12

INTRODUCTION

Saving to build wealth is investing. When people have too much money to spend immediately—that is, a surplus of disposable income—they become savers or investors. They transfer their surplus to individuals, companies, or governments that have a shortage or too little money to meet immediate needs. This is almost always done through an intermediary—a bank or broker—who can match up the surpluses and the shortages. If the capital markets work well, those who need money can get it, and those who can defer their need can try to profit from that. When you invest, you are transferring capital to those who need it on the assumption that they will be able to return your capital when you need or want it and that they will also pay you for its use in the meantime.

Investing happens over your lifetime. In your early adult years, you typically have little surplus to invest. Your first investments are in your home (although primarily financed with the debt of your mortgage) and then perhaps in planning for children’s education or for your retirement.

After a period of just paying the bills, making the mortgage, and trying to put something away for retirement, you may have the chance to accumulate wealth. Your income increases as your career progresses. You have fewer dependents (as children leave home), so your expenses decrease. You begin to think about your investment options. You have already been investing—in your home and retirement—but those investments have been prescribed by their specific goals.

You may reach this stage earlier or later in your life, but at some point, you begin to think beyond your immediate situation and look to increase your real wealth to ensure your future financial health. Investing is about that future.

Investment also goes beyond simply contributing one’s own individual wealth and financial health. The investments we make can contribute to the growth of businesses, organizations, and communities. The investment choices we make can have a significant economic and social impact in the world.

With regard to Indigenous communities in Canada, economic growth is fueled by investment. According to Chief Michael LeBourdais of the Whispering Pine/Clinton Indian Band, “investment can be generated from local residents through savings, through home equity or from outside sources. In Canada, private sector investment outweighs public sector investment by five to one. Three times as many jobs are created in the private sector as in the public sector” (Tulo Centre of Indigenous Economics, 2014, p. 6). Thus, attracting private investment to Indigenous business and economic development projects is an important part of economic growth. Many Indigenous entrepreneurs lack access to capital and rely heavily on personal and family support to help finance their businesses; “there is a growing need for ‘angel investors’ ” as well as other private investment options (Cooper, 2016). Furthermore, “investment creates jobs and business opportunities. This, in turn, builds the fiscal capacity of governments to support social improvements and build infrastructure. It also encourages a natural constituency for accountable, fiscally responsible government as the investment climate is enhanced. Indigenous governments must participate in federations and market systems to provide fiscal and economic opportunities for their governments and members” (Tulo Centre of Indigenous Economics, 2014, p. 7). Therefore, investing can help to increase your individual financial well-being, as well as the economic and social well-being of communities throughout the country.

Through the creation of the First Nations Fiscal and Statistical Management Act on March 23, 2005, the First Nations Finance Authority (FNFA), the First Nations Financial Management Board (FNFMB), and the First Nations Tax Commission (FNTC) were established. Canada’s First Nations and the Government of Canada worked together to support the creation of these new institutions in order to assist First Nations to better access capital markets and more investment opportunities. The FNFMB helps First Nations to build stronger community management and accountability frameworks, including best practices, standard-setting, and capacity-building, that enhance First Nations’ ability to participate in raising capital through the FNFA (Cooper, 2016). The FNTC, as mentioned in Chapter 6, helps First Nations use their property tax revenue to secure long-term borrowing and oversee the bylaw approval process, which provides greater investor certainty. As Cooper states, “the ability to successfully provide transparent, risk-related investment opportunities to private capital providers requires that First Nation communities undertake initiatives to enhance their ability to borrow. The practices and processes of the FNFA and the FNFMB are tools which can be of immediate assistance to the First Nations communities as they proceed to prepare themselves for dealing with private capital providers” (Cooper, 2016, p. 172).

How should you invest your money? This is a critical question that we must all ask ourselves as we reach that stage of our lives when we are ready to begin investing. Today, there are more and more options available to investors who wish to invest their money in socially responsible businesses. Furthermore, many businesses are focusing more on corporate social responsibility (CSR), which is focused on economic, social, and environmentally sustainable activities—and not only because they know it is the right thing to do, but also because it is good business. More and more companies are sharing their CSR record, which makes it easier for investors to research and make informed decisions.

12.1 INVESTMENTS AND MARKETS: A BRIEF OVERVIEW

Before looking at investment planning and strategy, it is important to take a closer look at the galaxy of investments and markets where investing takes place. Understanding how markets work, how different investments work, and how different investors can use investments is critical to understanding how to plan your investment goals and strategies.

