In this post I outline how you can increase your net worth and cashflow with 10 equity investing rules. My wife and I followed them and were able to take early retirement.
The 10 rules we followed are:
- Live within your means;
- Invest via tax advantaged and non-tax advantaged accounts;
- Minimize investment related expenses;
- Let you money compound;
- Make volatility your friend;
- Don’t sell too early;
- Stop looking for the “Home Run”;
- Don't take too little risk;
- Be actively engaged;
- Develop and stick with a sound strategy.
Live within your means
This is rule #1! If you are spending more than what you bring in on an after tax basis, you are falling behind. I don’t care how much you earn.
“You can’t soar with the eagles if the pigeons are pooping on your head”.
Sorry to be so blunt.
Invest via tax advantaged and non-tax advantaged accounts
In Canada you have Registered Retirement Savings Plans (RRSPs), Registered Education Savings Plans (RESPs), and Tax Free Savings Accounts (TFSAs).
Maximize both your RRSP and TFSA contributions if you have sufficient cash to do so. If you do not, some argue you should contribute to your TFSA before your RRSP and others argue vice versa.
I was speaking with someone recently who had sufficient money to contribute to one plan but not both. I suggested a contribution be made to an RRSP which would then generate a tax refund; the individual had not asked his employer to reduce the amount deducted at source so in essence too much was deducted every pay period and a tax refund was expected. Upon receipt of the tax refund, these proceeds could then be invested through a TFSA.
Circumstances are unique so what this person did may not be the appropriate course of action for you. You need to do the math to see what works best for you.
If you are a parent, contributing to a RESP is a must. Why would you not take advantage of the Canada Education Savings Grant (CESG)!? This is a 20% bonus ($500) you receive if you contribute $2500/year. Do this year after year and you can receive bonuses totalling $7200 which is the CESG lifetime limit.
If you are a US citizen, you have your own version of these types of accounts. Take advantage of them!
Do not restrict your investments to tax advantages accounts. If you accumulate a sizable portfolio in RRSPs, you could put yourself in the highest income tax bracket when you withdraw funds. Alternatively, when your RRSP is converted to a RRIF and you must withdraw funds according to government guidelines, your RRIF withdrawals could place you in the top tax bracket.
Since dividend income and capital gains are taxed at the same level when funds are withdrawn from a RRSP, you should carefully plan what stocks will be held in registered accounts and a non-registered accounts. It should be noted that if you hold dividend paying stocks within your TFSA that are listed on exchanges outside Canada, you will be subject to withholding tax.
If, for example, you held shares in 3M (NYSE:MMM) in your TFSA, the brokerage firm would deduct the appropriate withholding tax from the quarterly dividends you receive; you would only receive the net amount.
Dividends from Canadian listed companies are not subject to withholding tax.
Dividends received from foreign listed stocks which are held in your RRSP are not subject to withholding tax.
It would be worthwhile to meet with a financial advisor who understands the tax implications of various investments. The fee incurred for a meeting with a financial advisor could pale in comparison to the amount of tax you could save over the course of time.
Stop buying mutual funds! In 2015,found that "actively managed funds have generally underperformed their passive counterparts especially over longer time horizons, and have experienced higher mortality rates – that is many were merged or closed."
It found that over a 10-year period, active managers beat comparable index funds in only the U.S. mid-value stock funds. In essence, actively managed funds only beat comparable index funds in one of 12 categories. It also found that only 16.9% of active funds which focus on large cap US growth companies beat their passive counterparts over 10 years.
Morningstar’s findings that higher fees have a negative impact on the performance of actively managed mutual funds echoes findings of previously conducted studies.
- Buy exchange traded funds (ETFs) or
- Learn to manage your own investments.
Let your money compound
Albert Einstein is credited with the following quotes:
- “Compound interest is the eighth wonder of the world. He, who understands it, earns it ... he who doesn't ... pays it.”
- “Compound interest is the most powerful force in the universe.”
- “Compound interest is the greatest mathematical discovery of all time.”
Compounding your money is wonderful. It doesn’t care about your race, creed, color, or sexual persuasion. It impacts everyone in the same manner because it depends on time.
Building wealth is much like building a snowball hence the title of the book “The Snowball – Warren Buffett and the Business of Life” by Alice Schroeder.
Building a massive snowball takes a lot of work...in the beginning. First, you need to be strategic about where you start building your snowball if you want a massive snowball. The top of a hill is a good place to start.
You pack snow together into a snowball, you roll it, pieces break off and you fix it, and then you roll it down the hill. That is when the snowball grows without much interference from your standpoint.
Building wealth is much the same. The work you need to perform at the outset is often very painful and tiring and it may seem like you’re making no progress.
Sometimes you take one step forward and two steps back but you keep your eye on the prize. You fix what might have broken and you learn from your mistakes. Then one day, you realize your wealth is naturally attracting more wealth.
If you want to build your wealth through stock investing, you can either automatically reinvest your dividends to acquire new shares in the companies from which you are receiving dividends or receive the cash, pool your funds, and purchase new shares in companies of your choosing.
Personally, I reinvest all dividends received since I like the companies in which we have invested and I fully intend to hold them long-term. Another benefit I get from this strategy is that it removes the opportunity for me to do something foolish.
