A Base for Taking Risks

On my blog I talk a lot about investing in the stock markets and assuming risk in exchange for positive returns over time. In this world, things can feel advanced and overwhelming very quickly. Particularly for newer readers.

While it is fun to explore the deep dives of investment strategies and better ways to invest, sometimes we forget about the basics. A base for investing—being in a position where we can take risks.

I often get emails from newer investors who will ask questions about the various investing styles I explore. (And some that I don't.) Is Dual Momentum a good choice for them? Should they stick with static index investing instead? Is adding leverage to a portfolio too aggressive for them?

While I enjoy the interaction, it is always difficult to answer these emails. I'm not a professional financial advisor and don't hold myself out to be one. I'm a regular guy who is interested in the markets, is moderately well read when it comes to investing, have experienced some decent success, and am continuously learning myself.

But more importantly, everyone's personal situation is different. A retiree who needs stability and tax-friendly income requires a different portfolio from my own. Someone who is starting out but has a shaky job and a lot of debt is also in a much different category of responsible risk taking.

Speaking from personal experience, my ability to invest carefully with appropriate risk and the right mental mindset was advanced when my personal financial situation stabilized. It is very tough to invest properly when cash is low, money is tight, and debt is high.

When I had little money and a big mortgage, I was tempted to go for home runs, treating investing little different from a lottery ticket. The problem is these big wins rarely happen. In the worst cases the more likely large losses can scare a person away from the markets forever.

Very few people get rich with 5x, 10x, or 100x baggers on risky forms of investing (penny stocks, cryptocurrencies, options, etc.). Even fewer stay rich.

Sticky wealth is wealth amassed carefully and methodically over a long time with a lot of hard work.

A Firm Foundation

Like everything else in life, investing begins with a firm foundation. Before taking on risk and putting money into the markets, have everything else in your financial world tightened up.

Pay off debt. Debt is a major financial risk factor today. Way too many people carry enormous debt loads that bog them down. Deep down, most regret the choices that led them into debt. I cannot emphasize enough how important it is to buckle up and do everything in your power to pay off debts. Take a second job, work overtime, live with mom and dad or in a low-cost roommate situation, spend nothing, sacrifice, do whatever it takes.

Never invest if you are carrying credit card debt or have personal loan or an unsecured line of credit balance. Paying these debts off aggressively can provide you with a guaranteed after tax return of 7 to 25 percent. It can also save you a huge amount of stress.

That said, a modest mortgage is okay to carry while investing. Your interest rates are likely to be low and the payments should not be overwhelming.

Cut expenses. Having low living expenses can provide substantial peace of mind. It is also likely to simplify your life. While a million websites will moan about spending on lattes and avocado, the best places to save money are the big expenses.

Downsizing your house, going down to one (or none) fuel efficient vehicle, getting rid of pricey toys like motorbikes or ATVs, selling the vacation cabin or time-share, and taking modest vacations are perfect ways to live better and save money. Way too many people have no money but think it is normal to live like millionaires. It's not.

Earn a decent income. It doesn't need to be a huge six figure take. In Canada I peg the healthy number at C$70,000 gross per year. In the U.S. this could be closer to $50,000. That's only a bit above average for a full-time skilled worker. In some areas of the country it will need to be higher, in others the number can be lower.

Many younger people follow the herds into Toronto, Vancouver, San Francisco, LA, NYC, or Seattle. For most a much better bet is a city like Edmonton, Winnipeg, Montreal, Dallas, Atlanta, Charlotte, or Phoenix. Or the hundreds of very livable smaller cities with low cost-of-living. You would be amazed how location can drastically improve your odds of building wealth and financial independence.

Save money. This is a big one and is the culmination of the prior three points. You should be in a situation where your monthly income consistently exceeds your monthly expenses. Nothing is worse for your portfolio than being in a situation where you put in a dollar and pull out 50 cents two weeks later.

This includes investing for financial independence but pulling money out to "invest" in a kitchen upgrade or "invest" in more reliable car. Investing is for the long-term. It should be kept completely separate from saving for a larger purchase, even if that purchase adds a bit of value to your home.

Build a cash cushion. I like to maintain a decent cash balance in our chequing account. Depending on the time of month, when income comes in and expenses go out, our chequing account will bounce from around $3,000 to $7,000. This provides a nice cushion to cover any spending needs without worrying about overdraft or credit card balances.

We use credit cards for most daily spending to defer the bill for up to a month and a half. Free short-term loans, free purchase protection, and free travel rewards are awesome! But I make sure I can pay it off in full every month.

I'm not a big fan of maintaining large emergency funds because odds are you will never need to use them if you manage your finances properly. Instead, get a personal line of credit set up at your bank. Don't use it unless you are in a financial emergency. Save and invest the rest of your money so it is working for you, not the bank.

Risk and Investing

When most people think about risk and investing, they focus on how risky their investments are. They might even dwell on the risk of losing money when investing—a virtual guarantee at some point in everyone's investing journey.

I prefer to look at the entire picture of risk. This includes investing but it adds in your personal situation (which in many ways is more important). A commissioned real estate salesperson is in a much riskier situation than a power lineman at the utility company. Even if the sales lady drives a BMW and wears nice clothes (or maybe because of that).

A shaky relationship with one very spendy partner is much riskier than a stable partnership of two frugal individuals. A family with a large house and a large mortgage is much more fragile than a family that rents a smaller house or rowhouse.

