail our withdrawal strategy. Stay tuned for more on that!

Dividend

A stock dividend is a dividend payment made in the form of additional shares rather than a cash payout. Essentially, for every share of a dividend stock that you own, you are paid a portion of the company’s earnings. You get paid simply for owning the stock.

For example, let’s say Company X pays an annualized dividend of 20 cents per share. Most companies pay dividends quarterly (four times a year), meaning at the end of every business quarter, the company will send a check for 1/4 of 20 cents (or 5 cents) for each share you own. This may not seem like a lot, but when you have built your portfolio up to thousands of shares, and use those dividends to buy more stock in the company, you can make a lot of money over the years. The key is to reinvest those dividends!

Let’s use some numbers to look at an example.  Let’s say you invest $50,000 in a high dividend stock and each unit of this particular stock costs $20 and pays an annualized dividend of $1 per share.  This means you own a total of 2,500 units of this stock ($50,000/$20=2,500). Over the course of the year, you will get paid $2,500 every year simply by owning this stock (2,500 units*$1=$2,500).

Dividend Yield

Dividend yield refers to a stock’s annual dividend payments to shareholders, expressed as a percentage of the stock’s current price.

So in the example above, the dividend yield is 5%.  How did we get that?

Dividend yield = (annual dividend) / (stock price) * 100%

So (1/20)*100=5%

It’s important to realize that a stock’s dividend yield can change over time, either in response to market fluctuations or as a result of dividend increases or decreases by the issuing company.

Dividends are one component of a stock’s total rate of return, the other being changes in the share price. For example, if a stock’s price goes up by 5% this year and it pays a 3% dividend yield, then your total return is 8%. If you’re investing for the long term, be sure to consider a stock’s total return potential in addition to the yield.

And this is the main reason why I don’t invest in individual high dividend stocks and would rather invest in broad index funds tracking the overall market.  From the little research I’ve dug into on dividend stocks, these tend to be steady blue-chip stocks (large company – one of the market leaders in its sector – been around awhile – most people have heard of them – that type of company) which I have found do not have the growth potential as some other companies out there.

A rising dividend yield may simply be masking a money-losing stock. Math and the way dividend yields are calculated is why this happens. Go back to the dividend yield equation.

Dividend yield = (annual dividend) / (stock price) * 100%

Why does this equation matter? A falling stock can make a dividend yield look great.

Let’s go back to our example above. You bought a $20-a-share stock that pays $1 a year in dividends. You might be initially thrilled with your impressive 5% annual dividend yield ($1 dividend divided by $20 stock price). The stock’s yield is ~275% larger than the S&P 500’s roughly 1.8% yield. Go you!

Now, the stock crashes to $10 a share and the company holds the dividend the same. Applying the same dividend yield formula, the stock’s dividend yield doubles to 10%. Looks great. But wait a second, despite the higher yield, you’re worse off because you lost $10 a share on the stock. The stock market as a whole stays steady, but this particular stock takes a tumble.  The dividend looks great but the stock itself may not be worthy of investing in.  If you are looking into dividend stocks, please do your research! This is just a example and I’m sure there are great high dividend stocks out there but I would much rather not have all my eggs in a few baskets.

Emotional Risk

This goes back to the notion of zoning out all the noise that you see on the media.  The media’s job is to bring in eye balls to their programming so that more viewers see their paid advertisements.  Just like any other corporation, their job is to make money. Pair that up with the fact that humans have emotions and things can get crazy.

Today’s investors are bombarded with so much media. The news is received in seconds via smartphone and other devices, and reactions to the negative media often cause negative results for the investor’s portfolio. All too often, money management is influenced by investor’s emotions, emotions that can cause a loss of focus on the financial goals and objectives for both the short-term and the long-term.

When the market is experiencing erratic movements, an investor may panic and sell. On the other hand, if the market is at a peak, an investor may feel elated and buy. This kind of emotional behavior can have dramatic consequences on the performance of your portfolio.

Consumers tend to flock to an item when it goes on sale.  Like wait overnight in a fold out chair on Black Friday to get a TV 60% off. But these same consumers panic when the market dips and funds go on sale and sells instead of buys these undervalued products.  Our emotions get the best of us and dont let us think properly.  Don’t panic!  The value of your funds only matters when you actually sell these.  If there is a dip, this is a signal to buy.

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Phew.  Ok we are really getting there!  We will have one last post for this Investing 101 Series wrapping everything up.

Any questions for us?  Do you feel more confident and ready to invest?

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

• Investing 101 – Part 1: Introduction
• Investing 101 – Part 2: Compound Interest
• Investing 101 – Part 3: Accounts You Can Invest In (US Edition) 
• Investing 101 – Part 4: Accounts You Can Invest In (Canada Edition)
• Investing 101 – Part 5: Tax Advantaged Accounts
• Investing 101 – Part 6: Funds You Can Fill Your Investment Accounts With

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We believe in stacking up life hacks to keep your enjoyment levels to the max without depleting your bank account.  Here are some ways to further educate yourself and save thousands of dollars over your lifetime by making some simple adjustments:

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