Essentially, the compounding of our investments is on auto pilot.
Make volatility your friend
Sometimes there is euphoria and stock prices rise to parabolic levels. Other times, fear and panic sets in and stock prices plunge.
Don’t pay attention to short-term volatility. Create a basket of stocks of good solid companies. While you need to watch that basket closely, you don’t want to be constantly removing and adding stocks from this basket otherwise you will not benefit from the 8th wonder of the world (compounding).
If anything, you should wish for market swoons. We all look for “deals” when shopping. Why should that change when you are investing? If a company’s stock is overpriced, don’t buy it. Wait for a correction. If the correction in the stock price is due to a fundamental change in the underlying business, make sure you are comfortable that whatever deterioration which has occurred can be rectified.
Don’t sell too early
Give your investment a chance to grow.
We have held shares in companies for many years and by not doing anything rash, we have seen the value of some investments increase 4 and 5 fold.
Sure, I’ve made mistakes. I bought shares in FedEx Corporation (NYSE: FDX) in 1999 at around $48 and sold them shortly afterwards when they climbed to the $52 - $55 range. As I write this, the stock is trading at almost $186.
Sometimes a company’s price will do nothing for an extended period even though the company is performing well and it regularly increases its dividend.
A famous quote from Benjamin Graham, Warren Buffett’s mentor, summed up the movement of stock prices when he said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Don’t worry about the daily movement of stock prices and don’t view companies as merely ticker symbols.
Stop looking for the “Home Run”
When I was putting together my “10 rules” list and jotted down this tip, I immediately thought of examples where I saw people chasing the “Home Run”.
During the height of the “dot.com” craze, a co-worker came into my office. He informed me that he had just invested about $10,000 in BID.COM. He had received a tip that it was about to launch some online platform that would bring buyers and sellers of business services and products together and its stock was going to go parabolic. He hadn’t told his wife about the investment because when the investment went through the roof he was going to sell his shares and surprise her with a nice gift.
A few days later, a client told me that he had received a tip that BID.COM’s stock was about to go through the roof. He had acquired shares in the company and suggested I might want to look into acquiring some shares. I never did!
Whatever happened to BID.COM? It imploded!
In 2003, another co-worker told me about his investment nightmare. He had invested $40,000 in Commerce One, another internet start-up which had developed a platform to bring buyers and sellers together. To make matters worse he used leverage to buy the shares. How did that investment pan out? Find out here.
Don't take too little risk
On the flip side of “Looking for the Home Run”, you certainly don’t want to take on too little risk. If you just park your money in bank accounts, term deposits, or GICs, you will get sub-par returns. The returns on these investments don’t even keep up with our extremely low inflation rate.
If you live in Canada, go here if you want to see the effect of inflation on investments and savings.
You can also access The Bank of Canada’s Inflation Calculator if you want to see the impact inflation has on the cost of a fixed "basket" of consumer purchases which includes food, shelter, furniture, clothing, transportation, and recreation.
If you are a US resident, you can use the Consumer Price Index Inflation (CPI) calculator found here.
Be actively engaged
I recognize there are a host of reasons why people may feel uncomfortable in making investment decisions. Blindly following your advisor’s recommendations could put you in a position where your money is invested in securities that do not fit your investment profile or investments are “churned”.
Churning means excessive trading by a broker in a client's account with the primary intent to generate commissions for the broker. This practice is illegal and unethical and violates the rules and laws in place to prevent such practices.
In order to protect yourself, I suggest you learn as much as possible about investing. You and your advisor should also agree to an investment policy statement that clearly spells out your financial goals, risk tolerance, target asset allocation, and the circumstances under which changes are to be made to your investment portfolio.
You can certainly reduce the potential for conflict by entering into an agreement in which your advisor will be compensated by way of a flat fee based on your assets under administration as opposed to a commission structure.
In my opinion, a commission structure provides no incentive to beat any benchmarks. It certainly does incent activity!
Another issue I have with a commission structure is what additional level of work is involved to manage a $10MM vs. a $12MM portfolio. I would think it takes the same level of work yet you would be paying more simply because you have more funds being managed.
In addition, how much extra work is involved in executing a trade for 500 shares vs. 1000 shares? It is the same amount of work but under a commission structure, the fees would be different.
I decided years ago to manage our portfolio but that is because I enjoy learning about companies and whether they are reasonably valued or not.
You might be wired differently. For example, you may prefer to turn over the management of your investments to someone else for a variety of reasons. One of these reasons could be that during the time it would take you to manage your investments, you could make way more money in your field of expertise. Regardless of how you want to/don’t want to personally manage your investments, you should definitely be actively engaged.
Develop and stick with a sound strategy
Develop a strategy and keep your impulses in check. Countless investors go with the “flavor of the day”. They see the stocks in which they have invested are not performing as well as other stocks so they chase the “hot stocks”. What often happens is that the “hot stocks” revert to the mean (ie. pull back in price) because the market value of the company has become disconnected from the underlying value of the business. So, people move money into these “hot stocks” only to see them drop in value. They become dissatisfied with their new investment and see that something else is performing strongly and once again move their money in to the “flavor of the day”. This is a recipe for failure.
None of these rules are difficult to put into practice. You just need to set your mind to it.
I wish you much success in your journey to financial freedom!