How My Sons Invest
Rather than tell people how to invest and try to cover every need and circumstance, I’m going to describe my sons’ simple but powerful investment approach. Readers can decide for themselves how suitable this approach is for them.
My sons are young adults just a few years into investing some of their savings. Working on their investments isn’t in their top 100 favourite things to do. They have a simple plan based on do-it-yourself low-cost index investing that will beat the vast majority of other investors over time. They may modify their plan as their lives change and their assets grow, but for now they’re following the ideas described here.
Time horizon
It seems obvious to say that they have very long investing time horizon, but that’s only true for part of their money. Not all of their plans are long-term. One of them is considering buying a car. The other earns less income in the winter and needs a cash buffer. Both need a buffer in their chequing accounts and emergency savings in their high-interest savings accounts.
They only invest money they expect not to need for at least five years. Of course, we can’t predict the future exactly, and they may need money sooner than they expect, but they do their best to predict how much cash they should hold for shorter-term needs.
Another thing we should all consider is our ability to stay invested through a market crash. I told my sons that it’s not just about how much money you’ll need over the next 5 years. Just imagine that the market is crashing and your hard-earned savings are shrinking. How much money do you need to have safe in a high-interest savings account to keep your nerve and leave your investments alone while you wait for markets to recover?
It’s one thing to know intellectually that a market crash is a good thing for young people so they can buy stocks cheaply. But it’s quite another to live through a crash and try to keep your nerve. A buffer of emergency savings is a great way to feel safer.
There are some who say that having cash savings earning low interest creates a pointless opportunity cost, and that you’d make more money investing it all. However, the cost of losing your nerve and selling during a market crash is so high that it’s worth it to pay the much lower cost of having some cash savings. Another thing to consider is that being able to sleep at night is very valuable.
Account type
It makes most sense to use tax-advantaged accounts where possible. In Canada, this generally means either TFSAs or RRSPs. My sons’ incomes are low enough for now that RRSP contributions would give them only modest tax refunds, so they’re better off investing in TFSAs initially.
Neither of them is threatening to use up all his TSFA room anytime soon, so until their incomes grow, they’re likely to keep investing exclusively in TFSAs.
Where to open an account
My sons chose to open their accounts at a discount brokerage that will suit their needs when their savings are much larger. Some commentators recommend that young people choose mutual funds such as TD’s e-Series or Tangerine funds. These are fine choices for small to medium-sized accounts. My sons decided not to create a future need to change financial institutions and learn a new way to invest. Their plan is so simple that they can handle investing at a discount brokerage from the beginning.
Although my sons planned to own exchange-traded funds (ETFs), they didn’t worry much about choosing a brokerage with free ETF trading. Their plan involved very infrequent trading. They focused more on brokerage features that will suit them when their accounts become large.
Asset allocation and ETF choices
My sons chose all-stock portfolios. Although stocks are more volatile than bonds in the short term, their volatilities over 20 years or longer is almost the same. But bonds have much lower expected returns, so the only reason to choose to own bonds for the long term is to control short-term volatility. This is an important reason for holding bonds for retirees who could be hurt by short-term volatility or for anyone who might panic and sell at a bad time. My sons chose to maintain adequate cash savings to handle short term needs and to help them control any sense of panic during a market crash.
They chose a simple portfolio of one-third Canadian stocks and two-thirds U.S. and foreign stocks. Based on the size of Canada’s economy, this mix is overweight in Canadian stocks. But their spending needs will be correlated with the fate of the Canadian economy, and it seems appropriate to be somewhat overweight in Canadian stocks.
Vanguard is an investor-owned fund company with investor-friendly policies. It’s not clear how this carries over from Vanguard U.S. to Vanguard Canada, but Vanguard seems a better bet than any for-profit fund company. So, my sons chose the following allocation:
1/3 VCN (a Vanguard ETF of Canadian stocks)
2/3 VXC (a Vanguard ETF of the world’s stocks excluding Canada)
It might seem that this portfolio is just too simple. But the truth is that as long as my sons stay the course, they will get higher returns than the vast majority of other investors who get drawn into more complex strategies.
Costs
The Management Expense Ratio (MER) of VCN is 0.06%/year. It has no other significant costs to investors. VXC’s MER is 0.27%/year. However, to this we must add foreign withholding taxes on dividends. Based on Vanguard Canada’s 2017 Annual Financial Statements, this adds about 0.30%/year for a total cost to VXC investors of about 0.57%/year. The total cost of the blended portfolio works out to 0.4%/year. Over 25 years, this adds up to almost 10% (see this explanation of how costs build over 25 years).
A 10% haircut over 25 years may seem hefty, and it is, but most investors who own mutual funds pay much more than this; they just don’t realize it. The truth is that until my sons’ portfolios become large, costs aren’t critical. They will have plenty of time to find lower-cost ways to own U.S. and foreign stocks once their portfolios grow larger and include RRSPs.
Rebalancing
Over time, ETFs pay dividends, and people add new money to their portfolios. This creates a need to buy more ETF units. VCN and VXC will grow at different rates. While my sons’ portfolios are small to medium size, they will be able to maintain their desired 1/3, 2/3 ratios for VCN and VXC by buying more of whichever ETF is below its target allocation.
However, they don’t worry about their asset allocations being off by a few thousand dollars. For an initial deposit of $3000, it’s fine to just put it all in VXC instead of buying $1000 VCN and $2000 VXC. A second deposit of $2000 could go entirely into VCN. Each time they have enough cash to invest, they just buy VCN if it’s below 1/3 of the portfolio, or buy VXC if it’s below 2/3 of the portfolio. If they ever have a very large sum to invest, say above $5000, then they’d split it into two purchases with sizes that bring the portfolio to the target allocations of 1/3 and 2/3.
It’s conceivable that VCN and VXC could grow at such different rates that they wouldn’t be able to maintain their target allocations by just buying the ETF that is below its target allocation. But this is unlikely to happen until their portfolios grow significantly. If it did happen they might have to sell some of one ETF to buy the other to get back in balance.
They don’t worry about holding some cash in their accounts. They don’t reinvest each small dividend when it arrives. For those who don’t pay commissions on ETF purchases, it’s OK to invest small sums, but it isn’t necessary. My sons just set a threshold level and invest the cash whenever it exceeds the threshold. Their current threshold is about $1500.
Conclusion
This very simple plan will likely work well for my sons until their incomes grow to the point where it makes sense to open RRSP accounts. Very little else would need to change at that point, though.
They would just view their combined TFSA and RRSP as a single portfolio, and maintain their overall target allocation of 1/3 VCN and 2/3 VXC. Other subtleties like accounting for future income taxes on RRSP/RRIF withdrawals and reducing portfolio costs can wait until they’re closer to retirement.
My sons are young adults just a few years into investing some of their savings. Working on their investments isn’t in their top 100 favourite things to do. They have a simple plan based on do-it-yourself low-cost index investing that will beat the vast majority of other investors over time. They may modify their plan as their lives change and their assets grow, but for now they’re following the ideas described here.
Time horizon
It seems obvious to say that they have very long investing time horizon, but that’s only true for part of their money. Not all of their plans are long-term. One of them is considering buying a car. The other earns less income in the winter and needs a cash buffer. Both need a buffer in their chequing accounts and emergency savings in their high-interest savings accounts.
They only invest money they expect not to need for at least five years. Of course, we can’t predict the future exactly, and they may need money sooner than they expect, but they do their best to predict how much cash they should hold for shorter-term needs.
Another thing we should all consider is our ability to stay invested through a market crash. I told my sons that it’s not just about how much money you’ll need over the next 5 years. Just imagine that the market is crashing and your hard-earned savings are shrinking. How much money do you need to have safe in a high-interest savings account to keep your nerve and leave your investments alone while you wait for markets to recover?
It’s one thing to know intellectually that a market crash is a good thing for young people so they can buy stocks cheaply. But it’s quite another to live through a crash and try to keep your nerve. A buffer of emergency savings is a great way to feel safer.
There are some who say that having cash savings earning low interest creates a pointless opportunity cost, and that you’d make more money investing it all. However, the cost of losing your nerve and selling during a market crash is so high that it’s worth it to pay the much lower cost of having some cash savings. Another thing to consider is that being able to sleep at night is very valuable.
Account type
It makes most sense to use tax-advantaged accounts where possible. In Canada, this generally means either TFSAs or RRSPs. My sons’ incomes are low enough for now that RRSP contributions would give them only modest tax refunds, so they’re better off investing in TFSAs initially.
Neither of them is threatening to use up all his TSFA room anytime soon, so until their incomes grow, they’re likely to keep investing exclusively in TFSAs.
Where to open an account
My sons chose to open their accounts at a discount brokerage that will suit their needs when their savings are much larger. Some commentators recommend that young people choose mutual funds such as TD’s e-Series or Tangerine funds. These are fine choices for small to medium-sized accounts. My sons decided not to create a future need to change financial institutions and learn a new way to invest. Their plan is so simple that they can handle investing at a discount brokerage from the beginning.
Although my sons planned to own exchange-traded funds (ETFs), they didn’t worry much about choosing a brokerage with free ETF trading. Their plan involved very infrequent trading. They focused more on brokerage features that will suit them when their accounts become large.
Asset allocation and ETF choices
My sons chose all-stock portfolios. Although stocks are more volatile than bonds in the short term, their volatilities over 20 years or longer is almost the same. But bonds have much lower expected returns, so the only reason to choose to own bonds for the long term is to control short-term volatility. This is an important reason for holding bonds for retirees who could be hurt by short-term volatility or for anyone who might panic and sell at a bad time. My sons chose to maintain adequate cash savings to handle short term needs and to help them control any sense of panic during a market crash.
They chose a simple portfolio of one-third Canadian stocks and two-thirds U.S. and foreign stocks. Based on the size of Canada’s economy, this mix is overweight in Canadian stocks. But their spending needs will be correlated with the fate of the Canadian economy, and it seems appropriate to be somewhat overweight in Canadian stocks.
