You want to start actually investing those hard earned savings? You’ve read the basics and you’ve gotten yourself in a strong financial position via “Hack Your Way to Financial Independence”, and now you want to get started!?! Great!
We begin here with a focus on investing your financial assets. If right now most of your financial assets are cash or wherever, we show how to diversify across a broad universe of financial securities.
Must know these terms from The Baby Basics of Finance...
Opening A Brokerage Account
A brokerage account is what enables you to trade and hold stocks, bonds, ETFs, mutual funds, REITs, options and so on.
Wealthsimple Trade (for Canadians): Offers $0 commissions on buy & sell orders and no account minimums. Trading is done via a mobile app and is very intuitive and easy to use (great for beginners). Limitations are it doesn’t offer all securities, options or complex orders. Similarly, in the US there is Robinhood Financial.
Traditional Brokerages: Several well known online brokerages are Questrade, Interactive Brokers, TD Ameritrade, Schwab, Qtrade, and the brokerage of each large bank (such as RBC, Scotia, TD, BMO, CIBC for Canadians). They offer more complex tools and capabilities but have higher fees and are less user friendly. They vary in commissions & fees so be sure to evaluate several before selecting one!
When applying for these accounts you will have to choose which type of account you want to open. While the specific details can vary greatly from country to country there are 3 general types:
- Taxable Account: Invest your after tax savings and any gains or income is taxed (usually at a capital gains tax rate). Any investment losses can be “tax loss harvested” therefore lowering future capital gains taxes. Taxable accounts are typically used for the riskiest investments (due to the future tax benefit of losses) and after you have maxed out your Retirement and Tax Free Accounts.
- Traditional Retirement Accounts - RRSP (in Canada)/IRA (in the US): Any contributions (up to a limit) lower your taxable income (for example $60,000 of gross income and $10,000 invested, lowers your taxable income from $60,000 to $50,000 and reduces your current years’ income tax). Additionally, income & capital gains inside of these is not taxed yearly but only upon withdraw, enabling investments to compound. Normal capital gains taxes are paid on the total amount withdrawn after a set retirement age (usually 65), any withdraws prior to this age are both taxed and face an extra tax penalty.
- Tax Free Account - TFSA (in Canada)/Roth IRA (in the US): These allow you to invest your after tax savings (up to a limit) and pull out any capital gains or income, tax free at any time. While they do not lower your income tax like a traditional retirement account, they do offer more flexibility when it comes to usage and timing. For example, a 20 year old that has never contributed to their TFSA can contribute up to $18,000 ($6k per year since age 18).
Choosing between the 3 types of Tax Accounts: Most people utilize a traditional retirement account to reduce their tax burden and max out their tax free accounts BEFORE utilizing a taxable account. So, start off with either the Tax Free account or Retirement account. Eventually, you will have maxed out both of those and will be in a position to require a taxable account for the rest of your investments.
Once you are set up, it is up to you to be either an active investor who picks their own stocks to invest in (requires more work), or if you want to be a passive investor whose portfolio tracks a few indexes. You can also mix the two strategies.
Active Investing Basics – Building a Stock Portfolio
Whenever you buy a stock (or “share”) you are buying a piece of ownership in a real life business with sales, profits, customers, employees, assets, brands, products, services and so on. The better that company does (growing those) the better the stock of that company will do. Ideally, you want to buy low and sell high, meaning buy stocks that are low-priced/undervalued and sell them if they become high-priced/overvalued.
As an individual it can be hard to find time to research stocks, keep up with financial news and make trades (this is part of why passive investing is so popular) but that doesn’t mean you are at a constant disadvantage. Everyone has unique experiences & knowledge which can be useful tools for selecting stocks. Some examples of this are, the bookworm that sees a movie studio pick up the book she loves for a feature film, or the engineer that understands the significance of a technological breakthrough. It could also be more general such as buying stocks of companies you are a customer of and love to use. While this can give you a unique perspective and you do not need to become a financial analyst, you still need to know these critical metrics & concepts:
Market Capitalization (or Market Cap/Market Value/Price): Is the Stock Price times the number of shares the company has outstanding. For example, our company has 20 million shares and its stock price is $15.00 then it has a market cap of $300 million (=20Mx$15). Generally, when a shareholder owns over 50% of the shares they have control of the company since 1 share = 1 vote. All shareholders get to vote on major company issues (such as mergers/sale of the company) as well as appointing people to the Board of Directors (who, among other things, are responsible for hiring/firing the CEO). Remember, each company can have very different numbers of shares outstanding so the best way to compare firms is by checking their market cap not the stock price.
