These 25 points are the best primer on the essentials of personal finance.
Adapted from an article by Julie Cazzin and Ian McGugan, MoneySense magazine
When we asked a cross-section of Canada's leading experts on personal finance what they considered the greatest money tips of all time, we figured we would get a half-dozen or so points that would emphasize worthy but boring topics like compound interest or spousal RRSPs.
We were wrong.
Our experts surprised us by telling us in many different ways that money is a deep and emotional topic. One expert put at the top of his list some advice on choosing the right spouse. Another stressed the importance of selectively ignoring your portfolio. Yet another pointed out that your most important investment is your own carcass.
We stand corrected. After sifting through the scores of points that our experts nominated for consideration, we've gained a much broader appreciation of how our finances and our lives intersect. And after much discussion, we managed to winnow the collective wisdom of our panel down to 25 points, which we've arranged in five major groups — Starting Points, Family Values, Saving & Spending, Investing, and Finding Advice. At the risk of sounding immodest, we think that these 25 points are the best primer we've seen on the essentials of personal finance.
1. Money is a tool, not a solution
Bruce Cohen, author of The Money Adviser and co-author of The Pension Puzzle, observes that many people have things backward when it comes to their financial planning. They organize their lives to earn money, rather than using money to live the life they want. "The point of the exercise is not to amass a huge mountain of money, but rather to be able to buy the goods and services you find meaningful," he says. And that leads him to observe that…
2. How you spend it is more important than how you invest it
Most people equate brilliant money management with great investing and spectacular stock tips. But that's misleading. Not only is it next to impossible for the average person to outwit the professionals on Bay Street, but all the brilliant investments in the world won't build your wealth by a cent if you keep spending more money than you make.
The only way — we repeat, the only way — to amass money is to live on less than you generate. We're not talking deliberate poverty, mind you — just smart spending. You should live within your means and, ideally, a bit below what you could really afford. Incidentally, this strategy has some wonderful side effects when it comes to your peace of mind. "Knowing you can afford to tell your boss to buzz off creates a certain sense of serenity," says Cohen. And he goes on to note that "financial independence occurs when your savings enable you to meet expenses without having to rely on a regular paycheque. The less you need to live on, the easier — and quicker — it is to become financially independent."
3. Love your job — or leave it
Like Cohen, Jim Otar, a certified financial planner and author, stresses the need for balance in your life. Few things are more conducive to your happiness, he says, than working at a job you truly enjoy. "If you don't love your job, start searching right now," he says. "Don't stop until you find it — be it halfway around the world or in the basement of your own home."
As New Agey as it may sound, Otar's advice reflects some cold, hard number crunching. The numbers show that you would need to build a massive investment portfolio simply to match the income you could receive from even a modestly paid job that you love. Say you can earn $35,000 a year following your blissâ€”making stained glass, for instance, or working as a fishing guide. That's equivalent to the annual income you could expect to generate from a $700,000 portfolio of stocks and bonds. So if you're working hard at something you hate simply to build a huge retirement portfolio, you may want to consider a simpler option — finding something you love to do and working at it until you drop.
4. Put first things first
Malcolm Hamilton, an actuary with Mercer Human Resource Consulting Ltd. and one of Canada's keenest personal-finance observers, urges people to recognize that smart investments don't consist of just stocks and bonds.
Your health, for instance, is your most important asset, yet few of us treat our carcasses with as much respect as we do our portfolios. When you think about it, that's a massively misplaced set of priorities. "Take care of your health," Hamilton advises. "If you don't, money won't matter."
5. Know your spouse
Okay, all the political correctness detectors are going off even as we broach this subject, but one of the things we at MoneySense have noticed over the years is how many of our Family Profiles revolve around couples that are torn apart because they have very different approaches to money — he's a spendthrift, she's a saver, or vice versa. If that sounds familiar, we suggest you schedule a time at least once a month to sit down and discuss money matters with your spouse before minor irritations turn into a major crisis. Better yet, if you're not already married, take money attitudes into account when choosing your partner. "Your spouse can make a big difference in your success or failure," says financial planner Otar. "When selecting a spouse, let your brain work more than your heart."
6. Invest in your kids
Hamilton, who in addition to being an actuary is the father of two children, believes that one of the best investments you can make is in your kids. "The rewards — emotional and financial — are huge," he says. "Few retirement plans will cope successfully with dependent adult children." If you have school-age children and you're not already contributing to RESPs for them, maybe it's time to reconsider. These programs are easy to set up (just go to any chartered bank) and the federal government kicks in free money to bulk up the size of your annual contribution. What's not to like?
