For most people I know, deciding how to invest hard-earned dollars to fund a distant retirement is more painful than a root canal. How could there possibly be more options? And products? And promises? How do you sort through all the myriad of investment alternatives available?
Today I won’t cover how much you should put away for retirement, but rather some considerations in the type of investments that are right for you. Last time I wrote about understanding your own investment risk profile, which should assist with understanding asset allocation (the percentage weighting you should hold in equities vs. fixed income assets). But what if you don’t know what all of these terms mean?
Understanding what you are invested in is arguably one of the most important factors when it comes to investing. Imagine you invest in something that you think has some guarantee attached to it. You believe that, because it is a bond say, you will receive a cheque in the mail every 6 months and you will receive your principal in full at the end of the period, when the bond matures.
Then you read that the value of your bond has dropped significantly because prevailing interest rates have gone up – or you read that the company that issued your bond is about to go bankrupt and that bond-holders may receive only 20 cents on the dollar. What then?
If you don’t realize the product you have has risk associated with it (default risk, currency risk, interest rate risk, liquidity risk), and you find out later that it does, it is hugely disappointing and you often feel helpless having been sold something that you didn’t understand.
Financial advisors are required to sell products that clients understand, following the ‘Know Your Client’ rules, but this doesn’t mean that clients are honest about their own financial literacy, and don’t agree to a number of statements that they regret answering in the affirmative when sitting in the car an hour later.
Let me be clear. If you invest in mutual funds, you should know what a stock is and what a bond is – because you might own hundreds of them. You should understand the swings that can take place in unit values, and what drives markets up and down. You should review past performance, fees and get advice from someone whom you trust – preferably from someone who will not benefit financially from your investment decisions. A second opinion from an impartial party is golden.
And yes, you need to educate yourself. I have some great reading recommendations on my website including Canadian authors who are objective (because they don’t sell investment products), like Dan Bortolotti, Rob Carrick and Gail Vaz-Oxlade.
Always beware of the aggressive financial guru with the sales pitch for the latest big thing. There is no free lunch when it comes to investing. Tried and true is often the right answer. And yes, a higher expected return does mean generally that there will be a higher risk of capital.
If you or someone close to you has lost serious money from an investment (a private second mortgage, a property that went down in value and was sold, lost money on the stock market), there is likely high emotion associated with that loss. It’s painful to lose a lot of money – regardless of whether it happens quickly or slowly. Understanding BOTH the upside opportunity AND the downside risk is an important part of any investment decision. If you truly understand the risk, you’ll either accept that you are risking dollars you can afford to lose, or you’ll understand that values can fluctuate over time and you will hang in during the downturns.
It all comes back to education, so I recommend you keep reading. Again, anything by Dan Bortolotti is fantastic – he’s Canadian, he takes the guess work out of your investing, and his passive approach is supported by many of the world’s top investors, including Warren Buffett.