Financial Planning

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor.

Financial Planning

Postby The Management » 06 Dec 2005 12:54

The following has been reproduced with minor adaptation from the website of Libra Investment Management. We are grateful to Norbert Schlenker of Libra for permission to use his material. We also thank the forum members who suggested improvements (in this comment thread) that have been quietly incorporated in the text.

We also encourage you to explore these topics in our financial wiki, finiki.

Financial Planning

"Whatever failures I have known, whatever errors I have committed, whatever follies I have witnessed in private and public life have been the consequence of action without thought." - Bernard Baruch

A financial plan makes recommendations on a number of topics. It generally begins with a reprise of a person's (or family's) net worth and a list of income and expenditures and/or a budget. Following this picture of the client's current situation are the issues and recommendations in six key areas:
  • Day to day finances (budgeting, expense control, mortgages, other debt, emergency funds, etc.)
  • Insurance (life, health, disability, property)
  • Taxes (exemptions, deferrals, income splitting)
  • Investments (asset allocation, security selection, risk management)
  • Retirement (pensions, RRSPs, RRIFs, annuities, etc.)
  • Estate (wills, powers of attorney, use of trusts, planned giving, etc.)
Not all financial plans include recommendations for all of these topics. For example, a retired person with a mortgage-free residence and a pension that covers day to day expenses may want and need advice only with respect to investments, taxes, and estate planning.
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Postby The Management » 06 Dec 2005 12:55

Doing it yourself

Disclaimer
The advice hereafter is generic and not targeted specifically to any individual's circumstances. You may have personal or financial issues that must be handled specially, in which case you will need to learn more or consult a professional.

The following topics are organized as individual posts.
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Postby The Management » 06 Dec 2005 12:56

Encouragement
For many people, reading financial material or carrying on a financial discussion is a baffling and humbling experience. Jargon flies, everyone but you seems to know what's being talked about, and you don't know how to distinguish good information from noise.

The purpose of this thread is to provide good information, simplified enough that the average person becomes able to handle their finances on their own and at minimal cost. The information presented here is necessarily abbreviated and not at all tailored to your own circumstances. Complexities and subtleties have been glossed over.

However, the following simplified recipe is 80-100% of what the average person needs to know about personal finance. Following the recipe will allow you to achieve 80-100% of what you should achieve financially, a significant improvement over the 50% you are likely to get if you consult the typical salesperson at a typical financial services firm. The typical salesperson is not incompetent or a thief, but the typical fees will consume half your wealth over time. No missed subtlety -- likely noise -- is likely to be as expensive for you.

If you're already fed up and can't stomach reading the rest of these short lectures, here is the super-condensed version:
  • Spend less than you earn.
  • Save/invest a percentage of every paycheque, not what is left after expenses.
  • Don't put all your eggs in one basket.
  • Watch the pennies and the dollars will look after themselves.
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Postby The Management » 06 Dec 2005 12:56

The basics
No one cares as much about your finances as you do. You will not realize your financial goals, and no one else – not the most skilled advisor – can help you realize your financial goals if you are not engaged. While you can delegate some of this work, you cannot wash your hands of finance completely.

There is nothing complicated about basic finance. The guiding principle is avoiding self-destructive behaviour. If any of the following apply to you, fix them before you even think about investing:
  • Spending more than you make
  • Not paying off your credit cards every month
  • Not opening mail from your bank or broker because you don't want to know
  • Failing to take every free penny that comes your way, whether it be a matching contribution to a savings plan by an employer or a tax deduction from the government, because you don't want to put some money into the kitty yourself
  • Leaving your family exposed to a loss of earnings due to death or disability
  • Gambling (unless you're really good at it, in which case it's not gambling)
  • Buying a house or car more to impress than to use
  • Paying non-deductible interest on anything other than your home mortgage (and a good case can be made that you are better to pay off the mortgage than invest, which you are not likely to hear from someone who gets paid a commission to sell you investments)
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Postby The Management » 06 Dec 2005 12:57

Insurance
The guiding principle for insurance is to use it only when a loss would be financially intolerable.

You pay for insurance when:
  • It is legally required (e.g., liability insurance for a vehicle)
  • It is contractually required (e.g., your mortgage lender insists you have fire insurance)
  • A loss would cause serious financial hardship to your family (e.g. a paid for house burns down and you cannot afford to rebuild out of other resources; your family depends on your earnings from a job or business, and you are unable to work because of death or disability)
You do not pay for insurance when:
  • A loss is immaterial to your wellbeing (e.g., an extended warranty on a $300 television is a waste of money)
  • No third party can be harmed by an event (e.g., life insurance for a person with no dependents)
  • A loss cannot be compensated with money (e.g. life insurance on a child)
  • The risk is not really avoidable (e.g., segregated funds guarantee a minimum market value, but if the market really goes into the tank, are the insurance company's finances robust enough to make you whole?)
  • The all-in cost is similar to the loss you're trying to avoid (e.g., paying fat fees to life insurers to avoid paying fat taxes at death, but your children will end up with the same amount in either case)
No matter what, do not let a salesperson make you feel guilty about a non-existent or trivial risk. Never buy insurance for emotional reasons.

