What is investing?
by Jim Steel, CFA, CFP
Investing is the act of allocating your money to an asset or an endeavour (a business, real estate, etc.), with the expectation of generating an income or profit that can be used to fund your retirement, invest in a house, buy a car, travel, supplement your daily living income or really, anything you like.
There are a wide variety of vehicles and assets available to invest your money. A fundamental investment principle is something known as risk and return. Generally, the lower the risk you take, the lower the return will be. For example, Guaranteed Investment Certificates (GICs), bonds and fixed-assets are low-risk investments that generate low returns, while stocks or equity and commodities carry higher risk but with the potential to generate higher returns. It is important that investors determine their risk tolerance or preference - essentially the amount of risk they are comfortable taking before choosing an investment.
There are two broad categories (asset classes) of investment vehicles: Stocks and bonds (see What is a stock? and What is a bond?). An investor can invest their money in either category, or in both, depending on their individual risk preferences. Dividing your investments into different classes is your allocation.
It is important for investors to recognize that capital markets can be volatile. Generally, the higher level of risk, the greater the volatility. A riskier asset can fall by a large amount very quickly while a safer asset class does not fall very much, if at all, under the same circumstances. Risk and return are related: the more risk you expose yourself to; the higher your expected return; and the higher the potential for a loss.
Stocks are a “riskier” asset class, which is why they offer higher expected rates of return than bonds. Investors choosing stocks must be prepared to accept volatility, including significant decreases in the value of their investments for extended periods. Investors should avoid stocks if they need access to their funds within five to seven years or if they will lose sleep when their investments fall in value. Although stocks may generate expected returns of about 7% to 8% per year, they may experience one-year temporary losses as much as 30% to 50%.
Bonds are a safer asset class, but have lower expected returns than stocks. Investors choosing bonds must be willing to accept a very low rate of return in exchange for this safety. These low rates of return could mean that investors may not generate enough profit to meet their investment goals and may have to work longer or save more money. To put this in perspective, bonds may have an expected return of 1% to 3% per year but may experience one-year temporary losses of 0% to 5%.
A balanced approach is to invest some of your money in stocks and some in bonds. By doing this, you are blending the risk and return characteristics of each asset class. By adding bonds to your stock portfolio, you can reduce your risk while still maintaining an acceptable expected rate of return. By adding stocks to your bond portfolio, you can increase its expected return while still maintaining and acceptable risk level.
What is the right mix of stock and bonds for you? That depends on your risk tolerance, which is a topic for another day.