Investing with Training Wheels

In comments on my past two blog posts, two different commenters have taken issue with my advice to beginning investors to buy mutual funds. Let’s look at the costs and benefits to understand why this might make sense. I am assuming that a savings account, Canada Savings Bond or GIC isn’t an option, such as when beginning a long-term investment plan. Everyone has to start at the beginning, so we’ll assume a beginner investor, although that could mean a woman or a man anywhere from 20-something to mid-forties.

What options can a beginner investor consider? Possibilities include:buying a business, ¬†stocks, real estate, limited partnerships, mutual funds, ETFs, structured notes, variable annuities (seg funds). Many structured notes actually aren’t available to novices, as hedge funds are not. Buying a business or real estate directly usually involves onerous debt (at least for a novice), so we’ll exclude those.

What should a beginner investor look for in an investment? The first criteria depends on the person’s goals, but it should probably produce some form of learning from experience. A market linked GIC or a structured note wouldn’t achieve this goal because they sheild the investor from experiencing their own reaction to volatility. A real estate limited partnership should usually be avoided due to the massive risks, but it also shields investors from the responsibilities and risks of owning property. The second criteria would be that it is accessible with a small initial amount. This rules out most limited partnerships, structured notes and most individual stocks.

The most important criteria should be cost. This is what separates the remaining choices. Variable annuities (seg funds) are very expensive to own and should only be used for their unique features, which are generally more suitable for elderly people. Individual stocks, including ETFs, can be very expensive to buy, especially through a full service broker. Even a discount broker generally costs about $25 per trade (unless you have over $50,000 or trade frequently, which disqualify the novice investor). A mutual fund generally costs nothing (or very little) to buy and sell. The second aspect of cost is the recurring cost (MER). Individual stocks cost nothing, ETFs generally cost between 0.15% and 0.50% per year, and mutual funds generally cost between 2.0% and 2.5% per year.

The benefit of mutual funds and ETFs over individual stocks is the built-in diversification. Each fund might own shares in 50 – 200 companies, which can be accessed with a single trade. A stock trading account is typically more focused, with shares of 10 – 30 companies. The downside to this diversification is that a fund can perform worse (or better) than a given stock. Most investors seem to consider that unknowable and assume that the performance will be equal before fees (ie. costlier investments will perform worse).

Here’s some example numbers to clarify. A beginning investor decides to save $50 twice a month and wants to invest in the stock market. It is obvious that paying a $25 commission each time would be untenable. It would be possible to accumulate cash and invest in an ETF only once a quarter ($100 in commission, plus $1.20 in MER). But to maximize learning from experience, an investor can buy mutual funds with each $50 deposit (plus $12 in MER). The second year will cost more in MER for each fund, but the higher MER won’t outweigh the commission until the investor has accumulated between $10,000 and $15,000. But by the time he has $30,000, he should be able to invest in individual stocks with adequate diversification to further save money by paying no MER at all.

I will add only a single note on active vs. passive. It is possible to buy ETFs that incorporate active management and mutual funds that track an index. It is also possible to mostly replicate an index using individual stocks. So I don’t believe the preference for active or passive needs drive the choice between mutual funds, ETFs and individual stocks.

How did you gain experience when you began investing? What’s the best way to learn without getting in real trouble?

4 thoughts on “Investing with Training Wheels”

  1. Why not buy TD’s e-Series mutual funds with MERs around 0.5%? Once the portolio has built up, why not switch to even lower cost ETFs that give fantastic diversification instead of trying to become a stock-picker? Your suggestions for novice investors are great for financial advisors and stock brokers, but not so good for the investors themselves.

  2. Michael, The TD e-series is an excellent choice of mutual fund. I didn’t mention it only because I’m not hilighting specific product (and I’m not taking a stance on “active vs. passive”). Those mutual funds would achieve the criteria of diversification, experience and low cost and would make sense well beyond the $15,000 threshold. (But I don’t want to use them in my calculations for fear of overstating the case in favour of mutual funds.)

    I’m not suggesting becoming a stock picker. I can own shares in 30 of the TSX 60 index for a purchase commission of $208.50 (at $6.95 per trade, since my account is large enough) assuming I buy them all in a single year. Thereafter, the MER is 0%, far lower than the 0.20% of XIU. The break even point is $104,250, but that’s only in the first year. In following years, turnover is extremely low, so owning the individual stocks that make up the market is cheaper than owning the ETF. It only requires infrequent (quarterly) research to see if it needs to be rebalanced.

    You might think it’s silly to roll your own ETF, and it is if you want to “set it and forget it”, but I personally think that’s irresponsible. If you invest in the market, especially without advice, I feel it’s imperative to look at your account at least once a quarter to ensure nothing’s gone off the rails. But implementing it yourself also allows you greater flexibility in weighting. For example, research shows that fundamental weighting and equal weighting both tend to outperform market weighting.

    Finally, ETFs may be worth their cost for markets that aren’t easily accessible. There’s no point trying to roll my own portfolio of Chinese stocks to mimic the XIN index or European stocks to mimic FXI. Only North American trades are eligible for discount commissions. And some ETFs provide a currency neutral option, for those who desire.

    Of course, these are considerations for you and me, not for novice investors. For them, let’s agree that the TD e-Series (for customers of that bank or brokerage) are ideal.

  3. TD e-series, interesting. I deal with that bank and this is the first of heard of this. I’m going to check it out.

    As for me, I said it before and I will say it again. Get some good solid companies that pay a decent dividend. My rule of thumb is the 3 to 6% range and look for companies that don’t deal out more than 80% of their earnings as dividends which some article I read advised. I personally use the 50% to 70% payout rate as a guideline. I have Sun Life at the moment and am looking at BCE.

  4. I started with ING Direct’s mutuals as they were similar to the couch potato thing. I have since moved on to TD e-series now that I have more money and experience.

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