When I get reader emails, I typically respond to them directly, but this time around, I thought that this topic would be a good one to share with MDJers.
This reader mail is from a late 20 something-year-old who has already started a healthy savings habit. Helping young people with finances is one of my favorites because they have the huge advantage of time.
If you read my “Power of Compounding Returns” article, the article demonstrates that the serious investment returns occur not only with the right strategy, but also the amount of time that you stay invested. When they say “stay invested for the long term”, the reason is that compound interest really kicks in by the 20-year mark. Here is a snippet from my compounding returns article.
… assuming 7% returns, by year 20, annual market returns start to overtake the total cumulative TFSA contribution amounts. By year 30, annual market returns are double total contributions. By year 40, market returns are 4x contributions. By year 50, market returns are 7x contributions and year 60, 12x contributions. Compounding really takes off with an exponential curve that will look like a vertical slope if you give it enough time.
The greater your market return, the greater the power of compound interest. If you manage to increase your return by a percentage point (think lowering your MER), your compound interest works harder and will show significant results after 20-30 years. See this post for more details.
Ok enough yammering about the importance of compound interest, here is the question by the reader.
I’m a not so recent graduate in her late 20’s and I just got into financial planning and savings. I currently have a take home of $3,200 per month with the hopes of getting a better job after sitting for a certification exam. I have approximately $30k in savings (all in my TFSA account and not invested). I bank with TD and would like to stay with them
Where would be a great way to stay building financial wealth – something with lower risk?
Talking about Risk
I don’t know about you, but the part of the email that really stands out is “something with lower risk”. I understand the need to feel safe, heck, I’m fairly risk-averse myself as can be seen by my mental block with keeping cash lying around. Over the last few years, I’ve been doing much better, and having a goal of establishing substantial passive income has been a driving factor.
I digress, let’s start off by talking a little more about risk. The market defines risk as volatility in the market, in other words, how much returns go up and down every year. Some years can be up (like since 2009), or you could get some years that can be down (like in 2008). However, that is short-term thinking. Over the long-term, or any 20 year period, the stock market has gone up.
So in knowing that the market goes up over the long-term, is there any real risk over the short term? With the long-term in mind, corrections and bear markets are now an opportunity to buy assets at a lower price. Seeing an opportunity when everyone else is running for the hills (ie. selling) can be a real paradigm shift for some, even for some of the most seasoned investors.
Having said that, there is a risk to investors with shorter timelines to retirement where they will need to start spending from their investments. In this case, volatility matters because withdrawing large amounts during a bear market can be harmful to a portfolio. As investors get closer to retirement, asset allocation matters.
Ok, getting back to the email, as you can see, she has $30k within a TFSA. I like to treat TFSAs as long-term investment accounts due to the ability to grow your investments tax-free. Compounding can really help a portfolio take off when it doesn’t have a tax drag.
While she could play it ultra safe and go with super low-risk investments like GICs, the problem is that GICs barely keep up with inflation. And over the long term, you’ll see very little inflation-adjusted growth from your savings. However, GICs (or high-interest savings accounts) are better than keeping everything in cash where inflation will actually result in negative growth (ie. less spending power) over time.
I think the reader should invest her savings in an easy indexed portfolio with an asset allocation that fits her risk profile. While many young investors would benefit over the long-term by going with 100% equities, this reader should set an allocation to bonds to help smooth out the volatility and ultimately helping stay invested over the long-term. Something like a 60% equity and 40% fixed income/bond portfolio may do the trick.
The reader mentioned that she wants to stay with TD, which isn’t an issue because they offer low-cost index mutual funds – the TD e-series. In fact, I use these mutual funds for my children’s education fund and they have worked out great.
Specifically with Toronto Dominion Bank:
Toronto Dominion Bank
- TD Canadian Index Fund-I (MER 0.88%);
- TD US Index Fund-I (MER 0.55%);
- TD International Index Fund-I (MER 1.00%); and,
- TD Canadian Bond Index Fund-I (MER 0.83%).
- TD Canadian Index Fund-e (MER 0.33%);
- TD US Index Fund-e (MER 0.35%);
- TD International Index Fund-e (MER 0.51%); and,
- TD Canadian Bond Index Fund-e (MER 0.50%).
So if the reader wanted to go with a 60/40 portfolio with $30k, it would look something like this:
- TD Canadian Index Fund-e: 20% or $6,000
- TD US Index Fund-e: 20% or $6,000
- TD International Index Fund-e: 20% or $6,000
- TD Canadian Bond Index Fund-e: 40% or $12,000
If the reader wanted to get a little more aggressive with a 75/25 portfolio, it would look something like this:
- TD Canadian Index Fund-e: 25% or $7,500
- TD US Index Fund-e: 25% or $7,500
- TD International Index Fund-e: 25% or $7,500
- TD Canadian Bond Index Fund-e: 25% or $7,500
With new savings every year, you would rebalance back to your pre-determined asset allocation. In years that markets are up, your bond allocation would likely be a little lower, and would require new cash to rebalance back to your bond allocation. If the market is down in any particular year, the new cash would be used to buy more equities. The more robotic and boring you make investing, the more success you will likely have.
There you have it a fairly straightforward way to grow your savings over the long-term. As I mentioned, the earlier you start, the more power you harness from the freakish ability of compounding.
If you are looking to start a portfolio and want to stick with your bank, here is an article that I wrote a few years ago about which bank mutual funds to pick. For those of you interested in learning more about index investing, here are 6 ways to index your portfolio.
Invest your savings, make it systematic, and keep your eye on the horizon. Your wealthier future self will thank you for it.