These ideas extend to a multitude of other factors: high debt compared with no debt, dual versus single income families, old versus young, kids or no kids, level of flexibility in pursuing the best work opportunities, renting or owning, biking and the occasional Uber versus multiple vehicles. The list goes on.

A young, dual income, no debt, apartment renting, no child, biking couple has the capability of taking on high leverage in their portfolio while still being lower risk overall. Flip the situation and invest in GICs and you are still setting yourself up for a major financial wipeout.

Set yourself up for success in your personal situation. Then let the markets do the rest of the work.

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High Interest Savings Accounts

While writing my blog post on GICs last week, I also took a look at some of the high interest savings accounts out in the market today.

In the past, I have ridiculed high interest savings accounts, so most readers correctly got the impression that I think you should avoid them.

In a broad sense, that is still true. Most of the savings accounts in the Canadian market today are so utterly pathetic you may as well save yourself the hassle and keep money in a free chequing account where you do all your daily banking.

Moose Tip: Some good options for free chequing accounts include Tangerine and Simplii. There is no good reason to be with a big bank that charges you a monthly fee for your chequing account!

Thanks to the rising interest rate environment, a few bright spots have opened up in the savings account market over the past few months.

Right now, EQ Bank, a second-tier federal bank, is paying a whopping 2.3% interest on their savings account. Oaken Financial, another second-tier federal bank, is paying a solid 1.5% interest on their savings account. While Tangerine and Simplii are paying 1.25%.

All of these banks are CDIC insured, so provided you don't have more than $100,000 in a savings account with each bank, your money should be very safe. I go into more details on CDIC protection in my GIC post, so I won't bore you with those here.

Savings accounts should be used pretty sparingly for most people. But it varies depending on your stage in life. There are some reasonable uses for savings accounts.

Savings Accounts for Accumulators

Accumulators are working hard, earning as much as they can, maintaining a high savings rate, and investing aggressively. Savings accounts should not really be in the financial picture most of the time. Even for emergencies!

An accumulator should conduct their daily banking in their free chequing account while maintaining a small balance there. I personally don't see any benefit with keeping more than one month's worth of expenses in your chequing account at the low points.

For most people this means their chequing account will fluctuate from around $2,000 on the bottom end to maybe $10,000 on the top end. Your numbers depend on your pay schedule, your spending rate, when your bills are due, how often you contribute to your investment accounts, if you share a bank account with your partner, and so on.

The key for an accumulator is moving as much money as fast as possible from the chequing account (where income is deposited and bills are paid) into an investment account where it can be put to work.

In most investment markets, the more you invest as early as possible the better off you will be.

For emergencies you should have an already-approved personal line of credit waiting for you at the bank.

Your personal line of credit should have a credit limit equal to six months of expenses at the high side. However, you should not touch this available credit at all unless it is a true emergency.

True emergencies include income emergencies (job loss, severe illness, etc.) and some spending emergencies (unforeseen house or vehicle repair, death in the family, supporting a loved one who is in an income emergency, etc.).

If you have to use it, your aim should be to pay your line of credit off as fast as possible, even if that means setting aside new investment contributions for a few months.

The one scenario where a savings account may be worthwhile for an individual in the accumulation stage is when you are saving money for a specific large expense (well over $10,000) which is coming in the near future. This might be a vehicle, home renovation, home purchase, other something of that nature.

Savings Accounts for Retirees

When you are at the stage in life where you primarily live off your investment holdings, you need to become a lot more careful about how you manage your finances.

The majority of your money should be in your investment accounts invested primarily for growth. Alternatively, you could invest in a timing strategy for downside protection. Better still, consider two strategies to diversify your investment returns.

Depending on your personal situation, a good portion of your spending needs may be covered for through regular income. This can include CPP payments, OAS benefits, dividend income (from stocks or stock ETFs), interest income (from bond ETFs), or even some part-time employment or business income.

To keep things easier to manage with fewer manual electronic transfers, once you are retired you can set up your non-registered investment account so dividend income comes straight into your chequing account. Most dividend paying ETFs pay out quarterly or semi-annually while most bond ETFs pay out monthly or quarterly.

It is important to have some cash set aside for daily living expenses which are not covered by your regular income. It doesn't make sense to pull money out of your portfolio every month, triggering capital gains and trading costs while taking up your valuable time.

Instead, use a systematic method to pull money out of your investment account on an intermittent basis. Once or twice a year is good.

You should try realize gains or withdraw money from registered accounts in the most tax efficient method. The exact combination of RRSP withdrawals, TFSA withdrawals, and capital gains in your non-registered accounts will depend on your personal situation at that time.

If you have a high spending year, your spending may be tilted towards TFSA withdrawals and realized capital gains. In a low spending year RRSP withdrawals may form the majority of your investment income.

Since the withdrawals are not made frequently, they can be quite substantial in value. It would not be uncommon to need tens of thousands of dollars a year in these forms of income.

These large lump-sums should not be put in your chequing account. Chequing accounts pay no interest (typically), so your money will actually erode in value thanks to inflation costs.

Instead, set up a high interest savings account to hold this money. Shop around for an account that offers a higher interest rate along with free monthly money transfers such as Interac e-Transfer or electronic funds transfer to your chequing account.

Keeping this money in a high interest savings account will ensure your money generates moderate interest income while you are waiting to spend it.

Use of savings accounts in retirement can be instead of, or alongside a GIC Ladder. Just keep your overall cash balance in mind. Cash might be comforting, but too much cash is a problem.

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