The Rule of 72: Doubling of Money

When investing or borrowing money, probably the most determining factor in our decision is the interest rate we are paying, or getting, on our money. As discussed before, there are 2 types of interest: Simple Interest and Compound Interest. Simple interest, as its name suggests, is very simple to calculate. Compound interesting, however, can be a little more difficult.

The great Albert Einstein had come up with a concept called the "Rule of 72". This shows, by the compounding effect, how long it will take your investment or debt to double. What you do is divide the interest rate you're getting on an investment, or the interest rate you're paying on you're debt, and divide that into 72. The resulting # will give you the approximate time it will take for the money to double.

For example: If you're receiving 4% return on your investment, that means that if you held that investment, then every 18 years your investment will double (72 divided by 4 = 18).

Let's take a look at at a few different numbers and see what the difference could be.



As you can see, the potential difference is in the outcomes is astounding. Now, you have to ask yourself, where can you get these type of potential returns? If you look at the above example, the first rate of return of 4% is something you can't really even expect from a GIC, but lets just assume the bank gave you that on your GIC. After 36 years the difference is $600,000, which is potentially what the bank made off of you.

The highest rate of return on the example is 12%; which is probably the average return the bank will get from the money you invest with them (the bank doesn't just take your money and put it into a vault with your name in it, they take your money and re-invest it to make more money). Just think about your credit cards, what sort of rate do you pay? 18%-19%? So, think about it, they're giving you 4% on your investment, and they're charging you 18% on your credit card. Does that seem fair?

Why not do something smart with your money and invest yourself, rather then let someone else make money off of you. Now, there aren't many places you are likely to get average of 12% return, but over time, if you're invested in the market, the chances for getting better then 4% are a lot more likely.

The key is to do your homework, and let your money work for you. Let the compounding affect and rule of 72 work in your favour. If you have any questions, please do not hesitate to contact me. I hope you've learned something from this post!

Stocks vs Mutual Funds

This is the age-old question! A lot of people ask me what should they invest in, stocks or mutual funds? That's kind of a difficult question to answer, since most mutual funds are comprised partly (or in some cases fully) of stocks anyways. There is no general right answer for the entire population, so we must look at the differences of investing in 'single stocks' over mutual funds.


Mutual Funds are one of the most talked about and well-known investments available in Canada. We see them on TV, hear about them from our Advisors/Bankers, and also are one of the broadest investments we have access to.

Seems everybody has heard of "Mutual Funds", but not many actually understand what they are or how they work. Let's take a step back and examine what a mutual fund really is. Generally, this is how I explain to someone what a mutual fund is:

There are a group of people who all are investing into a pool of money, which is then invested into a company. That company has Professional Money Managers who then go and buy and sell certain investments (stocks, bonds, cash etc..). The sole purpose of these managers is to buy and sell investments and to get the best returns they can; they look over the balance sheets, income statements, research companies, look at executive statements etc... They are managing all the money that is invested with them, and the fund will earn a rate of return (either positive or negative -- hopefully positive). For doing this service, they charge an MER (Management Expense Ratio), which is like the 'service fee' so to speak for doing all that work.

In a nutshell, that is my very 'general' explanation of what a Mutual Fund is. Many mutual funds are comprised by a good percentage of stocks; usually ranging from about 20% to about 80% (there are some funds who have less then 20% stocks and some who have 100% stocks). Mutual Funds are designed for all types of investors, ranging from those with absolutely 0 level of market risk, to those who can stand a lot of market risk and go completely aggressive.

Now, both stocks and mutual fund investing CAN be profitable, however, both are risky as well. Let's take a look at some points on both types of investments.

Stocks:

- Investing in one company at a time
- If that company tanks, your investment tanks
- You have to use your time and energy to buy/sell, research etc...
- No Management fees
- Can be very expensive to buy each stock of a company
- Per transaction fees (buying and selling)
- More control over your investments
- More flexibility
- A lot more risk

Mutual Funds:

- Professionally Managed
- Can get a diversified portfolio
- Can have up to 100 (or more) stocks
- Also may contain some bonds/cash/t-bills etc...
- Lower risk
- Management Fee charged
- Less control
- If a few of the companies within the mutual fund tank, it will not affect your investments as much (risk is balanced)

Both of these types of investments have the potential for positive or negative growth, and both have some sort of degree of risk attached to them. Generally, stocks have a higher potential to get higher gains. We've all heard of stock prices doubling or tripling in a short period of time if that specific company has substantial growth or good news coming out of it.

That being said, stocks also have a higher potential for a lot more losses. From my experience, the average investor (not institutional or big money investors) who invests only in stocks, has between 3-5 stocks in their portfolio. Now, if one of those companies goes down the drain, then potentially that can be 20% (or more) of your portfolio (depending on how much was invested in each company).

These days it can be hard to determine which companies will grow and which companies will fall. In recent times we've seen several HUGE companies go belly-up, so stocks require a lot of research and analysis in the market.

