Be an owner, not a loaner
No matter the business cycle or the trends, there are some things that never change when it comes to saving, building and managing money. Financial Post columnist Jonathan Chevreau presents the fifth instalment of his seven eternal truths of personal fina
Savings is by definition the difference between the amount of money you earn and the amount you spend. To create a surplus, obviously you must spend less than you earn. If there’s a deficit and you spend more than you make, you have the problem of debt. But even if you live frugally within your means and pay yourself first, you’re not going to get rich just leaving your savings in a bank account paying almost zero interest.
Since the financial crisis hit in 2008, interest rates have hovered near generational lows and the pittance that’s paid in bank accounts, or even GICs or money market funds, is unlikely even to match the rate of inflation. If inflation is running at two per cent a year and you’re receiving one per cent in interest, you’re not even treading water: you’re losing money: the “real” return is minus one per cent.
Even worse, what little interest you are being paid will be taxed at your highest marginal rate, just like the last dollar you earn on your salary, or any bonuses.
Rather than loaning your money out through bonds, GICs, savings bonds and the like, you need to embrace the concept of being an owner, rather than a loaner. In practice, being an owner means owning stocks of quality businesses, or equity mutual funds or equity exchange-traded funds providing exposure to a whole basket of such enterprises. Of course, you can also start your own business and be an owner of a bricksand-mortar enterprise or one based on the web. But for the purposes of this article, we’ll assume you’re going to go the diversified ownership route of investing in equities.
A basic axiom of investing (it could even be our 8th truth) is that risk and return are related. Being a loaner supposedly entails low risk, so the expected return is low. Being an owner of a business or equities entails more risk, so the expected return should be higher.
One route would be to focus on quality dividend-paying stocks: these days you can find utilities, banks, pharmaceutical and telecommunications stocks paying dividends anywhere between three and five per cent, which is a far sight better than the one per cent you might get loaning your money out. Stocks also address two big long-term risks facing retirees: inflation and longevity. Over time, you can expect dividend hikes that keep pace or beat inflation, plus growth of the underlying capital.
The bonus is that this higher dividend income is taxed more preferentially than the interest income that goes to loaners. Qualifying Canadian corporations will generate the dividend tax credit that — depending on your income, tax bracket and province of residence — will provide a return roughly double interest income and, on an after-tax basis, as much as triple. Of course, this applies primarily to taxable or “non-registered” investment accounts. The dividend tax credit is wasted if the stock is held in an RRSP or TFSA. U.S. dividends are taxed like interest for Canadian investors, so they are best held in an RRSP.
The other benefit of being an owner rather than a loaner is capital gains. When you’re an owner, you can win twice: once on the dividend (if any) and again if the stock rises in value over the time you own it. For starters, only half your capital gains are taxed (that’s called the 50 per cent “inclusion rate”), so you should be able to keep roughly threequarters of the return from the capital gains.
Secondly, you can avoid even the partial tax as long as you buy and hold the stock without taking profits and “crystallizing” the gain. And third, even if you do choose to take partial profits, you may be able to neutralize the tax consequences by selling an equal amount of another stock on which you’ve suffered capital losses.
Capital losses, you say? Yes Virginia, the downside of all this ownership potential is that you must be prepared from time to time for an investment in any given stock to lose value. Capital gains and even steady dividends are not guaranteed the way a GIC “guarantees” an annual payout of one or two per cent. (guaranteed to lose to inflation, I’d say!)
Depending on how much risk and volatility you can stomach, you’ll want to work with a financial adviser to determine an appropriate mix of stocks and debt instruments. This is called “asset allocation,” which is really just a fancy way of telling you how much you should be an owner, and how much a loaner.