An excellent introduction to insurance and annuities for the layperson is Moshe Milevsky's Insurance Logic. The original edition is now out of print but may be available at your public library. See also our finiki.

Competitive rates for home and auto insurance can be obtained at http://www.insurancehotline.com or http://www.kanetix.ca (although registration is required at Kanetix).
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Postby The Management » 06 Dec 2005 12:57

Taxes
You do not need to know every detail of our incredibly complicated income tax system in Canada. The average person will be well served by taking advantage of these four types of tax planning opportunities.

Do:
  • Avoid taxes: Profits from the sale of a principal residence, and up to $750,000 of capital gains from the sale of an active business you own, are tax free.
  • Defer taxes: Contribute to pension plans or an RRSP, and an RESP if you have children. Investment gains are not taxed until withdrawal, which allows income to compound tax-free over long periods of time. Against that, you receive a tax credit upfront, which can be used to pay down debt or invest.
  • Split income: Our tax system has progressively higher rates as you earn more, so having income taxed in the hands of lower income family members saves money. Consider employing your spouse or children if you have a business. Contribute to a spousal RRSP. Split your CPP entitlements.
  • Generate tax-preferred investment income: Dividends from Canadian corporations and capital gains on the sale of investments get preferential tax treatment relative to earned income and interest. Earning $80,000 at a job in 2004 would cost about $23,000 in income tax plus CPP and EI premiums. The same income, half in Canadian dividends and half in capital gains, is liable for only $8,000.
  • Keep the least tax-efficient securities inside your RRSP/RRIF/TFSA and the most tax-efficient outside.
Don't:
  • Cheat on your income tax returns by falsifying your income or expenses.
  • Buy an investment that is being touted more for its tax benefits than its returns.
If you want to estimate income taxes payable, there are a few online tax estimators available.

Ernst and Young's personal income tax calculator
Walter Harder's Income Tax Estimator
TaxTips Canadian Tax Calculator
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Postby The Management » 06 Dec 2005 12:58

Retirement
The most common question asked by those who invest for retirement is, “How much money do I need to retire?” That cannot be answered until you answer the question, “How much money do you need to spend each year?”

The answer to that question – and the answer is entirely up to you – is the critical ingredient when it comes to knowing how much is needed to retire. No one can tell you what sort of lifestyle you want to lead. That is inevitably your personal decision. Some people are happy with a paid for house and $2,000 a month to spend. Others insist that $100,000 a year is what they really want. You must decide what's right for you.

Once you have done that, a ballpark estimate for how big your portfolio needs to be isn't too hard. First, if the estimate you have made is after tax spending, you need to bump it up a little to get back to pre-tax figures. Adding 25% is roughly right; you can refine your estimate by using the tax estimators in the previous message.

Now deduct what pensions you will receive in retirement, because your portfolio won't have to produce that income.

The historical evidence is that you can take roughly 4% from the starting value of an investment portfolio, raising it each year by the inflation rate, without running into disaster. If your portfolio will need to support you for a period longer than 30 years, e.g. because you are an early retiree, then shave a little from the 4%, say 3.3% instead. History is not a perfect guide to the future, but barring nuclear war, natural disasters, or complete economic collapse, 3.3-4% should be your guide. That gives a convenient way of estimating the total funds required as 25-30 times what the portfolio needs to produce each year.

A simple example: The 63 year old Mr. Magoo wants $40,000 per year after taxes to spend in retirement. Before tax, it's about $50,000. CPP will pay $6,000, OAS $5,000, and his company pension $11,000 per year. His portfolio needs to generate $28,000 per year in retirement. At a 4% withdrawal rate, his portfolio should be worth at least $700,000.

Consider annuities if any of the following are a concern
  • You and/or your spouse are relatively healthy and are likely to live longer than average.
  • Maximizing your income in retirement is more important than leaving an estate.
  • You want a guaranteed monthly income stream regardless of how long you live.
The first two-thirds of How to Completely Avoid Outliving Your Money provides a good introduction to annuities.

N.B. Since their purchase is irreversible, always seek professional advice before you purchase an annuity.
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Postby The Management » 06 Dec 2005 12:59

Investing
Investing can be a fundamentally simple process. There is so much jargon and so much information flying around that it looks incredibly complex. For someone untutored about investing, fobbing the whole task off onto someone else is very tempting.

