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During the middle of my undergraduate degree, when I was starting to get more disposable income from jobs, I wanted to start investing and putting some of the theory behind what we were learning at school to use. I lived in Canada, so for my first go at things started a TFSA account, where I could safely invest without being taxed. While there are lots of complex financial products, there are a few main types of instruments you can and should invest in, which I wanted to break down for you guys today.
Buying bonds are like buying an IOU from a company or government. You are giving them a loan, and the counterparty will pay you in pre-determined periods of time both principal and interest payments. Bonds are usually considered the safest form of investment (with treasury bills – i.e. bonds from the government – to be the safest), but because of their low risk they will have lower returns than the other investments I talk about below.
This is the most common type of investment. Companies that want to raise money will undergo an Initial Public Offering (IPO) which will allow them to be listed in the stock market. In turn, investors (us!) can buy shares of the company and participate in its growth. By buying stocks, you get a return on your investment in two ways:
- Dividends. This usually applies for large, established companies (think Walmart, or P&G). They will earn more money than they can invest back into the company, so they will pay this excess cash out to shareholders (again, us!) in the form of dividends.
- Capital gains. Not all companies pay dividends, because they want to use all the money earned to re-invest into and grow their business (think Tesla). For stocks of these companies, the only way you will earn money is to buy the stock at a lower price, and as the stock appreciates in value (due to the company performing better financially and looking like a better investment) to sell it for a profit.
There are tons of derivatives out on the market, but unfortunately most of them aren’t available to regular small-time investors like me or you. You can pretty much only pick from the following two categories:
Options. These are very aptly named – when you buy an option, you are given the option to buy or sell a stock at a certain price. This is helpful when you don’t have the cash to buy the stock itself but want to speculate on the stock (because option prices will rise or fall just like a stock, depending on the underlying performance of the stock), or you want to limit your upside or downside risk. More sophisticated investors will often combine options to suit their financial strategy – I can do another post on this if anyone is interested.
Futures. These are also aptly named – futures are agreements for delivery of a certain product (e.g. commodities like oil, minerals, or even cattle) at some point in the future. If you want to speculate on whether the price of these products will rise or fall in the future, but you don’t want to physically buy and sell these products, you can play around with futures.
If you’re looking to trade in derivatives, I highly recommend Interactive Brokers. I’ve been trading futures on their platform for a while and it’s been a low-fee, seamless express.
Stocks and derivatives are all well and good, but they can be riskier than most of us would like. For example, you might think the airline industry is doing well these days (spoiler alert: they’re not), but it’s still risky for you to invest all your money into one single airline because they could go bankrupt for reasons that have nothing to do with the airline industry, like lawsuits, too much debt, management turnover, etc. The risk of this happening is known as diversifiable risk – named this way because this risk can be completely removed if you diversify your investments. For example, if I invest in three different airline companies, I will be in a much better position if one airline company goes bankrupt for reasons unrelated to the industry because the other two airlines will not follow suit.
The problem with individually investing in several different companies to diversify your risk is that you are limited in both time and money. You might not have the time to individually research all the different airlines you want to invest in, or the money to buy stocks in all these companies. That’s where mutual funds come in. Mutual funds are financial vehicles where fund managers do all the legwork for you: they determine an investment goal, buy stocks and bonds in companies, and create a portfolio. They will buy or sell the investments within this fund based on the investment goal and the performance of the investments.
On your end, you can buy shares of the mutual fund, which will mean you are buying into the performance of all the investments the fund managers have made for you. When you make an investment account with your bank, oftentimes they will ask you what your investment goals are and then push their mutual fund products for you to buy.
ETFs are the same as mutual funds except they are not actively managed. This means that there is not a mutual fund manager sitting at his computer every day monitoring the performance of the fund and buying and selling for you. Instead, the ETF has a passive rule that it is following; for example, an ETF can be set up with the rule that it will always invest in the top 100 largest mining companies of the day. If one company falls below this rule, the ETF will replace it with the larger mining company.
The advantage of ETFs over mutual funds is that the management fee taken by ETFs is much smaller, because there is no “finance brain” behind trades which need to happen. This is the same difference which may scare some people off, because they like going to bed knowing that someone is looking out for and actively managing their money. The good news is that on average, due to the lower management fee, ETFs will outperform mutual funds.
If you’re looking to invest in ETFs, I recommend Questrade, because they don’t charge fees on ETF purchases.
What should I invest in?
This question largely depends on where you are at in your life, how much time you want to spend with investing, and what you want out of it. If you like taking risks and want to possibly get rich quick, investing in stocks is the way to go. If you’re nearing retirement age and don’t want anything to happen to your money, bonds and funds should be on the top of your list.
I personally invest mostly in ETF funds, because of their low fees and lack of diversifiable risk. One of my favorite ETFs is the SPDR DOW JONES INDL AVERAGE ETF, which mimics the Dow Jones Industrial index, one of the best indicators of the financial health of the US economy. The way I see it, by investing in this ETF, I’ve invested in the US economy. What do you invest in?