I got this question about banks and TFSAs and investing and realized I have not addressed such a good basic question in a long time. So, here goes:
I’m thinking of getting into investing a little bit of money, starting with a GIC, currently with Royal bank and most of their GICs are non registered only 🙁 so I thought I might look elsewhere. Do you have a bank that you might suggest? GICs stocks and bonds are the only terms that make sense to me rn lol, tried to understand mutual funds and ETFs but ended up being more confused haha
Ok that is an excellent set of very good, basic questions! Lets break things out a little bit.
First, most simply, I am sure you can purchase a term deposit or GIC-like investment inside the TFSA. It may be simply called something different.
However, let’s talk more about investment funds (mutual funds and ETFs) and try and make you less confused. Investment Funds invest in a variety of investments, the two most common being stocks and bonds. Let’s talk about those first
Stocks-what is a stock?
It’s a fancy, official document that proves you own a piece of a company, like a tiny slice of Apple, Nestle, Royal Bank or Microsoft or any company. Back in the day, these were actual paper documents, but nowadays, they’re mostly electronic records (less fancy, but a lot more practical).
So it means that you are an actual part owner of the company, a tiny tiny part but an owner still. A partner. Now, why would you want to own a part of a company? Well, for a few reasons:
- Profit Potential: If the company does well, sells lots of iphones or hot chocolate and its revenue goes up, the price of each share could go up, and you could sell your shares for more than what you paid. This is historically the best returning asset class over longer periods of history.
- Dividends: Some companies share their profits with shareholders in the form of dividends, which are like little ‘thank you’ payments for being one of the owners.
Of course, investing in stocks isn’t without risks. The company could perform poorly, another competitor company could make even more Hot Chocolate sales and the value of your shares could drop. That’s why it’s important to diversify your investments, or in other words, not put all your eggs (or stock shares) in one basket (or investment).
Bonds
Most bonds are not like Canada Savings Bonds.Think of a bond like a super official IOU from your friend. Imagine your friend asks to borrow $50 from you, and in return, promises to give you a little extra back each month as a ‘thank you’, and after a year, gives you your original $50 back. That’s basically what a bond is.
In more official terms, a bond is a type of loan that investors make to entities like governments or corporations. When you buy a bond, you’re lending money to the issuer of the bond. In return, they agree to pay you interest over a set period (that’s the ‘thank you’ part), and when the bond ‘matures’, they repay the original amount you lent them. This maturity could be 30 days or a 100 years.
Now, why might you want to own a bond?
- Steady Income: Bonds pay interest at regular intervals, usually every six months. It’s like getting a steady stream of ‘thank you’ payments from your friend.
- Return of Principal: When the bond matures, the issuer promises to pay you back the original amount you lent them. It’s like getting your original $50 back from your friend afterwords.
- Safety: Bonds are generally considered safer than stocks. While your friend might run off and never pay you back, it’s less likely that a big government or corporation will do the same. So this means that as long as the issuer is around, the market price of the bond doesn’t matter, at the end you will get back the money you put in.
- Diversification: Having bonds in your portfolio can balance out the riskier parts, like stocks. It’s like having both exciting, risky rides and calm, gentle rides at a theme park. The calm rides (bonds) can help balance out the thrills and spills of the roller coasters (stocks).
That said, no investment is risk-free. The issuer could run into financial trouble and be unable to pay the interest or repay the principal. So, if you want to earn regular interest payments and have a good chance of getting your original investment back after a certain period, then bonds might be something you want to look into!
Now once you understand these two investment vehicles the question becomes what is the best way to own them. You could open a brokerage account and buy some of each individually. OR you can use an investment fund which can be a Mutual Fund or ETF Exchange Traded Fund. They come -simplistically- in two flavours: passive or active.
Passive investment funds simply buy all the stocks or bonds of an underlying index, like the S&P 500 which is an index of 500 large American companies.
Active Management
Active investment funds have a manager or management team. To elaborate on this, lets use a cattle analogy.Imagine you’re a cowpoke out in the Wild West, and you’ve always dreamed of owning a herd of cattle. But cows are pricey, and you can’t afford a whole herd on your own.Now imagine all the cowpokes in your town are in the same predicament. So, you all decide to pool your money together to buy a big herd of cattle. Each cowpokes puts in what they can, and in return, gets a claim to a portion of the herd proportional to what they put in.That’s your investment fund, right there – a big pool of money from many different investors (or cowpokes), used to buy a diversified portfolio of investments (or a herd of cattle). These can be stocks, bonds, or a mixture of many different types of investments.Now, none of you cowpokes are experts in managing a herd, so you hire an experienced rancher (the fund manager) to take care of it. She decides which cows to buy, when to sell them when they get bigger, when to move the herd to greener pastures – all based on her experience and the goal of growing the herd as big as possible. The herd may also produce milk (interest payments) or calves (dividends) that can be extra revenue for you.So now, even with a little bit of money, you and your cowboy buddies own a piece of a big, diversified herd (or portfolio) – something you wouldn’t have been able to afford on your own. You don’t have to worry about the day-to-day cow management, and if all goes well, you’ll see your portion of the herd (investment) grow over time.Of course, the rancher charges a fee for her services, which is something to keep in mind when investing in a mutual fund or actively managed ETF. And some ranchers are not very good at their job which is why some believe its better to buy a cheaper, passive investment ETF or mutual fund.But it IS a percentage of assets so the rancher makes more money the bigger the ‘herd’ gets and less money the smaller the ‘herd’ gets. This helps tie her interest to yours, cowpoke
I hope this helps you understand some of the basic concepts AND helps you feel less overwhelmed. Here are a couple of excellent additional resources from the media:
