Why It Makes Sense to Invest NOW

As a young professional, investing in stocks is the sensible thing to do if you want to eventually own your own property and enjoy a good standard of living both now and after retirement. This has become especially important as housing prices continue to rise, and will likely continue to rise in cities where people want to live in (Vancouver, Toronto, Melbourne).

In this article, we discuss our investment philosophy and recommendation. For those who do not have the patience to get to the bottom, young professionals should ideally invest in mutual funds with a strong history of capital preservation during market downturns and a focus on value investing.

A simpler alternative appropriate for most investors is index funds with low expenses. Over time, returns from investing will become more meaningful than their salary in building wealth.

What Stocks (Equities) Are and Why They Earn the Highest Returns

Stock, in the form of shares, represents partial ownership in an operating business. When individuals trade stocks, the price of a share is theoretically the value of the future cash flows from the company. Ignoring the stock market, some businesses are very good and some businesses are not as great – and as it follows, if the stock price of a company just moves with the performance of the company, some stock prices will rise and some stock prices will fall.

Accordingly, investing in individual stocks is highly dependent on picking winners and losers in terms of business model and execution. However, over the entire universe of stocks in a mature and transparent market with strong legal frameworks, we can expect stocks to earn higher returns than bonds and certainly cash. This is because of the risks and rewards of ownership. A salaried employee knows exactly what they will receive in a given year because he is contracted to his wage. A business owner can make as much as he can sell.

Understanding our investment philosophy is simple (yes, we wrote our CFA exams). We look at:

1. Preservation of Capital – Don’t lose money and do not let the money erode in value
2. Appreciation (Growth) of Capital – Grow the money you work hard for and make it work hard for you

Preservation of Capital

As time passes in a healthy economy, the cost of goods rises gradually. $100,000 does not buy the same house it did 30 years ago ($100,000 does not buy a house right now at all). Stocks are effective protection against inflation as the earnings of an operating business will reflect current prices.

Appreciation of Capital

If you look at anyone who is wealthy and able to enjoy a good standard of living, chances are that their career or business income is augmented by investing income. This is because of compounding returns – which is just basic math.

Financial planners like to talk about the power of compound interest. However, compounding returns from a higher yielding investment such as stocks is far more compelling.

There is a quick and dirty rule in finance called the Rule of 72 (sometimes the rule of 70 or the rule of 69) – which states that if you divide 72 by your annual return on investment, that is the approximate number of years it takes for you to double your money.

So, imagine that you are a new teacher earning $50,000 per year. After paying taxes, rent and living expenses, let’s assume you pocket $25,000 a year. You will retire in 25 years.

Let’s compare putting the money into a savings account and earning 2% a year versus investing it into stocks for a 7% return per year (which is reasonable, if not conservative). As an extreme case, we also provide an example where you just held it entirely in cash and an example where you went for a balanced portfolio instead of an equity only portfolio.

If you did not invest at all and kept cash, you would have $625,000.

If you just invested your take home income into the savings account you would have $800,757 before you retired.

If you invested in a balanced portfolio with stocks and bonds yielding 5%, you would have $1,193,177 before you retired.

If you invested your take home income into stocks yielding 7%, you would have $1,581,226 before you retired.

Two observations – 1) if you invested versus not investing, you would have almost $1 million more and you would have made more from investing than your career; 2) you do not take out all your capital post-retirement, and that new sum can be used to generate new money for retirement.

Although we discuss the two separately, appreciation of capital is tied to preservation of capital. Warren Buffett’s first rule of investing is don’t lose money. This is because just one bad year can set you back substantially as the base you are building up from is much lower. As an example, let’s say you pick up on a bad stock tip and you lost 30% in your first year, you could end up with significantly less money for retirement.

Consider a similar situation where in any given year, your stock portfolio could go down (or up) by up to 30%.