You have looked at using the money markets to save surplus cash for the short term. By contrast, investing is primarily about using the capital markets to invest surplus cash for the longer term. As in the money markets, when you invest in the capital markets, you are selling liquidity.

The capital markets developed as a way for buyers to buy liquidity (i.e., raise capital). The two primary methods that have evolved into modern times are the bond and stock markets. Both are discussed in greater detail in Chapter 13 “Owning Stocks” and Chapter 14 “Owning Bonds and Investing in Mutual Funds,” but a brief introduction is provided here to give you a basic idea of what they are and how they can be used as investments.

Bonds and Bond Markets

Bonds are debt. The bond issuer borrows by selling a bond, promising the buyer regular interest payments and then repayment of the principal at maturity. If a company wants to borrow, it could just go to one lender and borrow. But if the company wants to borrow a lot, it may be difficult to find any one investor with the capital and the inclination to make that large a loan, taking a large risk on only one borrower. In this case, the company may need to find a lot of lenders who will each lend a little money, and this is done through selling bonds.

A bond is a formal contract to repay borrowed money with interest (often referred to as the coupon) at fixed intervals. Corporations and governments (e.g., federal, provincial, municipal, and foreign) borrow by issuing bonds. The interest rate on the bond may be a fixed interest rate or a floating interest rate that changes as underlying interest rates—rates on debt of comparable companies—change. (Underlying interest rates include the prime rate: the annual interest rate Canada’s major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable-rate mortgages. The Bank of Canada sets the prime rate.)

Bonds have many features other than the principal and interest; these include the issue price (the price you pay to buy the bond when it is first issued) and the maturity date (when the issuer of the bond has to repay you). Bonds may also be “callable”—that is, redeemable before maturity (paid off early). Bonds may also be issued with various covenants or conditions that the borrower must meet to protect the bondholders (the lenders). For example, the borrower (the bond issuer) may be required to keep a certain level of cash on hand, relative to his or her short-term debts, or may not be allowed to issue more debt until this bond is paid off.

Because of the diversity and flexibility of bond features, the bond markets are not as transparent as the stock markets—that is, the relationship between the bond and its price is harder to determine.

Stocks and Stock Markets

Stocks or equity securities are shares of ownership: when you buy a share of stock, you buy a share of the corporation. The size of your share of the corporation is proportional to the size of your stock holding. Since corporations exist to create profit for the owners, when you buy a share of the corporation, you buy a share of its future profits. You are literally sharing in the fortunes of the company.

Unlike bonds, however, shares do not promise you any returns at all. If the company does create a profit, some of that profit may be paid out to owners as a dividend, usually in cash but sometimes in additional shares of stock. The company may pay no dividend at all, however, in which case the value of your shares should rise as the company’s profits rise. But even if the company is profitable, the value of its shares may not rise, for a variety of reasons having to do more with the markets or the larger economy than with the company itself. Likewise, when you invest in stocks, you share the company’s losses, which may decrease the value of your shares.

Corporations issue shares to raise capital. When shares are issued and traded in a public market such as a stock exchange, the corporation is “publicly traded.” There are many stock exchanges in Canada and around the world. Internationally, the best-known Canadian stock exchange is the Toronto Stock Exchange.

Only members of an exchange may trade on the exchange, so to buy or sell stocks you must go through a broker who is a member of the exchange. Brokers also manage your account and offer varying levels of advice and access to research. Most brokers have web-based trading systems. Some discount brokers offer minimal advice and research along with minimal trading commissions and fees.

Commodities and Derivatives

Commodities are resources or raw materials, including the following:

• agricultural products (food and fibres) such as soybeans, pork bellies, and cotton;
• energy resources such as oil, coal, and natural gas;
• precious metals such as gold, silver, and copper; and
• currencies, such as the dollar, yen, and euro.

Commodity trading was formalized because of the risks inherent in producing commodities—raising and harvesting agricultural products or natural resources—and the resulting volatility of commodity prices. As farming and food production became mechanized and required a larger investment of capital, commodity producers and users wanted a way to reduce volatility by locking in prices over the longer term.

The answer was futures and forward contracts. Futures and forward contracts (or forwards) are a form of derivatives, the term for any financial instrument whose value is derived from the value of another security. For example, suppose it is now July 2018. If you know that you will want to have wheat in May of 2019, you could wait until May 2019 and buy the wheat at the market price, which is unknown in July 2018. Or you could buy it now, paying today’s price, and store the wheat until May 2019. Doing so would remove your future price uncertainty, but you would incur the cost of storing the wheat.

