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Saturday, February 19, 2011

My Plan B: Investing for the Long Term

Select Mutual Funds How to invest for the long term
This will probably sound like a boring post, mainly because if you are here you are probably a more active trader, either Forex or Options but I just wanted to change the topic a bit this time to talk about my Plan B. And I call it that way, because, although most of my money will always be working for me in the other areas (Forex, Options) I still think it is a good idea to have another weapon on your side.

As a standard individual, you will always have some money on a savings account. And I don't know your bank, but mine (Royal Bank of Canada) only gives you a 0.75% yearly interest on your savings (With a High e-Savings account). Maybe you can go to other banks, and get 1 point something, or credit unions etc. No matter how hard you look for one. The most you will get will be 3% on a Savings account. And that is per year!!! So pretty much your money is not working for you, it is doing barely nothing.

In Canada there is something called TFSA (Tax Free Savings Account) where you can deposit up to 5000 dollars a year and have that money invested at the same time. All the growth you get is Tax Free. This is very similar to a Roth IRA in the US. My strategy is very simple: Use the power of the TFSA and have that money invested in Mutual Funds, no GICs nor any other shit, only Mutual Funds. Now, which one?

Back in 2008 many retirement accounts with market exposure suffered terribly. 50% down in many cases after years and years of disciplined savings. It was a massacre!

This is the reason why the word "professional" in this industry means nothing. Although the amount of money I will have in this account is not significant by now, I still want to choose a right combination of Mutual Funds to avoid things like the ones that happened in 2008.

So I went to the Mutual Funds performance page of the Royal Bank of Canada and analyzed all the candidates one by one. You can probably do the same with the Mutual Funds managed by your bank(s).

My analysis is very basic and simple. Calculate the average yearly return for every mutual fund in the last ten years. Pay particular attention to the years of deep crisis like 2001-2002 and 2008, where the vast majority of the funds experienced some sort of draw down. Finally figure out which combination of funds would give you the highest yield combined with a decent draw down in case of crisis. Something you know you can psychologically handle. 2008 was a very tough year, and that is good, because it kind of reflects a "worse case scenario" on what you could experience with whichever the funds you decide. Also the MorningStar rating is a good indication of how good a fund is in comparison to similar types of funds. I try to focus in 4 star and 5 star funds all the time.

Many funds have a history of over 20 years. And while I am not going to put my money on a one year history fund, I also don't care about the history of funds 20 years ago. Times change, dynamic of the markets change, fund managers come and go, and funds' goals change over time too. That's why I don't care about history so back in time and prefer to focus instead in the last, say 8, 9, 10 years.

After my calculations were done some funds were in the 2% - 5% yearly return range on average. Some were in the 30% - 40% range of annual return. For the latest group, the problem was the draw down. They all fell strongly in 2008, no exception from -25% to -50%. Imagine what would have happened had you had all your money in one of them!

Those funds that yield less tend to be more secure and perform better in the tough times of the markets. Meaning a good portion of their assets is based on treasury bills and other forms of fixed income that basically means, these funds finance other governments' and institutions' debts. While it is true that these funds yield less, they are safer, and can help your portfolio during times of economical crisis.

So that's it, my basic strategy: Pick the best performing funds (Highest return in a decade and less draw down in 2008) and combine them with other more secure funds. And this is my personal combo. Little disclaimer here: I am not asking you to select any of these investments, and this is just for education purposes.

Average Yearly return   Year 2008
RBC Canadian Short-Term Income Fund3.22%+6.60%
RBC Canadian Equity Income Fund18.55%-18.80%
RBC Canadian Dividend Fund9.70%-27.00%
RBC Global Precious Metals Fund44.70%-26.20%

Past performance is not indicative of future performance. However what else have you got in order to do your analysis? This is all we've got folks. Years of history and numbers, and analysis of worse case scenarios to draw a picture in our minds. With this combination I can expect something around 19.04% in yearly returns on my money. And a possible -16.35% in a deep crisis environment similar to 2008. I personally can live with that. Maybe you can't and this is where your personal flavor comes in.

Now, how much would that mean? I mean How much does it mean to max out my TFSA every year up to $5000 while getting a 19.04% yearly return? The first year the calculation is easy, 5000 x 1.1904. But then it starts to get complicated because next year there is going to be 5000 more growing at this pace plus the whole money from last year, growing again 19.04% more! That's compound interest baby! and it is very powerful! I am 28 years old now, I will be 50 in 22 years.

Using this simple compound interest calculator we have the following result:

There you go 1.4 millions at 50 years old tax free!!! Also this is a TFSA, which is a flexible account, no restrictions as to when to withdraw your money, that's why I don't like RRSPs (no Roth 401K in the US). I know I know,....It is a long wait. But think about it,....if you are going to be 50 some day anyways, isn't it better to get there with 1.4 millions than without them?

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