Things to Consider When Developing an Investment Strategy

Depending on what personal circumstances are like, the order of importance varies. For individuals who can afford to take on more risk, appreciation of capital should be the focus. For individuals who cannot afford to take as much risk, preservation of capital should be the focus.

To oversimplify, when you have nothing to lose (new career with a good income, no savings and no near-term cash needs), this is when you can afford the most risk (however this does not mean gambling, your investing must still be prudent – however it has the fewest constraints). When you have much to lose (late in the career, substantial savings, obligations for house and children), this is when you can afford the least risk. There is obviously a large middle ground. We are going to focus on two of them.

Human Capital (Future Earnings Power)

Human capital is the future earnings income of an individual. Human capital is a function of how many years you have left to work, how much you earn, how much job security you have and how much your salary is expected to grow.

If you are a newly qualified nurse, crown prosecutor or engineer and if you have no student debt, you have stable and visible future earnings (that will likely grow over time). As such, you have high human capital and can afford to take on more risk to secure strong investment gains because your career is an excellent fallback. Your focus is on growing your money.

If you are a real estate agent working on commission and have had a great year but do not know if next year will be as bountiful, your focus is on preserving your capital – sacrificing large gains for stable growth and income whether through safe and stable dividend paying stocks or real estate.

Similarly, if you are late into your career and close to retirement, even if your current salary is high, your human capital is low because you will only have a few years of income left. As such, you cannot afford to take as much risk.

Investing for Professionals with Pension Plans

For certain professions, the job comes with a pension plan, whether it is defined contribution (the company gives you a certain amount of money every year that is invested for you) or defined benefit (the company guarantees you a figure that is based on your salary and other factors.

A defined benefit pension plan materially increases your ability to take risk and secure a huge nest egg or early retirement, especially early in your career. This is because with a pension, even if prudent investments take a hit early, the pension is a very safe cushion (that adjusts for standard of living and inflation). Ironically, most professionals with defined benefit pension plans are ignorant about investing.

With a defined contribution pension, the investment risk lies with the retiree and future cash flows are not certain. With a defined benefit pension, the investment risk lies with the employer.

As such, it makes a lot of sense for nurses, teachers and civil servants in the public sector to become savvy investors – it also makes for a very interesting hobby!

Time Horizon for Investing

The goal of investing also determines how much risk an investment portfolio can take. As we discuss above, over a long enough time period, stocks as an asset class will always outperform bonds and certainly cash because of the risks and rewards of ownership. As a young or mid-career professional saving for retirement and a good life, stocks are usually the best investment.

However, when there is a near-term or medium-term need for cash, preservation of capital may become more important than growing capital. Examples include paying for a child’s post-secondary education, plans to purchase a house in the next few years, weddings, or anticipated legal settlement.

How to Invest as a Young Professional

Now that the merits of investing have been outlined, the next question is what to purchase.

Although picking individual stocks is fun and if done correctly yields the highest return, the reality is that being a good investor is not easy. It is an exercise that requires an exceptional amount of patience in addition to having a strong foundation in understanding the law, financial topics, accounting and what makes a good business. Most young professionals both inside and outside of the finance field do not have the time or ability to do this, and the risk of loss is unacceptably high.

What are Mutual Funds?

Mutual funds are pooled investment vehicles using the contributions from many different investors. These funds are usually managed by a portfolio manager – usually an asset manager, whether independent like Fidelity or the wealth arm of a major financial institution such as TD Bank – who will charge a fee based on the dollar value of the assets they manage.

Mutual funds will usually be focused on stocks, bonds or money market funds. A popular mutual fund for retail investors is the balanced fund – which will have a mix along the lines of 60% in the flagship stock/equity fund and 40% in the fixed income fund. Older or more risk-averse clients sometimes opt for the balance fund instead of all equity. The MER will be between equity funds and bond funds, but closer to the equity fund – so it is cheaper to buy them separately.

Mutual funds are not traded on an exchange – rather, they are purchased and redeemed through the fund.