Some people try to 'time' the market, but this can be a HUGE challenge because in order to time the market properly you have to be right TWICE: first, when you buy, and second, when you sell. Even the most experienced traders and analysts have trouble timing the markets properly and many of them have lost a LOT of money when trying to do it.

Mutual Funds, in my opinion, are more seen as 'steady growth' over a longer period of time. They can be a better indicator of the performance of the broader market as a whole, rather then just one company. If, for example, a fund had 50 companies in it, and 5 of those went belly-up, that would not have as big an effect as if 1 out of 5 stocks went belly-up. So the risk is often spread out over different companies, sectors, and geographical regions, among other things.

Generally, for mutual funds, it is more of a long term investment. So, usually, you're not trying to 'time the market', because there should be the hope or expectation that in the long run the money will grow and compound anyways. It can be seen mostly as a 'buy and hold' type strategy (keeping in mind you're not in the same mutual fund for the entire period of your investment; I think it is key to be switching every now and again to make sure you're diversifying properly and keeping up with market trends).

It is clear that each strategy has its advantages and drawbacks. I generally suggest that the average person should not invest in stocks, because of the time and energy that is required to be devoted to do it. Most people do not have neither the time, the energy, nor the patience to do stock-picking. Why would you gamble with your future with something you're not able to commit proper time to?

Remember, we are all responsible for our decisions, whether we decide to invest in stocks, mutual funds or any other form of investments. One of the biggest causes of a portfolio going downhill is that we rely on other people for our advice. Some of these outside sources include Magazines, T.V., Radio, Newspapers, our friends, family etc... If you solely rely on these for stock picks, then you really should re-consider going into stocks.

Generally, for an 'average investor' I would recommend that if they are to do stock purchasing, to do so only with money that they are 'able to lose'. Meaning that if they lost that money because of that one company they invested in going out of business, then it wouldn't put them in a tough financial position. Sort of like, 'gambling money'; if you win, great, if not, no sweat off your brow!

Also, whenever making any decision, please consult a financial professional (your financial advisor/planner). If you require any more information, please do not hesitate to contact me. I hope this has been helpful!

How Much Protection Do You Need?

As I mentioned in one of my earlier posts (http://financialhealthblog.blogspot.com/2009/05/life-protection.html), Life Insurance is something that almost every family, if not every family, needs. In the earlier post I also described the 2 main types of insurance coverages (Term and Permanent). Now that you're educated about the types of insurance, you need to determine HOW MUCH coverage you need.

There are several different ways to come to this number, but I will show the method that I use, as a general 'rule of thumb' when calculating how much protection a person/family needs. The method that I use is called the "DIME Method". This stands for:

Debt (combined credit cards, loans, lines of credit etc...)
Income (Income replacement for x number of years -- usually around 10 year, or until the youngest child turns 18 for those who have kids)
Mortgage (Mortgage balance)
Expenses (Can be things like education for kids [in this example, Assuming 4 years per child @ $15,000 per year], funeral expenses, taxes, leaving money for charity, etc...)

Remember, this is a general calculation which should give you a 'ballpark' figure of approximately how much protection you will need; sometimes there are other circumstances that will increase/decrease the amount of protection needed.

Let's use an example.

Debt: $50,000
Income: $400,000 ($40,000 annual income multiplied by 10)
Mortgage: $250,000
Expenses: $150,000 [$120,000 (2 kids each attending for 4 years @ $15,000 per year) + $20,000 Funeral Expenses + $10,000 Taxes]

Total: $50,000 + $400,000 + $250,000 + $150,000 = $850,000

For the above example, this is the amount that will PROPERLY protect the family in the unseen case that the breadwinner passes away.

If the client, for example, already had some insurance put into place, then you would subtract that amount from the amount remaining. Lets assume that the client was sold a Permanent Insurance policy several years ago for $250,000; this would mean that remaining coverage needed is $600,000.

Now comes the point of choosing which type of insurance the client should take; Term or Permanent (or a combination of both)? This is something that needs to be discussed with your advisor. Every family situation is different and needs to be assessed individually.

A couple of things to remember:
- Insurance is a privilege, not a right, so you must qualify for it.
- YOU are your most important asset; your ability to generate an income

This post was mainly intended to give you a general calculation for how much insurance coverage you might need. Of course, everybody has a their own situation and the above example might not fit them properly, so it is always best to sit down with a well-informed advisor to go through the numbers that are right for you.

If you require more information, please do not hesitate to contact me. I hope you've learned something!

Investing Early vs Investing Late: Pay Yourself First!

In the 'wealth formula', point number 2 was 'Time'. In any sort of investment you need time to let your money grow and compound over and over. I've done a quick worksheet comparing 2 scenarios with 2 different people.

Person A starts investing $300/month ($3600/year) starting at age 25 and only invests for 7 years and then stop.

Person B starts investing the same amount, $300/month ($3600/year), but starts investing later in his life, at age 32 (the year after Person A stops contributing).

We will assume they are both investing in a tax-deferred account and are getting 8% return.



As you can see, at age 48, Person B surpasses Person A; however, Person A had only made a total contribution of $25,200. Person B had to contribute for 17 years, with a total investment of $61,200, in order to catch up to Person A. That's a difference of $36,000! The affects of compounding were in favour of Person A because he started early and let his money grow.

