Generating Returns on Your Capital

Interest rates have risen over the course of 2022. At the time of writing, Canadian investors can easily find High Interest Savings Accounts (“HISAs”) paying more than 4%. This might sound pretty good to investors sitting on lots of cash.

But, don’t be fooled. Anytime you’re parking your capital in a bank deposit (or any other nearly risk-free investment), your capital is shrinking. This post will explain why and describe alternative ways to invest.

Nominally, if you have $100 in a bank account earning 4% annual interest, it seems like your capital is growing. Even though after one year, your $100 might turn into more than $104. The real value of your account has likely fallen. As many of us know, inflation is ever present.

Inflation is a rise in prices, which can be translated as the decline of purchasing power over time. Curiously, your $104 purchases the same $100 worth of goods it did last year.

For capital to maintain its purchasing power against inflation, investors need to accept some risk. This risk might be accepted by lending for a longer period or by accepting some other type of credit risk.

Investing in the stock market is generally riskier than holding a bank deposit. The same is generally true of real estate. But because these assets carry some risks, they also have the potential to provide some returns (over inflation).

In the long run, stock market investors have done much better than cash sitting in savings accounts. This is because stock market investors are capturing a “risk premium”.

Investors who strategically accept risk will do far better than those who sit on the sidelines (in cash or other so-called “safe” investments).

If you build a portfolio of high-quality investments, diversification will help you mitigate the risk that any individual investment does poorly.

The result of diversification is an investment portfolio that captures the benefits of risk without “putting all your eggs in one basket”.

Over time, investors have learned that a well diversified portfolio of investments of various asset classes will virtually eliminate the risk overall that any one bad investment will make.

A portfolio diversified between some stocks, bonds, and real estate is a good start. Other investors might add in alternative investments such as gold and even bitcoins. Your individual investment goals and your risk tolerance will guide you towards investments that are suitable.

You can also use investments of each asset class to further diversify your risk. This might mean using a mutual fund or index fund that contains many different stocks rather than owning a single stock on its own.

How you invest, and which investments you might consider can also be expressed in your Investment Policy.

Your investment Policy is your written investment strategy. Your Investment Policy will outline what your goals are, your risk tolerance, time horizon, performance measurement, and asset allocation. Your asset allocation describes how much of your capital you might consider placing in different types of investments such as stocks, bonds, real estate, etc.

Your investment policy is your investing blueprint. Having an investment policy will help you stay on course and not get sidetracked by the “flavours of the month”.

An asset allocation is an investment strategy that seeks to balance risk between different types of investment assets.

The most common asset allocation is for investors to place 60% of their capital into stocks and 40% into bonds. Another variation calls for 1/3^rd of your capital in each of stocks, bonds, and real estate with the balance in cash.

Your own asset allocation will be guided by your investment goals and your personal circumstances. If you’re young, you may want to take more risk. But when you’re retired, you might want to take less.

The most important aspect of investing is you must invest!

To earn a return on your capital that outpaces inflation, you must accept some risk and invest for the long-run. What you invest in specifically becomes a lot less important once you diversify and invest with a clear plan in place.