Don't do it! You can do it yourself by following these simple guidelines:
  • Most news is noise. The biggest risk for most people when investing in securities is paying too much attention to the news. What is in the business news today is totally irrelevant if you follow the rest of these guidelines. If you want to read the business pages or watch BNN for amusement, that's fine. Just don't invest that way.
  • If your time horizon is really short and money is being invested that will need to be used within a few years, STOP! Putting your house down payment in the stock market is folly.
  • Don't make the opposite mistake either by underestimating your time horizon: A person starting to draw on an RRSP today may have 30 years of retirement ahead, so keeping that RRSP in cash is a mistake as well.
  • You must be willing to take some risks. While you may do fine just buying GICs at your bank, you can do much better. Even the most conservative investor is well advised to own at least some stocks, even if not individual stocks.
  • Do not be stupid about taking risk. Historical evidence is that even aggressive risk-seekers get scant extra return from going wild.
  • Write yourself an investment policy, using this template. Very conservative investors should probably have 75% of their portfolios in fixed income like GICs or bonds or preferred shares and 25% in equities. Very aggressive investors should have 20-25% in fixed income and the remainder in equities. If you're in the middle, a 50-50 or 60-40 mix is quite reasonable. Or you can use one of the many online questionnaires such as BMO Investor Profiler, Edmond Financial Group Risk Tolerance Questionnaire, or TD Waterhouse Portfolio Planner to help you determine whether you are a conservative or an aggressive investor.
  • Make adjustments to the policy mix if your job, hence your salary, is highly correlated with one type of investment. Tenured university professors with generous indexed pensions probably should not own indexed bonds. Software engineers with vested stock options should lighten up on high tech stocks.
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Postby The Management » 06 Dec 2005 13:00

Implementation
Don't put all your eggs in one basket. Once you have an investment policy with an asset mix, your job is mostly done. The asset mix goes a long way to getting you a diversified portfolio. Now go the rest of the way. Nowadays, you need not buy a single stock or bond in order to invest. For every asset class in your investment policy, there is a low-cost and tax-efficient vehicle that will work for you.

Some investors may choose to invest directly in stocks and bonds for all or part of their portfolio. If done wisely, this can be an effective strategy. But such direct investments must be carefully monitored and are not for everybody. If in doubt of your ability to "stock pick", you should either avoid direct stock purchases or limit such investments to amounts you can afford to lose. Further discussion of stock selection procedures is beyond the scope of this guide.

For those who prefer not to select individual securities, here is a list of possible investment choices. Exchange traded funds are listed with symbols in the lists below and should generally be used because their costs are lower. If you are accumulating funds, say by depositing funds regularly from a paycheque, then it's often better to use open-ended funds like the low cost TD-e series, because there are no commissions to buy or sell them.

Fixed income:
  • Individual bonds or GICs purchased through a broker
  • iShares bond ETF (XBB) and short-term bond ETF (XSB)
  • PH&N Bond and Short-Term Bond and Mortgage
  • CIBC Canadian Bond Index
  • TD Canadian Bond Index-e
  • Diversified Preferred Share Trust (DPS.UN)
  • iShares Canadian Preferred Share ETF (CPD)
Equities - Canada:
  • iShares Composite Canadian Equity Index Fund (XIC)
  • iShares S&P/TSX60 Index Fund (XIU)
  • iShares S&P/TSX Midcap Index Fund (XMD)
  • CIBC Canadian Index Fund [for clients with more than $150k at CIBC]
  • TD Canadian Index Fund - e
Equities - U.S.:
  • Vanguard Total Market VIPERS (VTI)
  • S&P depositary receipts (SPY)
  • iShares S&P 500 Index Fund (IVV)
  • Vanguard Extended Market Index VIPERS (VXF)
  • CIBC US Equity Index [for clients with more than $150k at CIBC]
  • TD US Index - e
Equities - Overseas:
  • Vanguard All World ex-US (VEU)
  • Vanguard Europe Pacific (VEA)
  • iShares MSCI EAFE Index Fund (EFA)
  • Vanguard European Stock Index (VGK)
  • Vanguard Pacific Stock Index (VPL)
  • Vanguard Emerging Markets Stock Index (VWO)
  • iShares MSCI Emerging Market Index (EEM)
  • TD MSCI EAFE Index - e

In recent years, both Vanguard and iShares have made available some of their U.S. offerings on the Toronto Stock Exchange for those who wish to forgo currency conversion costs incurred by buying on a foreign exchange.

