There are four categories of investments:
- Income
- Income and Growth
- Growth
- Aggressive
Income
Income investments pay you interest. They come in four types: savings accounts, government treasury bills, GICs, and bonds. Savings accounts pay low interest rates, but give you the flexibility to get at your cash. Treasury bills pay a decent return, but lock up your dough for short periods of time. GICs (Guaranteed Income Certificates) pay better than a T-bill, but lock up your money for longer periods.
T-bills are 100% guaranteed by the federal government (which equals zero risk—as long as the country remains stable). CDIC Insured GICs are also 100% backed by the feds, for up to $100K, for 5 years.
Bonds are loans to either governments or corporations, paid and guaranteed only by them. All bonds are rated for quality (the ability of the debtor to repay). High quality bonds are rated between A- and AAA+. Bonds rated below BBB (down to DDD-) are considered junk. The higher the risk, the greater the return should be.
Selling a bond is like selling real estate, the commission is bore by the seller. So the minute you buy one it’s instantly worth 1-2% less, because you have to pay a commission in order to sell it (and this is reflected on your statement). But if you hold bonds to maturity, no commission will ever be paid. As a result, short-term bonds are great since they can easily be held to maturity.
Bonds also fluctuate in inverse relation to interest rates. So if interest rates go up, bond values typically go down. Why? Because if GICs are paying 6%, who wants your 5% bond? Likewise, if GIC rates fall to 3%, everyone is now willing to pay a premium for your 5% bond. But again, this change in value is mitigated if you hold your bond to maturity.
Buying only high-quality, short term bonds avoids the inherent risk bonds have, since holding them to maturity means you’ll always get what you bargained for.
Income & Growth
Income and Growth are blue chip companies that are profitable and pay dividends (e.g., banks and utility companies). These stocks usually pay a 3-5% dividend.
Dividend income is preferable to interest income because it’s taxed at a lower rate. So, from a tax perspective, a 6% dividend is equal to getting 8% in interest.
There is some risk attached to these products since the stock price may decrease (which is the growth component), but they’re usually mature companies within mature industries—so they shouldn’t go broke.
Growth
Growth investments are non-dividend or lower-dividend paying stocks. They’re bought mostly for their share price potential. These companies haven’t yet reached their peak and are still growing. Under the right circumstance, they can deliver solid price appreciation but their stock price can decline just the same. As a result, they contain greater risk than income and growth stocks but they’re not as bad as those categorized as aggressive. Their primary risk lies in them having a bad year.
Aggressive
Aggressive stocks don’t pay a dividend. They only have the possibility of good stock price appreciation. Examples are gold mines or companies bolstering a new technology. Maybe they’re the next big thing, probably they’re not. So they can either boom or bust (and busting is the risk).
The goal of many “new product companies” is just to go public and make the founders rich. Many don’t stay the course and ever realize their potential. It takes more than a novel idea or something cutting edge to create a successful business. You need great management, awesome timing, and a little luck to pull it all off. So, this type of investment can almost be equated to buying lottery tickets. If they make it, they usually make it big. But it’s rare.
More conservative forms of aggressive investments are found in emerging markets (like India). They’re emerging (which offers great upside) but they’re also risky because third world governments are never quite stable (e.g., they can nationalize an industry on a whim).
Rule of thumb
The big myth is that young people should put their savings at risk when in fact everyone should be conscious of risk. And regardless of your tolerance, you should always have at least half of your investments in the categories of income, or income and growth. (This way, you won’t come ask me for money when you’re old.)