Revenue (Sales): This is the “top-line” sales a company receives from its customer for providing goods and services. Its important to understand trends in revenue growth, is it growing, shrinking, or flat and how does that compare to its competitors. For example, our company has sales of $150M or $7.50 per share.
Net Income (Profits/Net Earnings): The annual "bottom-line" profit a company makes after all business expenses and taxes. Revenue - Expenses = Net Income. As with revenue its important to understand the trends in Net Income growth, its margins, and compare to competitors. Early stage or struggling companies can be highly unprofitable.
Earnings Per Share (EPS): This is simply the Net Income divided by the total number of shares a company has, so it shows how much profit each share represents. For example, our stock has $1 EPS and 20 million shares then the total profit is $20 million.
Book Value (Equity):. On the company’s Balance Sheet this is the value of its Assets minus Debts and is what the company's net worth is on an accounting basis. Book value is especially important for businesses with many physical assets (real estate, factories, physical inventory, equipment etc.), it is less important for intangible businesses whose value is derived from human capital or intellectual property (like consulting or software businesses). For example, our company has a book value of $120M.
Price to Sales Ratio (P/S): Price to Sales Ratio takes the Stock Price divided by its Sales per share. This is primarily used to evaluate companies that are currently unprofitable. The P/S ratio is used to compare multiple companies with a lower P/S being "cheaper" and a higher P/S being "expensive". For example, our stock has a P/S ratio of 2 ($7.50 of sales vs a $15 share price).
Price to Earnings Ratio (P/E): Price to Earnings Ratio takes the Stock Price divided by its EPS. A P/E ratio of 10 means you are paying 10 years worth of Earnings to get the Stock Price. This ratio enables you to compare values of different companies since a lower P/E is generally "cheaper" than a higher P/E, however higher P/E ratios can be justified if the company is growing fast and/or has lower debt. You cannot use the P/E ratio for companies with negative earnings. For example, our stock has a P/E ratio of 15 ($1 EPS vs $15 share price).
Price to Book Ratio (P/B): Price to Book Ratio takes the Stock Price divided by its Book Value per share. Essentially it compares a company's Market Value with its accounting Book Value. Like a P/E ratio you can use the P/B to compare multiple companies with a lower P/B being "cheaper" and a high P/B being more expensive. Beware of P/B ratio's less than 1 as these can indicate both a good value stock and a stock in distress. For example, our stock has a P/B ratio of 2.5 ($120M Book Value vs $300M market cap).
Dividend Yield: Dividends are payments to the company's shareholders. Usually, profitable companies will pay a portion of their profits back to their shareholders on a quarterly or monthly basis. The Dividend Yield is the percentage return you get from a dividend paying stock. Dividend Yield = Annual Dividend Per Share/Share Price. When you buy a stock at a certain price you "lock in" that dividend yield as long as the company doesn’t change the amount being paid. For example, our stock has a dividend of $0.50 per year our dividend yield is 3.33% if we buy at the current price of $15 per share.
Value Investing: Tends to focus on stable established mature companies with a history of profits and a strong balance sheet. Therefore, they are usually growing slowly (0-5% per year), while also trading at low ratios such as a P/E less than 30, a P/B less than 4, and a P/S less than 3. These usually payout strong dividends and are overall less “risky” than younger high growth companies since they tend to be large enough to weather economic downturns. Companies like Walmart, Apple, Costco or McDonalds could be considered “value stocks”. Beware that sometimes stocks that look like value could be in a significant decline due to consumer preference changes or a technological change, an example of this is Blockbuster which went bankrupt after years of decline due to competition from Netflix and online streaming.
Growth Investing: Tends to focus on newer, high growth companies that have not yet reached the mature stage of their business. These typically offer a new product/service in an existing market or create a new category all together, as such their growth rate could be very significant (10%-80+% per year) and investors are willing to pay a premium for that growth (meaning high P/E, P/B and P/S ratios). Some risks are that the business model might be unproven, a new competitor could rise slowing growth, or they might be or remain unprofitable for longer than expected. Some examples of growth companies of the last decade are Starbucks, Tesla, Google, Amazon, Netflix, and Facebook. Beware if the growth rate slows unexpectedly growth stocks can quickly fall 30-60%, especially if they are unprofitable and need to raise money to stay in business.
Earnings Reports: Are released by every publicly traded company quarterly (every 3 months, called “10-Q”) along with a more detailed annual report (called “10-k”). They can be found on the company’s website usually under “investor relations”. These reports include full financial statements (Income, Balance, & Cash flows) along with discussions on strategies, results, senior management, and risks. They are the best source for information on a specific company.