Costs matter. Do not succumb to the siren song of marketing. Mutual fund companies tout last year's winners but neglect to mention the fees. Banks tout their portfolio managers but neglect to mention the fees. The fees are what will kill you in the end. The average mutual fund in Canada charges 2% a year, the average wrap account about 2.5%. It sounds so innocuous. Yet paying those fees for 30 years, the average working life, will result in half your retirement savings ending up in the hands of the mutual fund companies and the advisor they paid to sell you the products. That's hard to believe but you can check for yourself using the OSC's Mutual Fund Fee Calculator.

These are your choices but you can pick only one. It's up to you.
  • You can pay high fees.
  • You can double your retirement savings.
  • You can retire ten years earlier.
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Postby The Management » 06 Dec 2005 13:00

Estate
Prepare a will. If you are in anything other than the simplest family and financial situation, pay a lawyer to do it right. Residents of Quebec should consult a notary.

You should have an enduring power of attorney for financial matters. If you are disabled and unable to look after your own finances, name someone you trust who can and will do the job. You must have a lawyer draft this.

You should also have an enduring power of attorney for personal care. (The name and format of this document varies from province to province.) If you become incompetent to make decisions about where you live and your health care needs, someone needs to make those decisions for you. Appoint someone you trust to do so.

If you do none of these, the provincial government and/or the courts will step in and act in your stead. You may not get what you want and the costs may be high.
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Postby The Management » 06 Dec 2005 13:01

If you can't or won't DIY
It doesn't bother us to hire plumbers to fix a leak or to pay someone to change the oil in the car. Modern economies are built on Adam Smith's division of labour and are better for it. There is no shame in paying a reasonable fee to have someone look after your finances. The shame only comes from letting yourself pay far too much.

If you have a small portfolio, say under $100,000, then the advice you're getting - say a financial plan, not just "Buy this fund" at RRSP time each year - is reasonably balanced against the average mutual fund's fees ($1,500-2,500 a year). But if you have a $400,000 RRSP, all invested in mutual funds or wrap accounts, you could be paying $10,000 a year. At a million dollars, $25,000 per year. It's too much.

If you really don't want to invest on your own, ...

Contact a professional
You find a professional planner the same way that you find a plumber or a car mechanic, by word of mouth preferably or through the Yellow Pages. The industry provides search tools: Advocis’ consumer information and Find a CFP Professional. To help understand what financial planning entails, you should read the material on the Financial Planning Process and 10 Questions To Ask Your Planner. Working relationships are often improved when there is an Engagement & disclosure letter and an Investment Policy Statement (see this, for a mythical retired widow, as a template.).
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Postby The Management » 06 Dec 2005 13:01

Further Reading

Books
We are occasionally asked to recommend good books about personal finance and investing. There are many, although finding the good ones among the hundreds or thousands of titles at the book store can be difficult. We try to keep this list very short. Most people have a limited appetite for such material and want something simple but not simplistic. All are commonly available at libraries. The first two can often be found in used book stores or on garage sale tables, not because they are only worth a quarter but because people don't recognize good value when they see it.

Financial planning
  • The Wealthy Barber, David Chilton
  • Your Money or Your Life, Joe Dominguez and Vicki Robin
Investing
  • Risk is Still a Four Letter Word, George Hartman
  • The Four Pillars of Investing, William Bernstein (Bernstein's Efficient Frontier website is also highly recommended)
  • Winning the Loser's Game, Charles D. Ellis
InsuranceArticles
We highly recommend two very readable academic articles on investing, Nobel Prize winner Bill Sharpe's The Arithmetic of Active Management and Brad Barber's Trading is Hazardous to Your Wealth. Spend half an hour reading and absorbing the lessons of those two articles and you will be a better investor than most.

Good investing technique is not flashy and does not sell papers or magazines. The popular press exists as much to satisfy advertisers as it does to inform the public. The result is magazine covers that scream "10 Top Funds for Next Year" and the business section of the newspaper that tells you what happened yesterday.

In Canada, three finance columnists worth reading regularly are Rob Carrick (Globe and Mail), Jon Chevreau (MoneySense), and Ellen Roseman (Toronto Star). In the U.S., consistently good information comes from the pens of Jonathan Clements (Wall Street Journal), Jason Zweig (Money), and Scott Burns (Dallas Morning News).

The first two-thirds of How to Completely Avoid Outliving Your Money provides a good introduction to annuities.

If you are interested in serious studies of financial matters, a very comprehensive list of worthwhile articles can be found at Altruist FA. For recent and upcoming publications, check the links at Research Finance occasionally.

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Re: Financial Planning

Postby Administrator » 09 Sep 2012 11:25

Further evolution of this material can be found on our Wiki at Creating a Financial Plan
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Re: Financial Planning

Postby The Management » 22 Jul 2013 01:26

Bumping this sticky up: financial planning precedes portfolio management. Please read the above before tackling individual portfolio questions.
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