7. Give now
If you're a senior who is planning to leave money to your kids in your will, Hamilton suggests you think about handing over the cash right now. "Often seniors are earning 3% after tax on GICs while their children are paying 6% after tax on a mortgage. An interest-free loan from parent to child will help the kids more than it hurts the parent."
8. Talk it over
Several of our experts stressed the need for communication, especially within families and especially when it comes to estate planning. Rather than investing in sophisticated tax-avoidance strategies or spelling out your wishes in elaborate wills, the best and simplest way to avoid problems after your death is to talk things over with all of your kids and other heirs well ahead of time. Ensure that everyone knows how you plan to divvy up your money and why. Answer questions and settle disputes now, rather than leaving them to tear your family apart after you're gone.
9. Look at all-in costs
Most people don't consider the real cost of what they buy. They focus on the number that's on the price tag, but not on how much they have to earn to afford that amount.
The difference can be startling. Say someone offers to paint your house for $1,000. By the time you include various levels of sales taxes, you're probably paying close to $1,150. Then you have to factor in how much income you need to pay that sum. Assuming you're in the top tax bracket, you will need to earn an additional $2,100 or so to generate the money required after tax to pay the $1,150 painter's bill.
Amazing, isn't it? The real cost of the paint job in terms of your pre-tax income is twice its apparent cost. To put things another way, you could bulk up your income by the equivalent of $2,100 if you grab a brush and do the job yourself. No wonder that the U.S. researchers who wrote The Millionaire Next Door discovered that selfmade millionaires tend to be diehard do-it-yourselfers.
10. Set goals
Building wealth isn't a sprint. It's a marathon and one of your biggest challenges is staying motivated and on track. That means establishing mileposts and monitoring your progress. Patricia Lovett-Reid, senior vice-president of TD Waterhouse Canada, is a marathon runner herself and knows how important it is to keep your eye on concrete goals that will motivate you. "You are only going to get excited about saving your money if it's for something of importance to you," she says. "I recommend that you set short, medium- and long-term goals, then tweak the plan as required."
11. Emphasize rewards
Financial author Bruce Cohen observes that budgets often fail because people approach them as negative exercises — all the emphasis is on self-deprivation, what you're not willing to spend money on and what you will do without. A better approach, says Cohen, is to think of a budget as pre-spending and emphasize the objects or experiences that you want to spend money on. "A good budget doesn't tell you that you cannot have what you want," he says. "A good budget says, 'Yes, you can have what you really want'" whether that be a new car or early retirement.
12. Use debt intelligently
Our experts agree that you should never carry debt on a credit card — it's just too expensive. But after that their opinions on debt diverge. Hamilton, for instance, cautions people to be extremely conservative: "Don't borrow to contribute to an RRSP unless you can pay the money back in one year or preferably sooner."
Other experts disagree. "Many people's attitude and behavior toward borrowing is backwards and it costs them financially," says author and financial educator Talbot Stevens. He notes, for instance, that most Canadians borrow at expensive, non-deductible interest rates for personal consumption — cars, appliances, vacations, homes, and so on — but pay cash for their investments. He argues that it's far better from a tax viewpoint to pay cash for consumption items and borrow to invest. The interest on the amount you've borrowed to invest will generally be tax deductible. And by paying cash for consumption items you'll avoid the trap of paying outlandish credit-card rates to purchase things such as electronics or vacations that immediately fall in value.
13. Take the long view
"The power of time and compounding is truly the eighth wonder of the world," says Lovett-Reid. Most smart financial plans consist of nothing more than a regular practice of putting aside money (ideally through payroll deduction so as to remove temptation), then investing this money in a low-cost, well-diversified portfolio.
The results can be impressive, especially as you add more time to the mix. If you have 20 years to go before retirement and can put aside $200 a month into a portfolio that averages a 7% annual return, you will wind up with $100,000 at retirement. If you have 30 years to go, you will have $226,000.
14. Diversify, diversify, diversify
This is the most important rule of investing, according to actuary Hamilton: "No one really knows what the future will bring. Putting all your eggs in one basket, even a safe-looking basket, is taking a risk you don't need to take." Your portfolio should span both stocks and bonds and ideally should include foreign as well as domestic investments. Which brings us to our next point…
15. Plan your portfolio, then stick to your plan
Eric Kirzner, the John H. Watson Chair in Value Investing at the University of Toronto's Rotman School of Management, says investors should develop a strategy for allocating their money among different types of assets. A common mix, for instance, is 10% cash, 50% fixed-income investments (such as bonds) and 40% stocks. More aggressive investors may want to boost the stock component, more conservative investors may want to reduce it. But whatever asset allocation you decide upon, stick to it. Once a year or so, move money around to get back to your original split. This keeps you on track and prevents you from chasing the latest investing fad.