When you have a good handle on the metrics above for your target company you can use the common ratios (P/E, P/B, P/S) to compare to competitors. If your stock seems to trade at lower multiples while having similar growth it could be a sign that its currently undervalued. Further, if the company simply has a great business that grows each year and generates profits its likely that it would be a good stock to hold long term. As with all types of investing its important to diversify, so never hold more than 10% of your portfolio into one stock in order to limit the damage of any mistakes.
Our Example: At $15.00 per share, 2 P/S, 15 P/E, 2.5 P/B and a dividend yield of 3.33% our stock seems to be a comfortable value stock with a decent amount of income as well. From here we would still have to compare its ratios and its revenue/earnings growth to its competitors to see if its really undervalued.
A well constructed portfolio should be diversified across growth, value, size and industry. As an individual stock picker, you would likely need 15 to 25 stocks to be diversified. If all of your stock picks are internet companies than you are still not diversified! Ideally you have some REITs & dividend stocks to generate income, a gold/silver ETF, and value & growth stocks from different industries.
Passive Investing Basics – Building a Passive Portfolio
Passive investing is much simpler than active investing, it requires less research, a long term horizon, and an acceptance that your portfolio performance will earn roughly the market average rate each year (about 8% over the long run).
A passive portfolio is made by investing in index funds which track broad stock market indexes and can be done with either ETFs or Mutual Funds (ETFs have lower costs and are easier to trade). Some common indexes are:
- S&P500: the 500 largest US companies
- S&P TSX60: the 60 largest Canadian Companies
- S&P TSX Composite: the 250 largest Canadian companies
- NASDAQ 100: the 100 largest US technology companies
- Russell 3000: the 3000 largest US companies
- Dow Jones Industrial Average: the 30 largest US industrials
- FTSE 100: the 100 largest UK companies
When you buy an ETF that tracks say the S&P500 you are automatically diversified since you indirectly own the 500 largest US companies across all industries. From there you can also invest in an ETF that tracks an industry, a theme, a country/region, bonds (for interest income and more stability), gold/silver, commodities, or an inverse fund that performs the opposite of a select index (for hedging).
So, with just 2 to 6 index ETFs its possible to have a diversified portfolio. Overtime you let the value grow while simply buying more and more of the same. This effect leads to “Dollar Cost Averaging” which is the fact that if you contribute a set amount of money each month or each quarter (say $5000 every 3 months) and you buy the same funds you will always end up buying more units when they are cheaper and less when they are more expensive thus lowering your average cost and increasing long term returns.
A Diversified Portfolio with Passive & Active Investing
The example below is tracked in our Personal Investment Tracker. Note that we are not suggesting to buy the specific stocks listed, we are only illustrating a diversified portfolio.
The Personal Investment Tracker lets you input your trades from different accounts enabling you to easily track your whole portfolio to maintain healthy diversification levels.
A diversified portfolio focused on being passive could have 30-60% of its value into equity (stock market) index ETFs,10-25% into bond fund ETFs and 15%-35% into higher income REITs as the base of the portfolio. From there to help hedge against market turmoil a Gold/Silver ETF at 1-5%, an inverse ETF at 0-2% and cryptocurrency at 0-2% allocation could be considered. If there is some extra room you can select a few individual stocks or ETF funds that follow a theme (i.e. value or growth) or industry (i.e. Tech or Retail) that you like and believe will do well. There is no "correct" allocation, but diversification along these rough ranges is a great starting point.
Information Sources
The last thing you need to know is where to find all this information. Below are the most common freely available sources of information.
General News: Bloomberg, Financial Times, Financial Post, Yahoo Finance, CNBC, Wall St Journal, Reuters, Market Watch, Motley Fool, Barons, Morningstar.
General Financial Data: Yahoo Finance, FinViz (has a great stock screener), WeBull, Hyper Charts (great visualizations), TMX Money (for Canadian stocks), Trading View, your brokerage, and for ETFs: ETF Database or ETF dot com.
Specific Financial Data: The “Investor Relations” page of a specific company, SEC.gov (US regulatory agency for stocks), SEDER (Canadian regulatory filing system).
Blogs/Reference: Seeking Alpha (blogs), Investopedia (definitions, concepts).
Social Media: Twitter (news, companies, CEOs, investors etc.), Stocktwits (same as Twitter), Reddit (r/investing, r/stocks).
You now know how to open investing accounts, the types of tax advantaged accounts available, active investing basics, passive investing basics, portfolio diversification and where to get the information! Good luck and happy investing!