Chapter 3: Packing Snow - Quality of Investments

Last chapter we saw that the growth rate earned on your savings has a huge impact on your financial success. A natural question that may come to mind is how to earn the highest growth rate possible on your savings. While the rate of return is important for your financial well-being, so is the quality of your investments.

It’s common knowledge that different types of snow are better or worse at keeping a snowman packed together. The first thing most people want to know before starting to build a snowman is whether the snow is “packing snow”. The depth and freshness of a snowfall has little value if the quality of the snow isn’t right. The remainder of this chapter will discuss steps to ensure your investments are the equivalent of packing snow and not simply fluff.

The investment options that we’ll cover in depth in part II of this blog include:

• Stocks – Chapter 12

• Guaranteed investment certificates (GICs) – Chapter 13

• Bonds – Chapter 13

• Mutual funds – Chapter 14

• Exchange-traded funds (ETFs) – Chapter 14

• Real estate – Chapter 15

These investments offer differing rates of return. The rate of return may be known upfront when you invest, or unknown until later. In addition to these, we’ve already discussed one of the most versatile and widely used investment products, a high-interest savings account.

The Two Main Investment Types

When it comes to investment options, there are no shortage of complicated choices to make anyone’s head spin. Many of the products were created for investors with complex needs and elaborate opinions on what the future holds. The great news is that most of the opportunity is found in two simple investment types. You can purchase ownership, or you can lend your money.

Exhibit 7 – Investing is as simple as owning or lending. You can purchase something, like real estate, and own it. Or you can temporarily lend your money and receive it back, plus interest, sometime in the future.

You don’t need to know everything about all the options we’ll discuss to start benefiting from investing. What is crucial, however, is that with any investment choice you make, you put in the time to learn what risks you’re exposing your hard-earned money to.

Personal research and the assistance of educated professionals—such as a financial advisor—will expose you to the options available. Some products you’ll come across are great investments, the type of investment that could easily be compared to packing snow. However, there are some out there that, either by creation or misuse, can be very damaging to your savings.

Red Flags

A major red flag is any investment that seems too good to be true. Because of the number of educated people constantly watching for a free lunch, it’s unlikely for a sure thing to go overlooked.

An investment that claims equal risk to another and yet offers twice the return is cause for skepticism. Some products deduct a portion of the investment for fees, either when you deposit or withdraw. Another potential cause for concern is small print that places conditions on returns. In the worst of cases, it’s possible the investment could be fraudulent altogether, causing the loss of savings. Before investing, be sure to learn about the rules and check the credibility of the institution offering the investment.

Forecasting Investment Performance

Now that you know some of the dangers to watch for when searching through investments, you’re left with a range of great choices for your money. As we mentioned previously, some investments offer a known growth rate up front. An example is a high-interest savings account that offers 2% interest per year. Other investments, like stocks and real estate, are uncertain. This is because they depend on how much you’re able to sell them for in the future.

As you compare investment options, one thing to consider is how they’ve performed in the past. While it’s no guarantee of what you’ll earn, it can give you an idea and help with your decision. For example, the Canadian stock market grew at an average annual rate of 7% over the past twenty years. And over any given ten years, the return ranged from an average of 3% to 11%.

Long-Term Investing

In the last chapter, we mentioned that starting early was important to allow your money time to compound. Another reason to invest with a long timeframe is to minimize the uncertainty some investments hold. To demonstrate, let’s consider if you had invested in the Canadian stock market sometime in the last two decades. If you were invested for only a single year, you could have lost as much as 42% or made as much as 61%. In 2002, as the tech bubble burst, the Canadian stock market lost roughly 14%. In 2008, the recession led to a decline of 33%. On the other hand, the recoveries in 2003 and 2009 led to returns of 25% and 34%.

However, if you were invested for ten years, your average annual return would have ranged between 3% to 11%. Therefore, even though some investments are uncertain, the return is more predictable over longer periods.

Exhibit 8 – The year-to-year growth rate of most investments is unpredictable and can vary significantly. For instance, over one year, you could lose or gain a large percentage of your savings. However, returns over longer periods are more predictable.

Investing over a long period of time requires two things. Your goal must be far enough away, and you must have the emotional strength to avoid selling your investments before you need to.

The first point is a simple decision. For short-term savings where you need most of your money within the next year or two—like a vacation or car—it’s dangerous to invest in unpredictable options, like the stock market or real estate. However, if it’s a long-term savings goal—like retirement—then these investment options are more suitable.