Alternatively, you could buy a futures contract for May 2019 wheat in July 2018. You would be buying May 2019 wheat at a price that is now known to you (as stated in the futures contract), but you will not take delivery of the wheat until May 2019. The value of the futures contract to you is that you are removing the future price uncertainty without incurring any storage costs. In July 2018, the value of a contract to buy May 2019 wheat depends on what the price of wheat actually turns out to be in May 2019.

Forward contracts are traded privately, as a direct deal made between the seller and the buyer, while futures contracts are traded publicly on an exchange such as the Chicago Mercantile Exchange or the New York Mercantile Exchange.

When you buy a forward contract for wheat, for example, you are literally buying future wheat, wheat that doesn’t yet exist. Buying it now, you avoid any uncertainty about the price, which may change. Likewise, by writing a contract to sell future wheat, you lock in a price for your crop or a return for your investment in seed and fertilizer.

Futures and forward contracts proved so successful in shielding against some risk that they are now written for many more types of commodities, such as interest rates and stock market indices. More kinds of derivatives have been created as well, such as options. Options are the right, but not the obligation, to buy or sell at a specific price at a specific time in the future. Options are commonly written on shares of stock as well as on stock indices, interest rates, and commodities.

Derivatives such as forwards, futures, and options are used to hedge or protect against an existing risk or to speculate on a future price. For a number of reasons, commodities and derivatives are more risky than investing in stocks and bonds and are not the best choice for most individual investors.

Mutual Funds, Index Funds, and Exchange-Traded Funds

A mutual fund is an investment portfolio consisting of securities that an individual investor can invest in all at once without having to buy each investment individually. The fund thus allows you to own the performance of many investments while actually buying—and paying the transaction cost for buying—only one investment.

Mutual funds have become popular because they can provide diverse investments with a minimum of transaction costs. In theory, they also provide good returns through the performance of professional portfolio managers. Chapter 14 section 4 “Mutual Funds” provides more information on portfolio management fees.

An index fund is a mutual fund designed to mimic the performance of an index, a particular collection of stocks or bonds whose performance is tracked as an indicator of the performance of an entire class or type of security. For example, the Standard & Poor’s (S&P) 500 is an index of the five hundred largest publicly traded corporations, and the famous Dow Jones Industrial Average is an index of thirty stocks of major industrial corporations. An index fund is invested in the same securities as the index and so requires minimal management and should have minimal management fees or costs.

Mutual funds are created and managed by mutual fund companies or by brokerages or even banks. To trade shares of a mutual fund you must have an account with the company, brokerage, or bank. Mutual funds are a large component of individual retirement accounts and of defined contribution plans.

Mutual fund shares are valued at the close of trading each day and orders placed the next day are executed at that price until it closes. An exchange-traded fund (ETF) is a mutual fund that tracks an index or a commodity or a basket of assets, but is traded like stocks on a stock exchange. An ETF trades like a share of stock in that it is valued continuously throughout the day, and trades are executed at the market price.

The ways that capital can be bought and sold is limited only by the imagination. When corporations or governments need financing, they invent ways to entice investors and promise them a return. The last thirty years have seen an explosion in financial engineering, the innovation of new financial instruments through mathematical pricing models. This explosion has coincided with the ever-expanding powers of the computer, allowing professional investors to run the millions of calculations involved in sophisticated pricing models. The Internet also gives amateurs instantaneous access to information and accounts.

Much of the modern portfolio theory that spawned these innovations (i.e., the idea of using the predictability of returns to manage portfolios of investments) is based on an infinite time horizon, looking at performance over very long periods of time. This has been very valuable for institutional investors (e.g., pension funds, insurance companies, endowments, foundations, and trusts) as it gives them the chance to magnify returns over their infinite horizons.

For most individual investors, however, most portfolio theory may present too much risk or just be impractical. Individual investors don’t have an infinite time horizon, but rather a comparatively small amount of time to create wealth and to enjoy it. For individual investors, investing is a process of balancing the demands and desires of returns with the costs of risk, before time runs out.

 

 

REFERENCES

Cooper, T. (2016). “Finance and Banking.” In K. Brown, M. Doucette, and J. Tulk, eds., Indigenous Business in Canada, pp.161–176. Sydney, NS: Cape Breton University Press.

Tulo Centre of Indigenous Economics. (2014). Building a Competitive First Nation Investment Climate. Retrieved from: https://static1.squarespace.com/static/55565d7ae4b0447c46dd53e8/t/559c0405e4b0b280226825cc/1436288005495/tulotextbook.pdf.

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12.2 INVESTMENT PLANNING

Allison has a few hours to kill while her flight home is delayed. She loves her job as an analyst for a management consulting firm, but the travel is getting old. As she gazes at the many investment magazines and paperbacks on display and the several screens all tuned to financial news networks and watches people hurriedly checking their stocks on their mobile phones, she begins to think about her own investments. She has been paying her bills, paying back student loans, and trying to save some money for a while. Her uncle just died and left her a bequest of $50,000. She is thinking of investing it since she is getting by on her salary and has no immediate plans for this windfall.

Allison is wondering how to get into some serious investing. There is no lack of information or advice about investing, but Allison isn’t sure how to get started.

Allison may not realize that there are as many different investment strategies as there are investors. The planning process is similar to planning a budget or savings plan. You determine where you are, where you want to be, and how to get there. One way to get started is to draw up an individual investment policy statement.

Investment policy statements are outlines of the investor’s goals and constraints, and they are popular with institutional investors such as pension plans, insurance companies, or non-profit endowments. Institutional investment decisions are typically made by professional managers operating on instructions from a higher authority, usually a board of directors or trustees. The directors or trustees may approve the investment policy statement and then leave the specific investment decisions up to the professional investment managers. The managers use the policy statement as their guide to the directors’ wishes and concerns.

This idea of a policy statement has been adapted for individual use, providing a helpful, structured framework for investment planning—and thinking. The advantages of drawing up an investment policy to use as a planning framework include the following:

• The process of creating the policy requires thinking through your goals and expectations and adjusting those to what is possible.
• The policy statement gives you an active role in your investment planning, even if the more specific details and implementation are left to a professional investment adviser.
• Your policy statement is portable, so even if you change advisers, your plan can go with you.
• Your policy statement is flexible; it can and should be updated at least once a year.

A policy statement is written in two parts. The first part lists your return objectives and risk preferences as an investor. The second part lists your constraints on investment. It is sometimes difficult to reconcile the two parts, so you may need to adjust your statement to improve your chances of achieving your return objectives within your risk preferences without violating your constraints.

Defining Return Objectives and Risk Tolerance

Defining return objectives is the process of quantifying the required annual return (e.g., 5 per cent, 10 per cent, etc.) necessary to meet your investment goals. If your investment goals are vague (e.g., to “increase wealth”), then any positive return will do. Usually, however, you have some specific goals—for example, to finance a child’s or grandchild’s education, to have a certain amount of wealth at retirement, to buy a sailboat on your fiftieth birthday, and so on.

Once you have defined goals, you must determine when they will happen and how much they will cost, or how much you will have to have invested to make your dreams come true. As explained in Chapter 4 “Evaluating Choices: Time, Risk, and Value,” the rate of return that your investments must achieve to reach your goals depends on how much you have to invest to start with, how long you have to invest it, and how much you need to fulfill your goals.

As in Allison’s case, your goals may not be so specific. Your thinking may be more along the lines of, “I want my money to grow and not lose value,” or, “I want the investment to provide a little extra spending money until my salary rises as my career advances.” In that case, your return objective can be calculated based on the role that these funds play in your life: safety net, emergency fund, extra spending money, or nest egg for the future.

However specific (or not) your goals may be, the quantified return objective defines the annual performance that you demand from your investments. Your portfolio can then be structured—you can choose your investments—such that it can be expected to provide that performance.

If your return objective is more than can be achieved given your investment and expected market conditions, then you know to scale down your goals, or perhaps find a different way to fund them. For example, if Allison wanted to stop working in ten years and start her own business, she probably would not be able to achieve this goal solely by investing her $50,000 inheritance, even in a bull (up) market earning higher rates of return.

As you saw in Chapter 10 “Personal Risk Management: Insurance” and Chapter 11 “Personal Risk Management: Retirement and Estate Planning,” in investing there is a direct relationship between risk and return, and risk is costly. The nature of these relationships has fascinated and frustrated investors since the origin of capital markets, and it remains a subject of investigation, exploration, and debate. To invest is to take risk. To invest is to separate yourself from your money through actual distance—you literally give it to someone else—or through time. There is always some risk that what you get back is worth less (or costs more) than what you invested (a loss), or is less than what you might have had if you had done something else with your money (opportunity cost). The more risk you are willing to take, the more potential return you can make, but the higher the risk, the more potential losses and opportunity costs you may incur.

