Now that I have a TFSA/RRSP, what should I invest in? – Boring, but correct and responsible answer

In my last blog post, I discussed the basic differences between a TFSA and an RRSP from a tax perspective. Today, I wanted to give a little guidance on what can be put into your TFSA/RRSP. As always, my assumption is that you have resources to contribute to your TFSA and your goal is to maximize your gains with a fairly long investment horizon.

The investment strategy I would recommend is called the couch potato portfolio. The concept is quite simple. Use ETFs to build a well-rounded portfolio with a few “buckets”. Each year, redistribute your allocations in each bucket. ie, invest more in the buckets which returned less, and less in the buckets that returned more. This allows you to in essence buy low and sell high. If you look at the historical returns of this method, you will be hard-pressed to find another technique which combines high gains with low volatility. I will explain the various pieces of this strategy below.

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Rule 1. Most people (myself included) should NOT be picking stocks to invest in.

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What we learn in finance 101, is that there are two types of risks. Systematic and unsystematic. The key difference is as follows:

Systematic Risk – the volatility of the market/market segment as a whole

Unsystematic Risk – The volatility of a specific stock or company

If you invest in individual stocks, you end up with exposure to both types of risks. Some of you may think, the increased risk means potential increased gains, and while this is true, if your objective is to grow your investment long term, the logical solution to mitigate this risk and to purchase investments which contain a group of stocks to diversify your portfolio. Historically, this is why mutual funds were started. The downside of mutual funds is the management fees associated with them. Typically, these range in the 2-3% range. This may not seem like a lot, but just plug it into the rule of 72 equation from my last blog post, and you quickly see that over the course of 30 years, this will cost you half of your investment, OUCH!

This is where ETFs (Exchange Traded Funds) shine. ETFs or index funds are stocks that are traded on a stock exchange like the TSX or NYSE, but they contain a collection of individual companies similar to a mutual fund. They differ from mutual funds in two critical ways.

ETFs are not actively managed, they are meant to represent an entire index/segment like the S&P500, Nasdaq or TSX, etc.

ETFs have much lower management fees than mutual funds.

Let’s delve into these two points some more. Index funds, as the name suggests, try to mimic an entire index. The allocation of holdings within the fund is done passively as the index itself changes. As stated earlier, this allows the fund to mitigate the unsystematic risk associated with picking individual stocks.

Since the fund is passively managed, the Management expense ratios (MER) are under 1%, with some newer funds being under 0.1%. For those of you who already invest in ETFs, the MERs have come down dramatically with increased competition in this space. When I started investing in ETFs ten years ago, an MER of .5 was about average. Now there are ETFs with MERS in the 0.03 range so I’ve personally been updating my portfolio to contain more of these ultra-low MER ETFs. Here is a great website that outlines some of these low MER ETFs.

At this point, some of you may be thinking, with these reduced risks and reduced fees, there must also be reduced returns on this type of investing. Let’s look at the historic returns of some of the largest indexes. (As of December 2017)

S&P500 – A collection of 500 large cap US companies trade on the NYSE 

1 year – 18.57%, 5 year 14.17, 10 year 7.39%

TSX – The Toronto Stock Exchange

1 year – 9.55%, 5 year – 8.68%, 10 year – 4.49%

NASDAQ – Benchmark index for US technology Stocks

1 year – 31.99%, 5 year – 20.67%, 10 year – 12.82%

Here is a list of the major indices around the world.

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One thing that has changed in the world of ETFs is that they no longer just represent large indices, they now have an ETF for almost every segment and sector. This progression is allowing for people to invest in specific interests but still be hedged against picking out individual stocks. I will review this concept on my next blog.

Thanks for reading.

Edit: I listen to a lot of podcasts and one of my favorites is Freakonomics. The episode from July of last year titled “The Stupidest thing you can do with your Money” actually explains ETFs really well. I highly recommend this podcast in general, but this one, in particular, is very good. I thought I knew a lot about ETFs before this podcast, and I learned a few things as well.