The second point may not seem like it now, but it’s arguably the most challenging part of investing. You must ignore the constant ups and downs your investments will go through and remember the long-term potential the investment holds.

To give you strength for the inevitable day your investments go down in value, consider your reaction to a warm day in winter. If midway through January the temperature increased above freezing, you wouldn’t pack your winter jacket in a box and drive out to your storage locker to put it away for the year. You’d know that while it may be warm today, or even for the next week, winter always has a way of returning when you least expect it.

Investments, as we’ve mentioned, go up and down as good and bad news come to pass. It’s possible that at the end of a year’s worth of investing your savings may not have grown at all, or they could have lost money. If you panic at the sight of losses and sell your investments, you’ll no longer be exposed to the great potential they hold. Yes, investments lose money from time to time, but that’s the nature of the unknown. However, as has been shown throughout history, successful investments outweigh the ones that fail. As a result, on a long-term basis, you’re likely to experience the growth you require to reach your goals, provided you give your investments enough time.

Another thing that can challenge you emotionally, even when your investments are growing, is someone saying you should sell. Whether it’s a friend or a financial analyst on TV, there’s never a shortage of people claiming to know what’s coming next.

The first thing we need to agree on is that no one knows for sure what the future holds. Instead, people rely on historical trends and probabilities of what could happen in the future. Based on this, financial analysts and TV personalities make predictions about where investments will go next.

The approach these people follow is quite like forecasting the weather. You may have realized over the years that weather forecasts are rarely exact. They may be close some days or get the temperature correct the next, but the consistency is unpredictable. It’s not due to a lack of effort but, instead, to the challenge of predicting something with so many random variables involved. Therefore, when you hear that the market has reached its peak and that you should sell, think back to the last time a major snowfall caught you off guard and forecasts had read a 0% chance of snow, and remind yourself no one knows what the future holds.

Diversifying Your Investments

As we’ve now covered, many investments offer unpredictable returns. 2000 was a great year to own tech stocks, and the next year wasn’t. Similarly, 2005 was a great time to be invested in real estate, and 2008 wasn’t. A second way to make investing more predictable is to have a wide range of investments. This approach, referred to as diversification, is another key tool available to help you reach your financial goals.

For example, instead of investing all your money in the Canadian stock market, you can invest in different geographies and investment options. The advantage to this approach is that not all investments behave the same each year. Canadian oil companies may fall by 10% the same year that European bonds increase by 6%. By holding both Canadian oil stocks and European bonds, your total savings would grow at a more predictable rate.

Exhibit 9 – The following three individual investments offer varying growth each year. If a large portion of your money is in a single investment, your returns will be more irregular.

Exhibit 10 – Investing your money equally in all three of the above investments smooths out your returns and reduces uncertainty.

You could guess—or speculate—which investment will outperform the others. However, by diversifying the number and type of investments, you’ll minimize the risk of major losses.

Let’s explore another snowman analogy to help solidify the importance of diversification in reaching your financial goals. While individual days throughout the winter may call for large snowfalls and others for none, we know with near certainty that there will be snow during the winter. You could try to pick individual days that will bring in the best results, but if you look at the whole season rather than any small part, there’s much less risk you’ll be wrong.

If you were tasked with building as many snowmen as you could in a winter, there’s several ways you could do it. You could watch the weather report and decide on a few days with high forecasted snowfall. Or you could choose to set aside a little of your time every day to take advantage of any fresh powder that may fall.

The first option is like picking individual investments and hoping that they’re better than all the rest. While it’s possible the forecasts are right, if they’re not, you’ll build zero snowmen all winter.

The second option is like diversifying your investments. Since it’s so hard to predict which single day will bring the most packing snow, you can spread your time across the whole season, ensuring that a few days will allow you a chance to build a snowman.

Final Thoughts

This chapter isn’t meant to frighten you away from investing. It’s designed to inform you of the risks and uncertainties involved and provide several key steps to address them. Investing doesn’t have to be complicated and time-consuming. Take on as much as you’re comfortable with and seek guidance from others as required.

Key Takeaways

• Create a list of investment options you understand and trust.

• Spread your money across a diverse assortment of investment options.

• Give your investments time, allowing them the best chance to grow.

This blog is a duplicate of the recently self-published book The Snowman’s Guide to Personal Finance available for purchase here.