Investing in Mutual Funds

As such, the best option is to find a money manager that respects the principles outlined above – 1) preservation of capital; 2) growth of capital. Unfortunately, this is also difficult to figure out without a strong investing background and the marketing of mutual funds can be murky. In fact, most mutual funds underperform the broader stock market (buying an index) after fees.

Advertised strategies are hard to confirm and many portfolio managers are guilty of index hugging (their mutual fund is basically the benchmark they compare themselves against, with a few tweaks, ensuring that they never deviate too far and keep their jobs. This is useless to an investor, as you are essentially receiving the index but paying heavy management fees.

Fortunately, there have been asset managers who have championed disciplined value investing over time – most notably Fidelity Investments, PIMCO and Mawer Asset Management. These investors can fulfill both mandates we set out above. 1) These investors preserve capital by holding cash and waiting for bargains; 2) These investors grow wealth under management on two fronts, one which indexing does not provide – a. Stocks as a whole go up on average over time (beta exposure); b. due to their conservative analysis and investment discipline, they outperform the market over time (alpha exposure).

Investing in Index Funds through ETFs

We have a more extensive page on ETF investing here.

Realistically, most young professionals will and should go with indexing, or purchasing famous index funds such as the iShares (Blackrock) S&P500 and Vanguard Total Stock Market. An investment in a market index is essentially the same as emulating the returns of the broader stock market.

As stocks have always gone up over time (for a logical reason), this allows investors to get market exposure almost for free (management expenses for index funds are very low due to scale and securities lending).

Indices are excellent for addressing the appreciation of capital. However, indices do not address preservation of capital, because they are susceptible to stock market crashes due to corrections from irrational valuation or financial crises.

It is impossible to time the market, but this risk can be smoothed out via dollar cost averaging. For an investor that is just starting out with regular income streams (a stable job), a market crash is not necessarily a bad thing because it means that their next purchase of the same basket of stocks (the ETF represents the same stock market) is actually cheaper than the last purchase.

To illustrate, let’s pretend the stock market is made up of Apple and Google, both of which are $100. Carmen purchases 1 unit of VFV for $200. In 2 weeks, the stock market falls 50% and Carmen’s next paycheque comes in. She purchases $200 of VFV (representing 2 units now). The stock market rises 100% and now Carmen is back to where she was on her first week’s investment but has profited $200 from her second week’s investment.

As such, Carmen is likely to realize healthy 7% returns overall until when she retires.

Investing in the Middle of a Career

What if I already have some money saved up (over $200,000)? The good thing is that it is never too late to become educated and start investing. Having saved up diligently is certainly not a bad thing.

We recognize that at a certain point in a career with a large amount of disciplined saving, dumping everything into the stock market at once will bring up market timing fears and a poorly timed market downturn may have psychological consequences.

If you have had problems saving in your 20’s, the good news is that you probably have a higher salary in your 30’s and you still have some time before your retire, so the appropriate strategy is the same as for young professionals.

Purchasing Residential Real Estate as an Investment

If you plan on staying in your city long term, it may be prudent to purchase your own home. If you plan on living in your home for the rest of your life, then you do not need to worry about the vagaries of the real estate market. If your house price falls, and you are looking to move homes, the house you are looking to switch into probably will have fallen too. For homes, we prefer freehold houses or strategically positioned high quality condominiums.

Purchasing Investment Real Estate as an Investment

If you already have a property, an investment property can be a good way to generate returns as a business which are uncorrelated with your stock market holdings. We may develop a real estate section later, but the idea is that you will rent out the property to a quality tenant base (cut out the property manager as this hurts the economics). If your net operating income (post property tax and maintenance) exceeds your debt service (interest and principal), you should be earning a decent return. The catch is that this is a job in itself and comes with the complications of running a business.