Vanguard is an investor-owned fund company with investor-friendly policies. It’s not clear how this carries over from Vanguard U.S. to Vanguard Canada, but Vanguard seems a better bet than any for-profit fund company. So, my sons chose the following allocation:
1/3 VCN (a Vanguard ETF of Canadian stocks)
2/3 VXC (a Vanguard ETF of the world’s stocks excluding Canada)
It might seem that this portfolio is just too simple. But the truth is that as long as my sons stay the course, they will get higher returns than the vast majority of other investors who get drawn into more complex strategies.
Costs
The Management Expense Ratio (MER) of VCN is 0.06%/year. It has no other significant costs to investors. VXC’s MER is 0.27%/year. However, to this we must add foreign withholding taxes on dividends. Based on Vanguard Canada’s 2017 Annual Financial Statements, this adds about 0.30%/year for a total cost to VXC investors of about 0.57%/year. The total cost of the blended portfolio works out to 0.4%/year. Over 25 years, this adds up to almost 10% (see this explanation of how costs build over 25 years).
A 10% haircut over 25 years may seem hefty, and it is, but most investors who own mutual funds pay much more than this; they just don’t realize it. The truth is that until my sons’ portfolios become large, costs aren’t critical. They will have plenty of time to find lower-cost ways to own U.S. and foreign stocks once their portfolios grow larger and include RRSPs.
Rebalancing
Over time, ETFs pay dividends, and people add new money to their portfolios. This creates a need to buy more ETF units. VCN and VXC will grow at different rates. While my sons’ portfolios are small to medium size, they will be able to maintain their desired 1/3, 2/3 ratios for VCN and VXC by buying more of whichever ETF is below its target allocation.
However, they don’t worry about their asset allocations being off by a few thousand dollars. For an initial deposit of $3000, it’s fine to just put it all in VXC instead of buying $1000 VCN and $2000 VXC. A second deposit of $2000 could go entirely into VCN. Each time they have enough cash to invest, they just buy VCN if it’s below 1/3 of the portfolio, or buy VXC if it’s below 2/3 of the portfolio. If they ever have a very large sum to invest, say above $5000, then they’d split it into two purchases with sizes that bring the portfolio to the target allocations of 1/3 and 2/3.
It’s conceivable that VCN and VXC could grow at such different rates that they wouldn’t be able to maintain their target allocations by just buying the ETF that is below its target allocation. But this is unlikely to happen until their portfolios grow significantly. If it did happen they might have to sell some of one ETF to buy the other to get back in balance.
They don’t worry about holding some cash in their accounts. They don’t reinvest each small dividend when it arrives. For those who don’t pay commissions on ETF purchases, it’s OK to invest small sums, but it isn’t necessary. My sons just set a threshold level and invest the cash whenever it exceeds the threshold. Their current threshold is about $1500.
Conclusion
This very simple plan will likely work well for my sons until their incomes grow to the point where it makes sense to open RRSP accounts. Very little else would need to change at that point, though.
They would just view their combined TFSA and RRSP as a single portfolio, and maintain their overall target allocation of 1/3 VCN and 2/3 VXC. Other subtleties like accounting for future income taxes on RRSP/RRIF withdrawals and reducing portfolio costs can wait until they’re closer to retirement.
But the good thing is they have received some guidance from you. I didn't really learn about investing as much as blundered my way until I figured it all out. This kind of Financial Smarts is an important lesson for all kids.
ReplyDelete@Alan: I agree. I wish someone had taught me a few things about investing when I was young.
DeleteOne of the mentalities that helped me, was when I read, "only invest what you are prepared to lose."
ReplyDeleteIn my head it was not to expect it to go to zero, but that it is 'gone', it is invested and now can no longer be touched. Thus in effect, gone.
Now whether that will backfire when I do retire.. I'll deal with later.
@aB: Apparently, some of the best savers aren't very good at spending when they retire. I guess that shouldn't be too surprising.
DeleteWhat about purchase costs? If you're buying in amounts of $500-$1000, even a small fee materially increases your cost of holding it.
ReplyDelete@Evan: As I explained, my sons don't make any small purchases in the $500 to $1000 range.
DeleteSorry, I read that they would be investing in chunks of about $1500, which I thought would be $500 in the Canadian one and $1000 in the other.
DeleteTo this point I've used TD e-series for this type of investing, but am thinking of moving to ETFs.
@Evan: I understand your question now. Yes, by not worrying too much about getting the asset allocation exact, my sons limit the number of trades they make.
DeleteTD e-Series is a solid choice. The costs aren't too much higher than VCN/VXC. For my own portfolio, I use US-listed ETFs in place of VXC to get costs even lower, but this only makes sense once the portfolio is sufficiently large.
When we started the grand-kids RESP I used my brokerage which offers a basket of no commission ETF. I kept it simple 30-30-30- US, Europe and Canada. the other 10% is in a preferred fund. Simple couch potato, new money balance amounts. You can buy as few as 5 shares at a time. I just follow my original plan and it takes no planning like my other accounts. Over the last 5 years it has done better than most of our other accounts. Simple is good.
ReplyDelete@DJ: I agree: simple is good.
Delete