But lets think realistically, especially those of us who are married and have kids and other responsibilities (i.e. mortgage, taking care of elder parents etc...). Does it become easier to start saving early or start saving later? I think we can all agree that as time goes on it becomes harder to start saving. That's why it's VERY important for younger people, especially younger couples, to start saving as soon as possible.

As you get older it becomes harder to save because more expenses start to come up; for example maybe you just bought a new house and have a mortgage to pay, or your kids are now growing up and college/university expenses are coming up, or you need to start caring for elder parents. Whatever the case may be, something always seems to come up that makes us say "okay, I'll start investing next year". The key is to start investing early and build that discipline.

The above example is just for illustration purposes, so I'm not saying that you should only invest for 7 years and then stop, not at all! Investing should be done over the long term so you can take advantage of market cycles and compounding.

Procrastination is one of the main causes of failure, when it comes to accumulating wealth.

Now comes the point of some people who will say "I don't have $300/month to invest". What if we make some small changes in our life and spending habits that will help you get that $300/month -- $10/day? There's always things you can cut down, such as:

- Sodas
- Cigarettes
- Lattes
- Cable TV
- Games
- Sweets
- New Gadgets
- Shopping
- Driving a Big car
- Eating from outside
- Partying
etc...

You don't have to cut out every single one, but cutting back on a few of these things can be the difference between you retiring successfully, or un-successfully! You MUST have discipline and consistency if you want to win the 'wealth game'!

Now, of course, the numbers given above are for illustration purposes only. Whether someone has $300 a month or $100 a month to contribute, or whether a person is getting 8% or 5% as a rate of return, is not really the point. The main point is that, if we want to have a chance of achieving our financial and retirement goals, we need to start as early as possible and be disciplined as well.

From experience, I have seen that those who start at a younger age are more inclined to keep saving and also will increase their contributions over time. Once the habit of savings is developed, and you see the dollars accumulating in your savings plan, it becomes easier and more fruitful to see your hard earned money at work for you!

Formula for Wealth

Since I've talked about savings/investments already, I thought I'd go back to the basics. We've all heard people talk about wealth and how to accumulate it, but its always been pretty complicated. Here is a simple formula that I show all my clients which is just the bare basics. The "Wealth Formula" or the formula to creating 'wealth' is:

MONEY
+ TIME
+/- RATE OF RETURN
- INFLATION
- TAXES
__________________
WEALTH

1. In order to create wealth, you need to start off with your own money. Whether it be lump sum contributions or regular (monthly, weekly, bi-weekly etc..) contributions, we need to start somewhere.

2. Time is a very important thing. A lot of people wait to start investing, which usually results in them not having enough money in retirement. Some excuses they use are "we'll wait until the kids are out of the house" or "wait until my debt is paid down" or the like. Most people will tell you, that some of those excuses will never pan out. You need to give your money as much time to compound as possible, so that you can live the type of lifestyle you want to live. Accumulating wealth is not done over-night; it takes years, sometimes even decades, to do it. Even if it's a small $25/month, start somewhere and then gradually increase.

3. There is always a rate of return that dictates how much return we get on our investments. You can either have a positive or negative return; obviously we all want a positive one. This kind of ties into point #2 of time, the longer you keep invested, the better chances you have of having a positive rate of return; your money will have time to compound and go through the market cycles.

4. This point is something that the vast majority of people overlook. Inflation pretty much erodes your purchasing power. In English: A dollar today is not worth a dollar tomorrow, as cost of living continues to increase - examples include Gas, Groceries, Clothing, Homes etc.. When investing, you must make sure that you're beating inflation, otherwise even though it might seem that you have a 'positive' return, you might actually be 'losing money'.

** As a side note: We often hear the Government and/or Bank of Canada talk about Inflation levels and what their 'target' inflation is. It would, however, be a little difficult for the government to back up their claims for the inflation numbers they give us (whether its 1.5% or 2.0% or whatever they tell us). The reality is, the numbers the Government/Bank of Canada  use when telling us about the current inflation rate, are not entirely accurate, as they don't take into consideration all the things they should, and they're not all weighted the way they should be. For example, they can tell us day and night that the inflation number is 2.0%, but we all know that prices for goods and services have increased much more than 2.0% -- just check your gas and grocery bills!

5. Like I said in my previous post, the only thing certain when living in Canada is death and taxes. Taxes can take a HUGE chunk out of your investments, especially if the plan is not set up properly. Have a financial professional help you with setting up your portfolio so that you can reduce and sometimes even eliminate taxes altogether. Wouldn't it be unfortunate to have to give 30% or 40% of your hard-earned money to the government when you're ready to retire?

A proper financial plan will take a look at every point discussed here. These days too many institutions are just focused on taking your money and don't set up a proper financial foundation with you. Building a strong financial foundation will drastically increase the chances of you retiring successfully and living the type of lifestyle you want to live!

If you have any questions about anything discussed, please do not hesitate to contact me!