This consideration is very different when considering a city in high demand (Vancouver, Melbourne) versus a city that is relatively cheaper. For a cheaper city, you need to make sure that cash flows comfortably cover interest and principal on the mortgage and that the city is growing (so you know that vacancies will be controlled and rent will rise with inflation) – the property should pay for itself. For a hot city, you are looking for some sort of capital appreciation, but rent should still help you cover interest and a good chunk of principal.

Investing in Stocks with a Large Lump Sum of Money

If you choose to allocate your money into passive investments, we would still recommend the stock route, and the basket you pick is dependent on your risk tolerance. If you have a stable job and a pension, your ability to take risk rises. If you have children and obligations, it falls. If you are comfortable with risk, a pure index ETF as discussed above should be favored. Otherwise, the following options can be considered:

Historically, a balanced fund (60% stocks and 40% bonds) was recommended as the volatility of this portfolio is lower while providing a better risk-adjusted return (absolute return is lower than an all-equity portfolio). However, in today’s interest rate environment, downside in bond prices is larger than the upside while coupons on bonds are unattractive so we prefer an all equity mix until yields rise to attractive levels.

With a larger nest egg and a desire for stability, there should be a tilt towards strong dividend paying stocks with good business profiles, and there are ETFs that hold those baskets.

Getting Started with Investing

1. Pay off any non-mortgage debt immediately
2. Keep a $2,500 cash reserve for emergencies (this may vary based on how large you perceive your emergencies to be)
3. Put all incremental money into index exchange-traded funds/ETFs (publicly traded mutual funds that look to emulate a major stock index, such as the S&P 500 or Dow Jones Industrial Average) or a quality value focused mutual fund with a history of capital preservation and outperforming the market

Pay Off Debt First Before Investing

Paying off debt is common sense – as you are a single exposure to the bank and any non-mortgage debt you owe is likely to have poor or no collateral, your interest rate (negative carry) is likely to be high.

The expected return on the stock market is ~7-8%, so in a normal year you are capturing a 3% gain if you choose to purchase an index fund instead of paying down “cheap” debt (we classify “cheap” as a secured loan for someone with good credit at prime + 1.00%) with a very large amount of risk. Credit card debt and car loans have exorbitant rates per annum, and no cash should be put anywhere else until these are extinguished.

Keeping a Cash Reserve

A cash reserve is important for unforeseen circumstances such as a leak in your condominium or your dog getting sick. Canada has a more robust social safety net compared to the US, so the cash reserve can be relatively smaller.

Not having a cash reserve can be problematic because if you have an immediate cash need, you may need to sell your investments, which may have lost money due to swings in the market.

Investing and Selecting Securities on Your Own

If you have a curiosity for the markets and enjoy evaluating how businesses work and making guesses supported by research, you may consider supplementing the index holdings with a few select stocks of companies you genuinely admire that are adequately capitalized and have good prospects going forward.

We certainly feel it is a noble hobby and one that educates an individual well beyond finance and business – please refer to our industry section for an introduction to the analytical process. However, it is important to remain humble and realize that becoming a good investor is a full time job and requires years of experience and learning from mistakes. Discipline, patience, mental coolness and an ability to turn data into information are paramount to success.

As an interesting aside, our recommendation is gaining momentum and more institutional and retail money is now flowing into passive indexing. Active managers are consolidating and shuttering due to the pull out of money as a response to their inability to generate alpha. If this trend continues, passive indexing will cause all stocks, good and bad, to move with the market and active management and security selection will be easier, allowing for outsized returns. This inflection point may not have been reached yet, but investors should be cognizant of this to take advantage of when individual securities become increasingly mispriced.

Related Reading for Investing

Investment Asset Classes

Stocks (Equities)
Fixed Income – An introduction to bonds and other fixed income instruments
Index ETFs – An introduction to index ETFs and why they make sense versus most mutual funds
Avoiding Exchange Rate Fees at Banks for Investing and Travel
Gold
Real Estate
Taxes – All investors have to deal with taxes but it is important to know how to minimize tax drag on your investments through understanding TFSAs and RRSPs

Commentary on Investing

Investing

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