Individuals have different risk tolerances. Your risk tolerance is your ability and willingness to assume risk. Your ability to assume risk is based on your asset base, your time horizon, and your liquidity needs. In other words, your ability to take investment risks is limited by how much you have to invest, how long you have to invest it, and your need for your portfolio to provide cash—for use rather than reinvestment—in the meantime.

Your willingness to take risk is shaped by your “personality,” your experiences, and your knowledge and education. Attitudes are shaped by life experiences, and attitudes toward risk are no different. Chart 12.2.1 shows how your level of risk tolerance develops.

Chart 12.2.1 Risk Tolerance

Investment advisers may try to gauge your attitude toward risk by having you answer a series of questions on a formal questionnaire or by just talking with you about your investment approach. For example, an investor who says, “It’s more important to me to preserve what I have than to make big gains in the markets,” is relatively risk averse. The investor who says, “I just want to make a quick profit,” is probably more of a risk seeker.

Once you have determined your return objective and risk tolerance (i.e., what it will take to reach your goals and what you are willing and able to risk to get there) you may have to reconcile the two. You may find that your goals are not realistic unless you are willing to take on more risk. If you are unwilling or unable to take on more risk, you may have to scale down your goals.

Defining Constraints

Defining constraints is a process of recognizing any limitation that may impede or slow or divert progress toward your goals. The more you can anticipate and include constraints in your planning, the less likely they will throw you off course. Constraints include the following:

• Liquidity needs,
• Time available,
• Tax obligations,
• Legal requirements, and
• Unique circumstances.

Liquidity needs, or the need to use cash, can slow your progress from investing because you have to divert cash from your investment portfolio in order to spend it. In addition, you will have ongoing expenses from investing. For example, you will have to use some liquidity to cover your transaction costs such as brokerage fees and management fees. You may also wish to use your portfolio as a source of regular income or to finance asset purchases, such as the down payment on a home or a new car or new appliances.

While these may be happy transactions for you, for your portfolio they are negative events, because they take away value from your investment portfolio. Since your portfolio’s ability to earn returns is based on its value, whenever you take away from that value, you are reducing its ability to earn.

Time is another determinant of your portfolio’s earning power. The more time you have to let your investments earn, the more earnings you can amass. Or, the more time you have to reach your goals, the more slowly you can afford to get there, earning less return each year but taking less risk as you do. Your time horizon will depend on your age and life stage and on your goals and their specific liquidity needs.

Tax obligations are another constraint, because paying taxes takes value away from your investments. Investment value may be taxed in many ways (as income tax, capital gains tax, property tax, estate tax, or gift tax) depending on how it is invested, how its returns are earned, and how ownership is transferred if it is bought or sold.

Investors typically want to avoid, defer, or minimize paying taxes, and some investment strategies will do that better than others. In any case, your individual tax liabilities may become a constraint in determining how the portfolio earns to best avoid, defer, or minimize taxes.

Legalities also can be a constraint if the portfolio is not owned by you as an individual investor but by a personal trust or a family foundation. Trusts and foundations have legal constraints defined by their structure.

“Unique circumstances” refer to your individual preferences, beliefs, and values as an investor. For example, some investors believe in socially responsible investing (SRI), so they want their funds to be invested in companies that practise good corporate governance, responsible citizenship, fair trade practices, or environmental stewardship.

Some investors don’t want to finance companies that make objectionable products or by-products or have labour or trade practices reflecting objectionable political views. Divestment is the term for taking money out of investments. Grassroots political movements often include divestiture campaigns, such as student demands that their universities stop investing in companies that do business with nondemocratic or oppressive governments.

Socially responsible investment is the term for investments based on ideas about products or businesses that are desirable or objectionable. These qualities exist in the eye of the beholder, however, and vary among investors. Your beliefs and values are unique to you and to your circumstances in investing, and they may change over time. For more information on socially responsible investing in Canada, please go to the following websites:

• US SIF: The Forum for Sustainable and Responsible Investment
• Rocky Mountain Humane Investing
• Responsible Investment Association (RIA)
• The Globe and Mail article “Confused by ethical investing? Here’s a primer“

Having mapped out your goals and determined the risks you are willing to take, and having recognized the limitations you must work with, you and/or your investment advisers can now choose the best investments. Different advisers may have different suggestions based on your investment policy statement. The process of choosing involves knowing what returns and risks investments have produced in the past, what returns and risks they are likely to have in the future, and how the returns and risks are related—or not—to each other.