16. Be cheap
Many of our experts made the point that costs matter more than most people realize. "Paying 2% a year for investing advice may not look like much, but 20 years later you've lost one third of your investment," says actuary Hamilton. You can evaluate the cost of a mutual fund by looking at its management expense ratio or MER. Many funds charge 2.5% or more, but you can find many excellent funds with fees of 1.5% or less. So find a good fund with a low fee and neither objective will be compromised.
17. Forget last year
What a fund did over the past year is totally irrelevant to what it will do over the next year. In fact, top performers in one period usually lag behind in the next. As a result, there's no surer recipe for dismal returns than chasing last year's winners, says Kelly Rodgers, president of Rodgers Investment Consulting in Toronto. "When choosing a fund or a manager, look for consistency through many years."
18. Ignore your portfolio — selectively
Smart investors avoid looking at their portfolios too frequently. "Frequent reviews — such as daily — make you overly emotional and they can cause you to make unwise decisions," says U of T professor Kirzner.
19. Keep it simple
All of this investing advice may sound rather complex. In fact, if there's one common misperception among investors, it's the notion that an effective investing strategy has to be complicated, involving a dozen or more mutual funds and constant fine-tuning. None of that is true. "Keep your investment program simple," says financial author Cohen. "Remember that the financial industry is a fashion industry focused more on selling a never-ending stream of baubles than on helping you build wealth."
The MoneySense Portfolios offer a smart way to construct a great portfolio in just 15 minutes a year. If they don't appeal, find a good, cheap balanced mutual fund and funnel your contributions to that fund. (For the names of some good funds, check out Suzane Abboud's annual mutual fund rankings.) A balanced fund automatically divvies your money up among stocks, bonds and cash so you don't have to worry about micromanaging your portfolio.
20. Look for the right fit
"The first thing you should ask a prospective financial adviser is to describe the kind of client he or she likes to work with," says financial author Cohen. "If you don't fit that description, keep looking."
21. Understand how your adviser is paid
Many people don't understand how their adviser makes his or her money, observes financial consultant Rodgers. As a result, they don't know why an adviser may have a vested interest in churning their account, putting them in myriad funds, or constantly rejigging their portfolio.
To avoid that problem, ask your adviser to put on paper a complete list of all the ways he or she will derive compensation from your account, as well as estimated amounts. This list may include trailer fees paid by mutual funds, it may include upfront fees, it may include separate advisory feesâ€”the possibilities are endless. But only by understanding your adviser's incentives can you judge whether the advice you are receiving is unbiased.
22. Consider risk
"If your financial adviser says a strategy or investment has 'little or no risk'," says financial author Cohen, "ask the adviser to put that in writing."
23. Ask questions
Rodgers urges investors to quiz any prospective adviser. Ask about his credentials (a Certified Financial Planner designation should be the minimum you settle for); also ask if he is restricted in the funds or investments he can recommend (some firms encourage their advisers to recommend only funds operated by the company or by approved outsiders). Make sure you understand his fee structure — and be aware that nothing is written in stone. If the price for his services strikes you as too high, don't be afraid to suggest that a discount is in order. Nobody should pay more than 2.5% a year, including mutual fund MERs, for financial advice. If your portfolio tops $500,000 you should be able to negotiate fees of 2.25% or lower and that should fall below 1.5% as your portfolio nears the million-dollar mark.
24. Beware of 10% solutions
Many financial advisers seem to think that history guarantees a 10% annual return from stocks. Not so, says Cohen. "Those statistics reflect index returns that make no provision for fees. Also, much of those historical gains occurred during the 1990s before the big boom went bust." In today's environment, counting on a 5% to 7% annual return is more realistic.
25. Write it down
Both Abboud and Rodgers recommend that you and your adviser draw up an investment policy statement that describes your level of investing knowledge. It should also outline your goals in terms of both the returns you want and the risk you will accept.
That's just the beginning. The statement should go on to list your investment constraints (for instance, whether you need your portfolio to generate regular cash payments) and your unique needs and preferences (such as, for example, not investing in tobacco companies or leaving behind a large bequest for your niece's education). A good investment policy statement should also state how frequently you and your adviser will meet (once a year should be the minimum) and how you will be kept up to date (by monthly reports mailed to your house, for instance). It should also select a benchmark, such as a stock market index, that the performance of your portfolio will be judged against.
How do you know if your statement is complete? Ask yourself if a new manager who has never met you could, with only that information, handle your portfolio the way you would like. Only if the answer is yes should you be satisfied.
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